Is a Global Debt Crisis coming soon?

If you enjoy my writings, do follow my Facebook page at "stock-take.blogspot.sg" (https://www.facebook.com/stocktakeSG/). This is a platform where I will share interesting financial stories or articles that I find helpful in increasing financial knowledge and self-development.    

The recent sell off in the equities markets have resulted in some world indices currently in "technical correction", defined as a drop of more than 10%. From the table below, European, Germany, Shanghai, Japan, Hong Kong and Philippines have dropped below 10% from their peak. A few other world major indices from USA, UK, France and Korea are not far from it.

Table 1: Performance of major world indices
Source: Yahoo

There are a few reason for the sell off and one of the explanations was due to the recent job reports in the USA where employee wages grew more than expected. This signifies that economy is growing which is suppose to be good news. Ironically, stock markets were worried that this might result in faster than expected inflation and force central banks around the world to increase interest rates at a much faster pace. So why is this dangerous?

Since the 2008 global financial crisis, central banks have reduced interest rates to near zero in order to encourage borrowings to increase economic activities. We have since lived in a decade of low interest rate environment and we have gotten so used to it that any minor indication that interest rate will be increased creates volatility in the market. 

In accordance to the chart below, due to the low borrowing cost, global debt has jumped by more than 40% (from $147 trillion in 2007 to $199 trillion in 2014). By the end of 3Q 2017, global debt has soared a record high of $233 trillion. Governments and corporations have been identified to borrow intensively at a faster rate before the pre-crisis level.

Chart 2: Global debt by type
Source: Mckinsey Global Institute, Debt and (not much) deleveraging, Feb 15

As companies have much more debt in their book, an acceleration of interest rate will result in increased interest cost and thus impacting on their profits. Whereas for government, more revenue will be needed to pay off debts. This might result in tax increases for consumers and corporate, thus further impacting their financials. 

Taking the world largest economy USA as an example, since 2007, around 15% to 16% of their revenue was used to pay off interest cost. This has dropped to below 13% in 2015, probably due to higher revenue generated as economic environment improved and with the low interest cost. If rising interest cost outpace GDP growth, the interest payment as a % of revenue is expected to start trending upwards. Furthermore, with USA President Donald Trump recently announcing huge corporate tax cut, this is projected to cost $1.5 trillion. If the tax cut doesn't generate higher revenue through higher investment and job creations, this will further increase the financial burden on the USA government. Somehow, someday, someone has to pay for all of this cost and the only way is through taxation.

Chart 3: USA interest payment as % of revenue
Source: The World Bank Group

Also as shown in chart 2, global debt-to-GDP ratio has continued to increase, from 246% in year 2000 to 269% in 2007, and to 286% in 2014. According to Investopedia, GDP is defined as "monetary value of all the finished goods and services produced within a country's borders in a specific time period." When debt is growing at a faster rate than GDP growth rate, this means the country takes on more debt but produce less. This is dangerous as revenue is not sufficient to pay off debt and more debts have to be incurred to pay off existing debts. 

It is expected that debt is going to continue to grow. Based on Institute of International Finance figure, debt-to-GDP ratio stands at 318% in 3Q 2017, though this is a reduction of 3% from its record high reached in 3Q 2016. Fortunately, current global growth rate is expected to continue to grow at a faster pace. According to International Monetary Fund, global growth is projected to rise 3.9% in 2018 and 2019, faster than the 3.7% in 2017. This positive market sentiments have supported the market currently.

Will the soaring of global debt results in another financial crisis? Well nobody knows. In my own capacity, for the coming months, I will follow very closely on economic data such as inflation rate, GDP growth rate, interest rate, etc. I believe the current correction in the market is temporary as global GDP growth continue to support the market. However, with the increased interest rate by US central bank, and if they decides to accelerate it due to higher than expected inflation, this might send shock wave throughout the financial market.  

Below is an interesting and easy to understand video about how the economy works by Ray Dalio. Do watch it and enjoy!