Fix The Roof While The Sun Is Shining On The Global Economy

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Martin Wolf

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The world economy is enjoying a synchronised recovery. But it will prove unsustainable if investment does not pick up, especially in high-income economies. Debt mountains also threaten the recovery’s sustainability, as the OECD, the Paris-based group of mostly rich nations, argues in its latest >Economic Outlook. This report is the swansong of Catherine Mann, who was an outstanding OECD chief economist. It suggests that relief is legitimate, but complacency definitely is not.

The OECD forecasts 3.6 per cent global growth this year, up from 3.1 per cent in 2016. Growth is forecast to reach 3.7 per cent in 2018, close to the 1990-2007 average. The only member of the Group of Seven big economies whose growth this year is not expected to be higher than in 2016 is the UK. China and India are setting the global pace. The OECD monitors 45 economies that generate 80 per cent of global output. Not one is forecast to contract in 2017, 2018 or 2019.

Yet we have reason to question the sustainability of this rate of growth. Throughout the G7, net investment rates are lower than before the financial crisis. The growth of labour productivity is forecast to improve somewhat, yet remain well below its average between 1995-2007. Above all, high indebtedness continues to menace the recovery.

In the high-income countries, the ratio of corporate debt to gross domestic product has stabilised since the crisis in some countries, but continues to rise in others (such as France). Over the longer term, corporate debt has grown faster than the productive capital stock in the US and eurozone. A part of such debt has been contracted in order to buy back shares and so raise their prices. Such financial engineering is a result of the tax advantages of debt and the fashionable link between executive pay and stock prices. Household debt remains high in many high-income economies, including the US and UK.

Emerging economies do not, at least, have high household debt. But many have accumulated substantial corporate indebtedness, much of it in foreign currencies. The ratio of corporate debt to GDP in China is now higher than in virtually all high-income economies. Not surprisingly, ratings of corporate bonds have deteriorated in both high-income and emerging countries.

So what are the risks associated with the persistently high and, in many countries, rising debt? One is that capital is locked up in zombie companies. Above all, beyond a certain point, more credit tends to lower growth and increase inequality. The more immediate risk is that higher interest rates might render currently manageable debt unmanageable. This might generate a second wave of crises. Those would not be so much new crises as a resurgence of the turmoil that hit US and European economies between 2007 and 2012.

One reason for believing this will not happen is the switch from bank lending to corporate bonds. The ability of highly leveraged intermediaries, such as banks, to bear losses is limited. A reduction in the importance of such institutions should make these highly leveraged economies more resilient. Nevertheless, the exposure of such institutions remains significant, not least their exposure to overvalued housing stocks.

A greater dependence on bonds creates its own risks. Emerging market economies are exposed to foreign currency risk. Moreover, if a substantial number of corporations were to tumble into bankruptcy, their banks would also be adversely affected. Large losses on bonds might trigger runs on bond funds and so a cessation of funding, including of needed rollovers. Thus, a transition from bank to bond financing also carries risks in highly indebted economies.

A crucial question is why interest rates might rise. A benign reason would be stronger growth, which should at least improve prospects for many indebted companies and households. A malign reason would be a surge in inflation. If central banks needed to tighten monetary policy sharply some debtors might fall into severe difficulties, as happened in the early 1980s. A tightening in response to surging inflation could trigger waves of defaults and an unexpectedly sharp slowdown. The opposite worry is that central banks might have insufficient room to respond. In all, high debt makes calibrating monetary policy more difficult.

Now that a recovery is under way, it is essential to deleverage economies. A crucial change is elimination of favourable tax treatment of debt. Stock-related pay encourages excessive borrowing: its treatment by the tax system must be reconsidered. More equity capital would make banks less fragile. Emerging economies should, in addition, discourage foreign currency borrowing.

Meanwhile, every effort must be made to raise public and private investment. One of the most important areas for increased investments is housing, though without stoking the sort of boom seen in Spain before the crisis. More broadly, it is important that the upswing be led by investment if it is to be sustained. Public investment will have to play a part in this, especially to improve infrastructure and support vital scientific and technological progress.

Low investment and high indebtedness are not the only constraints the world economy faces. Political risks are also high, as are threats to liberal trade. But raising investment and lowering debt are high priorities. As President John F Kennedy said in 1962, “the time to repair the roof is when the sun is shining”. It is essential to hack off the overhangs of unproductive private debt bequeathed by the crisis and its aftermath. The transformation will not happen overnight. But we should eliminate the incentives for such risky behaviour.

Letter in response to this column:

Kindly allow CFOs to know better about payout and investment policies / From Théo Vermaelen, professor of finance, Insead

This is source I found from another site, main source you can find in last paragraph

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