Nick Martin's Marketing Pages

Now for Public Deleveraging

Nearly 2 years ago I wrote about the risks of a double dip recession. 

Here's what The Economist  had to say about likely economic impact of debt reduction, in a study released in January 2010.

It (the study) finds 32 examples of sustained deleveraging (at least three consecutive years in which ratios of total debt to GDP fell by at least 10%) in the aftermath of a financial crisis. In some cases the debt burden was reduced by default. In others it was inflated away. But in about half the cases—which the report regards as the most appropriate points of comparison—the deleveraging came through a prolonged period of belt-tightening, where credit grew more slowly than output. The message from these episodes is sobering. Typically deleveraging began about two years after the beginning of the financial crisis and lasted for six to seven years. In almost every case output shrank for the first two or three years of the process. 

Bang on cue, we are in all probability now entering a new, massively significant phase of debt reduction, two years on. That's why the banking crisis that became the soveriegn debt crisis may once again turn into a painful liquidity squeeze.

Whilst quantitative easing saved the world from depression - effectively replacing money supply growth that in the normal course of events would be provided by business investment - countries now have no alternative other than to reduce levels of public debt. The fact we've finally reached the point of unsustainability is evidenced by the urgency with which countries need to manage the rates at which they borrow, and to rebuild shattered investor and investment confidence.

As public debt is deleveraged, we must hope that the process of private debt reduction is nearing the bottom. If not, another recession is surely all but guaranteed. That's why everything must be done, however radical, to encourage private sector investment and hope for a rapid return to more predictable functioning of markets.

Dangerous 'peep show' of EU banking sector

A second round of EU banking stress tests - designed to bring transparency and hence confidence to shore up confidence in the eurozone, may well have served simpy to score another own goal.

The European Banking Authority said eight of the 90 banks it examined fell short of the required amount of capital under the tests' simulations of a deep, two-year economic downturn. Those banks faced a total shortage of €2.5 billion ($3.54 billion) of capital.

Compare these results to the last set of stress tests conducted a year ago that saw 7 banks fail, with a combined deficit of €3.5 billion. If this first attempt at flushing out banks with shaky foundations failed to inspire market confidence, do we really think this year's much vaunted round of weighty stats will do any better, the analysis of which adds just 2 more banks to the 'at risk' register with a valued shortage in Tier 1 Capital of a measly €2.5bn?

Sure, banks have raised tens of billions in the intervening period to increase their financial cushions, but is it enough if leading indicators deteriorate? Have current asset values on banks' balance sheets in the property markets of Southern Europe been factored in, or are lenders holding back on write-downs? 

If stress tests are meant to determine the ability of banks to withstand the worst realistically imaginable scenario, how meaningful are the tests when they exclude the shock of a debt default by Greece or Portugal? Whilst such a default may be politically unpalatable, that isn't a good reason not to countenance it. What happens when the strengthened EU Stability Fund comes knocking asking for banks to take haircuts on their holdings of debt, assuming they've not already been sold on to the next institution down the line?

These sorts of impossibly difficult questions point to some of the potential challenges we might face in the months to couple of years ahead. In this scenario, we can expect stuttering growth, with sluggish consumer spending as banks restrict outflows and households pay down debt at record rates. The dismantling of rocky high street retailers will surely continue with an outcrop of liquidations in the faltering weeks following each quarter end.

This isn't to say that the EU banking sector is at risk, but simply to point out that lending to business and funding the consumer, whilst strengthening their own balance sheets and ensuring that they can transparently meet the stress tests' criteria are incompatible goals, with lending certain to take a back seat to the more pressing factors.

Meanwhile, companies will increase focus on investments that have a direct and immediate return. Firms that have built up strong cash reserves are in a wonderful position to pick and choose their moves and are very well placed for a consumer uptick, whereas those that are tight on cash will surely draw in their horns. This is the perfect backdrop for disruptive innovation, driven by market appetite towards lower cost, more transparent and direct ways of delivering value to buyers. In this context, business & marketing innovation, stellar reputation and strong cash flow truly matter.

Welcome to 2011

I unapologetically reproduce an economic viewpoint for 2011-12 from a Chinese source (Andy Xie: my1510.cn) since continued short term economic relative stability is surely inextricably linked with China. Before you question what an economic piece is doing in a marketing  blog, let us just agree that the global economic context affects market behaviour and business priorities. In any case, it makes for fascinating reading!

2011 may look like 2010, beginning with hope, sliding into fear in the middle, and ending with hope again. Read more....

Basle III - Banks mauled by sheep

So the regulator's tough love turned out to to be missing the tough bits. The banking lobbyists can claim a comprehensive victory. 

Even proposed Chinese regulation makes Basle III look tame. The long implementation window of 2013-2019 presumably is a tacit admission that the banks won't lend anytime soon if they are entirely focused on rebuilding their balance sheets, no matter how severe the exhortations of Government. It's a fingers crossed strategy: demonstrate greater long-term rigour whilst praying to God for no more near term banking crises.

Banks Wriggle On Hook Of Basle III

The Financial Times reports today that 'economic growth in the eurozone, the US and Japan would be cut by 3 per cent between now and 2015 if current proposals to force banks to hold more capital and liquid assets go forward unchanged, the world’s leading banking industry group warned Thursday.

As a result, 9.7m fewer jobs would be created in those areas over the period, according to an impact assessment issued by the Institute for International Finance at a meeting in Vienna.

The industry group is pushing hard for the Basel Committee on Banking Supervision to water down or at least delay implementation of the proposals, which are slated to be voted on later this year.

According to the IIF, the eurozone would feel the largest impact from the new Basel proposals with growth cut 0.9 percentage points per year, resulting in a cumulative reduction in gross domestic product of $920bn or 4.3 per cent by 2015. The US would see a cumulative reduction of 2.6 per cent ($951bn) and Japan would see a 1.9 per cent cut ($130bn). The group did not look at the impact on the UK or Switzerland.

“There is a price for making the banking system safer and more stable, and that price will inevitably be borne by the real economy. The challenge is to strike the right balance, to get the maximum benefit for the minimum negative impact,” said Peter Sands, chief executive of Standard Chartered and chairman of the IIF committee on effective regulation.'

The fears relate to money supply. If banks cannot leverage their equity base, called Core Tier 1 Capital, to lend money (increasing the risk-weighted & assessed assets on their balance sheet) then they shift focus from lending to shrinking their balance sheets.

This is already happening, both in respect of commercial and consumer lending, and Basle III rules will make it worse. At what point will banks also have to write down more of the value of their assets (since many will have dropped in value in the last 2 years)?

What's worrying is if in background The Institute of International Finance (IIF) is genuinely fearful for some of its members, squeezed by the likely need to write down assets anyway, and by the added requirement to get to a equity to asset ratio that is more demanding than currently. It is the resulting solvency concerns that are really very serious. 

All this means less investment lending from banks, which in turn means that money supply will continue to be squeezed, and therefore growth is likely to remain subdued until banks' balance sheets are repaired.

Since state spending has run its course, it can no longer afford to continue to prop up GDP growth via employment and other initiatives. We have seen very clearly this last month that governments that do not show a real appetite for reining in their runaway deficits will get hammered by the markets. Their is in effect no choice other than fiscal restraint.

Consumer spending is unlikely to pick up the baton soon, and statistics showing consumers are paying down debt faster than ever, is probably counting banks' cutting down their loan books and defaulters. Of course, whilst interest rates remain historically low no one is in screaming pain, but that would change with any creeping inflationary pressures.

Whether this means that a double dip, takes the form of another fall in GDP in certain countries or prolonged subdued overall economic activity (what commentators are calling a lost economic decade) remains to be seen. 

On the positive side the WSJ has reported a Federal Reserve statistic that nonfinancial companies had socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26% from a year earlier and the largest-ever increase in records going back to 1952. Cash made up about 7% of all company assets, including factories and financial investments, the highest level since 1963. 

In today's world, cash is most definitely king. The vogue of leveraged organisations belong to a not-so- distant past. Anything that can reduce operational costs is therefore more attractive than ever. Combine that with the sea-change in consumer and buyer behaviours and the corresponding commercial need to engage with markets quite differently than in the past to sustain and defend a customer base, and you can see why companies are attracted to innovative solutions that improve marketing operational performance and outcomes.

There is undoubtedly money to invest, whether in the form of companies cash reserves, venture capital, or private capital; just not in the things we've always done the way we've always done them.

Planning for the double dip

Roger Martin-Fagg delivered a revealing workshop at Ashridge management school on the current state of the economy and where we go from here.

His principal theme is that money supply into the economy has dried up, which in mature economies is the primary driver of GDP. Whilst growth turned fractionally positive in the last quarter of 2009, that included the effect of £200bn of new money supply in the form of Quantitative Easing this fiscal, and the massive benefit to the economy generated by the car scrappage scheme, due to end this month. How dramatically would have GDP fallen were it not for all the money pumped into the economy via Government measures? Martin-Fagg believes it would have been apocalyptic without these unprecedented steps.

Here's the catch. In order for money supply to grow back to the 7-11% annual trend growth needed to produce 3%+ annual GDP, the banks need to start lending again. However, they can't, whatever the exhortations of Government, as long as the value of assets on their balance sheets are overstated. UK banks in particular continue to deleverage their balance sheets, and will discretely write down (or write off) parts of their asset base for a while longer in order to build up their Core Tier 1 Capital base and sweep the rest of the bad news under the carpet. Lending therefore will be severely constricted from its traditional source whilst the banks' capital base is insufficient. That can only get worse as global rules tighten, as they will when Basle III requires them to decrease leverage ratios further.

Meanwhile the consumer expects taxes to rise over the next few years whoever forms the next Government, so are paying debt down as fast as they can. Unused debt provisions extended to individuals in the expansionist prior decade are also being withdrawn by banks. 

Quantitative Easing aside, Government has been consistently increasing investment in the economy since early 2008. On the other hand business investment has fallen to around -12% in the last two quarters, and exports have not sustained their growth, so the only thing preventing the economy from shrinking is Government spending. Guess what's going to happen after the May election? Pressure on Government to reduce public sector net borrowings will intensify, leaving very little stimulus left to prop the economy up.

The net result, Martin-Fagg argues, is a further recession in 6 months' time accompanied by further quantitative easing.

He is not alone. A report from the McKinsey Global Institute shares his behavioural-led approach, and realistically highlights at least 2-3 more years of deleveraging.

Here is The Economist's summary of what it means:

Assigning the odds of further deleveraging is not the same as gauging its likely economic impact. To do that, the study looks to history. It finds 32 examples of sustained deleveraging (at least three consecutive years in which ratios of total debt to GDP fell by at least 10%) in the aftermath of a financial crisis. In some cases the debt burden was reduced by default. In others it was inflated away. But in about half the cases—which the report regards as the most appropriate points of comparison—the deleveraging came through a prolonged period of belt-tightening, where credit grew more slowly than output. The message from these episodes is sobering. Typically deleveraging began about two years after the beginning of the financial crisis and lasted for six to seven years. In almost every case output shrank for the first two or three years of the process. 

The Solid red circles on the above chart represent household debt ratios at over 300% of GDP. This compares with 286% after the Second World War. In other words, at a record high comparable with or worse than the worst prior scenarios.

All this means that the economic characteristics over the next few years point to slowdown, asset price stagnation (including property prices), therefore low levels of corporate borrowing and consumer lending, along with higher taxes. 

In business terms, Martin Fagg's predictions are as follows:

1. There will be a wave of innovation across all sectors — creative destruction — as new ways of creating value drive out old, less effective and less efficient business models.
   
2. There will be a marked change in social values and preferences from consuming to being; from transactions to relationships. Trust will be a key differentiator. This will be particularly noticeable in the under 35 age group. Businesses will be required to demonstrate their green credentials and apply more sustainable business models to attract customers — particularly in this age band.
   
3. There will be a significant increase in business failures and start-ups.
   
4. The banks will be bypassed by informal networks of business people linking entrepreneurs with funding.

Taken in context of the long tail theory, this may yet be the best ever time to be specialised and entrepreneurial.