Russell Napier joined a recent edition of FS Insider to discuss the rising global debt levels and fears of a systemic banking crisis. He said the common wisdom of debt-to-GDP ratios tell a misguided story and explained where the starkest examples of debt overload can be found around the world.
Napier is the author of the global investment report, The Solid Ground and is the co-founder of the investment research portal ERIC: Electronic Research Interchange.
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Too Much Debt?
While there is a massive amount of debt in the global system—the world's total debt-to-GDP ratio is near an all-time high— Napier said that ratio is not a good indicator of upcoming instability. Rather, a more prescient indicator in forecasting a financial crisis is the growth in debt-to-GDP relative to trend. And by that measure, 43% of the world's GDP is signaling that we might have a systemic banking crisis.
“The general rule—that there's too much debt—isn't always true,” Napier said. “Sometimes there isn't too much debt. But clearly where we stand today, there seems to be far too much debt in the system.”
Misallocation Increases Amid Low Interest Rates
When interest rates are low, fraud and capital mismanagement tend to increase. Napier said this is a direct result of the hunt for yield and based on historical examples, humans are hard-wired to seek at least four to five percent yield return. Couple this observation with the fact that at no time in recorded history have we seen interest rates this low for this long, and it is easy to understand why misallocation of capital is becoming a problem.
The search for yield is becoming excessive, especially in Europe, where institutions and banks are dealing with negative yields. While most think of banks when they consider the impact of low or negative yields, these conditions are also detrimental to life insurance companies and pensions.
As rates head ever lower, liabilities increase because it becomes more difficult to discount future payments in a low interest rate environment.
“One of the great lessons of modern financial history is that when something goes wrong, a German financial institution is one of the first to be involved,” Napier said. “They tend to have the lowest interest rates and therefore they tend to be more aggressive in searching for yield or more needy for yield. … Interest rates have been low or negative for a long time. I'd be surprised if those institutions haven't been a little bit too aggressive buying assets with yields … that will turn out to be quite risky.”
Flagging a Systemic Banking Crisis
Roughly 43% of the world's GDP is signaling a possible systemic banking crisis and the problem is perhaps most pronounced in China. This analysis comes from the Bank for International Settlements, which has constructed a detailed database including private sector debt going back 20 years. The study found that growth rate and debt-to-GDP relative to trend are indicators of a potential systemic banking crisis within three years.
“Canada, Turkey and China are all flashing red on both. … There are quite a lot of other reds and the countries that I think really stand out are France, Belgium, the Netherlands and Finland. And that surprises people because they're inside the Eurozone and that really is a big problem,” Napier said.
China’s Red Signal
China’s inclusion in the list of countries signaling increased risk of a systemic banking crisis is especially notable for several reasons. For one, information coming out of China is notoriously unreliable under the Chinese government’s control.
China has become increasingly totalitarian under President Xi Jinping . China is looking for more control, in a bid to reduce uncertainty, Napier said. In a totalitarian system, information is opaque which sends false price signals, and ultimately leads to the misallocation of capital. This appears to be happening on a large scale in China now. The Chinese and foreign investors are buying faux certainty for the price of an increased risk of systemic banking collapse.
“When you're charged with investing capital for the future, do you really want to put it into a regime where prices and information are not flowing freely, and where the wrong signals are going to the wrong place at the wrong time?” Napier questioned. “It's in praise of uncertainty to say that, in an uncertain world, prices help us allocate resources. And in a certain world—and that's the world I think China is trying to head back to—history tends to suggest it helps us misallocate resources.”
While foreign investors have piled into China for years, another group of investors have signaled a counter bet, which may be worth attention.
“There are capitalists who understand China very well, and these are the Chinese citizens themselves, who are actually taking money out of China,” Napier said. “I’ve been covering emerging markets for 30 years, and when there's a debate between the local taking money out and the foreigner putting money, in the long run, the local is always right.”
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