The financial crisis of 2007 wiped trillions off our global financial ledger. National economies reeled in the wake of banking’s biggest boo-boo since Reagan’s deregulation of the American Savings and Loan industry triggered the failure of almost two-thirds of the 3,234 savings and loans institutions in the United States from 1986 to 1995. Now, sovereign debt threatens to break the back of our world economy. How did we get here?

Two years after Lehman Brothers went under and TARP bailouts gave banking executives bonuses and share buyback plans, the general consensus for economic recovery for the rest of us involved austerity and cheap debt.

With interest rates falling to zero, corporations and countries across the globe loaded up on loans and the Euro zone was no exception. Credit given to the European private non-financial sector made up 165% of the region’s GDP by Q4 2009 and EU public debt ballooned to 83.3% of GDP in the same period. Problem was most of this borrowing was to spend, not to invest.

Meanwhile traders began touting the economic promise of BRICS or the Brazil, Russia, India,  China and South Africa super-combo that was supposed to emerge and evolve into the next global financial hegemony. Emerging markets were where it was at, but nobody seemed to notice the build up of blood red ink on BRICS’ bottom line.

BRICS’ burdens

Map of China on Earth in the national colors (doesn’t really look like this)

All anyone could talk about was China’s endless appetite for consumption which had been whetted with the implementation of a 4.0 trillion yuan stimulus program in 2009 and 2010 worth approximately 11 percent of the country’s GDP at the time.

This building splurge was thought to be an integral actor in preventing the global economic recession that was already in full effect from getting any worse.

Paul Krugman, a celebrated American economist and professor of economics at the Graduate Center of the City University of New York, wrote in 2010 that China’s balls-to-the-wall infrastructure push was a “much more aggressive stimulus than any Western nation – and it has worked out well.”

While everyone was singing praises, they forgot to look at how the Chinese were funding these stimulus ventures. Local governments are prohibited from borrowing or running deficits, but they got around this snag through a special dispensation from the central committee which allowed them to form off-balance-sheet companies known as local financing vehicles (LFVs).

Local governments would then use these entities as intermediates. For instance, transferring ownership of government-controlled property to the LFV. The LFV would then use the land as collateral when borrowing from banks and shadow banks or as the basis for the issuance of bonds.

Needless to say, China went credit crazy and no one really knew how bad it was because most of the debt was off-balance-sheet in a LFV. In the heady days of wanton development between 2011 and 2013, Zhōngguó poured 6.4 gigatons of cement. That’s more concrete than the United States used in the last hundred years.

The Oxford Handbook of Megaproject Management editor, Professor Bent Flyvbjerg, noted in the last 90 years, 90% of all mega construction projects miss deadlines, cost more than budgeted and their societal benefit doesn’t necessarily outweigh the challenges and costs of their construction.

There are examples all over the world of protracted megaprojects like the Sydney Opera House which came in 10 years late at 14 times the original estimated cost of $7.0 million or the English Channel Tunnel which went 80% over it’s budgeted cost of £4.87 billion.

China’s off-balance-sheet spending made up 11 percent of GDP by 2015, but unfortunately for the Chinese people, greed took control of LFV operators. Of the 11% that was dispersed, only 2.4 percent was spent on local infrastructure while the remaining 8.6 percent went on to fund private commercial projects.

Just how much Chinese sovereign debt is out there waiting to go bad is hard to determine, but according to the National Audit Office (NAO) of the People’s Republic of China, the country’s governing bodies are legally on the hook for 10.9 trillion yuan or USD$1.5 trillion. That only covers direct debt, though.

According to China’s Ministry of Finance, the ratio of government debt to GDP would increase from 39.4 to 41.5 percent if the government was responsible for 20 percent of indirect debt. Editors for the Fall 2016 edition of the Brookings Papers on Economic Activity determined this would infer an indirect financial obligation of 7.1 trillion yuan for a total local government debt of 23.1 trillion yuan or USD$3.2 trillion by the end of 2015.

Nobody knows the true number on this unless they were able to individually go through the books of over 7,000 LFVs operating in China. The Chinese central government has issued numerous decrees in an attempt to curb LFVs and have even taken a “dredging and blocking” strategy in the hopes of eliminating LFVs in the next three years by replacing their debt with local government bonds.

Not gunna happen. In fact, Chinese banks doled out a record 16.17 trillion yuan or USD$2.3 trillion in new loans last year. Now its attempting to stimulate lagging economic growth that fell 0.02% from a record low in 2018 to rest at 27-year low of 6.2%. It is also expected that China’s economic expansion will shrink to 5.5% by 2024.

Oh boy, that doesn’t bode well for creditors.

India’s Taj Mahal. It really does look like this

India was thought to be a shining star of the BRICS collective, but it too fell victim to senseless economic growth powered by sovereign debt and corporate chicanery. Like China’s LFVs, India’s NFBCs or Non Banking Financial Companies, are helping to bring the emerging economy to its knees.

India’s shadow banking system was, and is, rife with corruption. The Infrastructure Leasing & Financial Services (IL&FS) scandal which came to light late last year illustrates just how broken India’s financial system actually is.

Ravi Parthasarathy Courtesy: India Times

Ravi Parthasarathy ruled over IL&FS with an iron hand, intimidating both journalists and company directors since the corporation sprang from a infrastructure white paper penned in the 80s. Parthasarathy used a web of 300 companies to borrow from banks, mutual funds and pension pools.

After running through the initial World Bank loan, Parathasarathy and his army of managers, enacted what could be termed as a pyramid scheme where monies raised currently would be diverted to pay for past projects instead of funding new ones.

In keeping itself alive, IL&FS accumulated more than Rs 5,200 crore or USD$724.3 million in debt by 2017. Failure on behalf of auditors and regulating bodies, like the RBI, left management alone to cover up its felonious activity for almost four decades.

A year after IL&FS took the long walk off a short pier, India’s debt crunch hasn’t improved much. The country’s farmers are locked in a debt trap and certain state governments have handed out loan waivers on three occasions since the scheme was implemented in 2008.

Between 2014 and 2018, 11 states announced farm loan waivers totaling more than a trillion rupees or USD$12.75 billion. Many small farmers in India live in a world of debt, having to borrow to buy seeds and equipment, it would seem like a smart idea to allow them to write off some of their fiduciary commitments so they can keep their head above water, but there are more hindrances to the agricultural and banking sector than benefits.

For instance, debt relief schemes create an environment of expectation where farmers not included with the program may think its only a matter of time before someone cancels their debt too. This happened in 1990 when the central government announced a nationwide loan waiver.

As a result of this “humanitarian” move, there was a decline in the rate of recovery of non-waived loans by financial institutions. Everybody wanted a piece and banks suffered as recovery rates in one state went from 75% to 40% within the space of a year after the waiver was announced. Now that politicians promised another national farm loan waiver program in 2019, banks will once again take it in the teeth.

However, as much media attention as farm loan waivers get, India’s corporate debt is the real elephant in the room. In fact, total credit to industries was Rs 27 lakh crore in 2018 which is 35% of the total credit given to companies and individuals that year. Agricultural credit amounted to Rs 10 lakh crore, making up 13-14% of total bank credit given. India’s billionaires are more in debt than its farmers. Not good and it’s getting worse.

Macrotech Developers, India’s largest real estate developer, grew its debt 13% to 25,640 crore or USD$3.6 billion in FY 2019. It was also reported in September that the ailing conglomerate laid off up to 400 people to combat a liquidity crunch, the company’s mounting debt and a slumping real estate market. According to rating agency, Icra, Mumbai carries 45,000 crore or USD$6.27 billion of unsold residential units in the city.

No one is buying, no one is building and Macrotech had to pass on a planned IPO that would have raised 4,500 crore or USD$627 million to repay some of that debt. The defaults are coming, not only for sovereign debt holders.

Christ the Redeemer looking over Rio de Janeiro, Brazil

Brazil’s foreign policy with Bolsanaro isn’t necessarily conducive to the BRICS collective with its protectionist ideals and focused effort to topple Maduro’s rule in Venezuela. The removal of Maduro, who has friends in Beijing and Moscow, will most likely sour Brazil’s relationship with BRICS formative heavyweights.

Bolsonaro has proudly announced he is anti-globalist, taking a page from Trump’s ham-handed attack on world trade. Populist politics aside, Brazil’s bottom line is leaking red and bloated with debt. Since 2006, the country has hovered around 50% sovereign debt to GDP but in 2013 that ratio took a decided upward trajectory, ballooning to 77.22% by 2018.

Brazil isn’t doing well the moment, socially, having secured the title of the most violent south american country. Bolsonaro’s Social Liberal Party cabinet is a who’s who of corrupt cranks including revisionist education ministers, military drug mules, an alleged colluding ex-judge.

The economic outlook isn’t that great either as this month Brazil’s central bank pulled back their projections for GDP growth by over half, going from 2% to just 0.8%. Brazilians have lost faith in this administration’s ability to deal with its economic woes as illustrated by recent polls.

Bolsonaro’s only tool is force and even though the murder rate dropped again this year by a fifth after already dropping in 2018, there is little to no correlation to Bolsonaro’s preference for dead criminals and rampant police brutality.

In fact, experts surmise the cease fire in a gang war between the Capital Command and Red Command criminal organizations led to the drop in homicides across the country. Oddly enough, in states where police brutality was the highest, the murder rate actually grew or dropped less than the national average.

As the future of Brazil depends on the health of its ailing economy and reduction of its sovereign debt, Bolsonaro’s ineffective populist antics and the continued lethargy of global trade won’t help it establish a position within the BRICS pact, never mind maintain a leadership role.

The PIGS of EU

Italy’s recent bond sale gives the impression that the once sickly EU member is on the mend, but appearances can be deceiving.

Giuseppe Conte’s new “yellow-red” ruling blend with the Democrats is a far more moderate mix than the right-leaning Salvini-led “yellow-green” coalition. Conte isn’t interested in breaking from the Euro or thumbing his nose at Brussels.

It is this compliance, not economic fundamentals, that triggered the success of Italy’s US-dollar-dominated bond offering which brought in more than $18.0 billion in orders, but only sold $7 billion in 5-, 10- and 30-year notes as well as $2.0 billion in 10-year notes.

Otherwise, Italy remains in economic uncertainty. Even though Italy was a post-war growth story whose per capita income surpassed Britain in 1989, it has slipped into recession twice since the 2009 global financial crisis and its per capita income hasn’t moved an inch in the last 20 years.

That’s not all, the country’s sovereign debt totaled $2.7 trillion back in July, making up 132% of its GDP – second only to Greece. Growth continued to be flat in H1 2019 and Q3 data is unimpressive.

Sovereign debt weighs heavy on unemployment as it continues to hover around 10% compared to the Eurozone average of 7.5%, but youth unemployment (15-24), which sits at 28%, dwarfs the Eurozone average of 15.4%. Whether its correlative or causative, there are five million Italians living below the poverty line and the distribution of that pain runs disproportionately along a geographical divide between north and south.

To make matters, the new government has to reduce spending by $23 billion by January 1, 2020 or face increases in its value added tax (VAT) regime. The 2020 budget that was just announced promises to do that and is waiting for approval from Brussels. Whether that budget is possible or based on a fantasy remains to be seen as it still hasn’t been released to the public.

Budgeting and taxation become especially thorny considering Italy has a $200 billion dollar grey market shadow economy which grew out of the 2009 financial crisis that it needs to be brought into the light if the government hopes to meet any of its fiduciary commitments to the EU in 2020.

Italy’s bond popularity is a dead cat bounce against a crappy global outlook, not recovery. This doesn’t bode well for the Eurozone banking system as it is heavily exposed to Italy’s outcome.

Catalan protesters

Spain is in political chaos as it attempts to quell violent protests after the country determined last week it would jail some high profile Catalan secession activists for up to 13 years.

This turmoil sits on top of a sluggish global economy which the IMF forecasts to slip to 1.9% in 2020 from 2.2% in 2019. Unemployment figures have improved somewhat, but they’re still an economic black eye at 13.8% in August this year. This dismal rate is more than Italy and France which sit at 9.5% and 8.5% respectively.

Unfortunately for Spain the IMF has predicted its unemployment rate will increase to 14.3% in 2020. This doesn’t speak well of the fourth largest economy in the Eurozone whose sovereign debt makes up 98.9% of its GDP.

Spain produces 20% of the world’s olive oil and olive farmers are getting hammered by plunging prices, often selling bottled oil for less than it cost to produce. Now they have a new 25% tariff to look forward to on EU goods going to the U.S.

Consumers may be spending more, but they also got a 22% hike to Spain’s minimum wage this year. This shot in the arm may not be sustainable perhaps illustrated by the more than 50,000 Spaniards who lost their jobs in August.

Speaking of employment, Spain also has a shadow economy worth 190 billion Euros or USD$224 billion annually. Second only to Italy’s grey labor market, Spain’s under-the-table business segment could add as much as 20% to the country’s GDP.

Adding insult to injury, domestic car sales in the country dropped 31% in August compared to the same month a year earlier and automobile exports remain flat. Bad news for autoworkers who make up almost 10% of Spain’s employed.

The Spanish government just published its plan to stabilize growth. It intends to reduce sovereign debt to 95.9% by the end of 2019 with the goal of reducing sovereign debt further to 94.6% by the end of 2020. However, like most government promises, they didn’t clearly state how they would do that.

Despite this sunny projection, analysts still call for continued deceleration in Spain, naming trade conflicts, protectionism and weakened political will as reasons.

The staggering sovereign debt accrued by the BRICS and EU members in a bid for growth has evolved into a millstone around their respective necks. Interest rates, trade disputes and global economic lethargy threaten to topple this fiscal house-of-cards, but is that an entirely bad thing?

With Trump’s foray into anti-globalization and the resulting tariff wars, do trading blocks like BRICS or the EU really empower their members or subjugate them? Is regionalism the answer? Is sovereign debt a problem to be solved? Should globalization be taken behind the barn and put out of its misery or just Trump? The next 12 months are going to be very interesting…

 

–Gaalen Engen

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Gaalen Engen

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Spyrock

Great Piece Gaelen. What an extensive piece!