2012: The Year of Debt Restructuring

Over the next twelve months, expect unsettling developments, EconoMonitor reported. The global crisis is still unfolding, and it could escalate. Weakening growth, rising systemic risks, and contagion-prone markets are likely to enhance economic and financial fragility. We are entering a perilous new phase.

First, growth will remain below potential, hindered by excessive debt. Since 2000, total world dues – the debt globally held by governments, corporations, and households – doubled (from 32 to 63 percent of global output), mostly in developed economies. This rise fuelled international growth for more than a decade but now, to avoid a structural deceleration of global activity, the balance is due. In other words, public and household balance sheets are overstretched by excess leverage. Deleveraging, essential to return to pre-crisis levels of per-capita income, will weaken growth.

In 2012, the world economy is expected to grow at a frail 3 percent. Advanced economies face anemic prospects. Fiscal austerity – underway in Europe and much-needed in the US – and a credit crunch due to tighter bank lending will curb the recovery.

Second, downside risks are rising: too many issues remain unresolved, and policy is out of steam. The massive stimuli – fiscal injections, interest rate reductions, QE – that kick-started the recovery in 2009 are to be progressively withdrawn. Across the Atlantic, policy makers will be forced to address structural economic issues, but the political process will delay difficult decisions. Global demand could be weakened further by negative feedback-loops between high debt, fragile sovereigns and banks, fewer jobs and social grievances, insufficient rebalancing, higher uncertainty and lower confidence. Over the course of the year, a few negative shocks are to be expected.

To clean up balance sheets, debt needs to be paid down or restructured. Political and economic considerations will determine who will pay. The private sector will face tax increases. Workers will suffer high unemployment and declining wages. In absence of sustained growth, creditors will face debt-restructuring, a wealth transfer to their debtors. In the EU, Germany will have to forgive peripheral-debt and guarantee central government debt of core countries. In the US, negative-equity mortgages will need to be written-down.

Third, global markets will operate in a jittery landscape. Europe’s challenges will keep investors worried. Italy could become the largest source of contagion. Concerns about sovereign debt and banks’ balance sheets, widespread downgrades of earnings and credit ratings, rising systemic risks and elevated correlations will restrain financial flows and spark periodical sell-off of risky assets. The strong corporate sector’s financial position and the weakness of the economy will favor mergers and acquisitions (M&A). In bond and equity markets, a “home bias” will persist. US Treasuries will remain a refuge, with yields at 2 percent or below. If further stimuli measures do not get enacted, equity performance will suffer economic stagnation, underperforming bonds. Alas, policy makers will not be able to supply the same amount of liquidity they provided in late-2008. As inflation will continue to ease globally, central banks will indeed cut rates, but will not significantly grow the monetary base. Budget constraints and political impasse will hamper fiscal expansion. In the EU, the ECB will walk the fine line between moral hazard (printing money and buying bonds would lift pro-reform pressures from the periphery) and financial instability (markets dislike unsustainable rises in bond yields). Article 123 of the Lisbon Treaty, also known as the “no bail out clause”, forbids the ECB to print Euros in order to be the lender of last resort. In the US, further QE is possible, with the Fed creating more money to buy financial assets, but the policy has become controversial, as it is unclear that previous rounds could lift the real economy. Read more.