Descending a mountain of debt

By Richard Dobbs, Susan Lund and Anu Madgavkar

In the past, a perennial fear in the global financial system was that an emerging market nation would crumble under unsupportable debt and spark a contagious financial crisis. The credit bubble's collapse in 2008 showed that such fears were well-founded—but geographically misplaced. Instead, it was the unmanaged debt of mature economies that led to a global financial crisis, and continues to hamper the global economy today, write Richard Dobbs, Susan Lund and Anu Madgavkar in Mint.

How mature economies manage their debt overhang will determine the pace of global growth in the years ahead.

In the past, a perennial fear in the global financial system was that an emerging market nation would crumble under unsupportable debt and spark a contagious financial crisis. The credit bubble's collapse in 2008 showed that such fears were well-founded—but geographically misplaced. Instead, it was the unmanaged debt of mature economies that led to a global financial crisis, and continues to hamper the global economy today.

In the next few years, how successfully the largest mature economies address their debt overhangs will determine the pace of global economic growth. Some of these countries face debt ratios of 300-500% of gross domestic product (GDP) (compared with 122% for India). They must carefully reduce this debt without choking off recovery and global demand. Thus far, they have been spared the forced deleveraging that many developing economies have experienced in the aftermath of debt crises—rapid contraction in bank lending driven by acute funding and capital shortages cutting off investment and growth. The euro zone crisis serves as a reminder of such risk.

Even controlled deleveraging can dampen growth, which is why the rest of the world should pay close attention to large mature economies such as the US and the UK. In our research into relevant historical deleveraging episodes, e.g., the cases of Sweden and Finland in the 1990s, deleveraging has proceeded in two phases. In the first, the private sector (households, corporations and financial institutions) reduces debt, but consumption and investment are slow and GDP growth is low or negative—typically raising government deficits. In the second phase, GDP growth rebounds and governments begin the long process of paying off their debt.

Tracking how mature economies are deleveraging, will give business leaders in India insight into where and when growth is likely to accelerate. Of the 10 largest mature economies, we found that the US has made the greatest progress in private sector deleveraging. Household debts, the largest category in the US, have fallen by more than half a trillion dollars, thanks largely to defaults on mortgages and consumer loans. The ratio of household debt to income has fallen by 15 percentage points, leaving US households with perhaps two years or less of debt reduction ahead. Households in the UK and Spain have made less progress and may face many years of paying down debt.

But household debt is only one metric to watch. In Spain, for example, it may be more useful to watch the corporate sector. Spain's non-financial corporations have a ratio of debt to national income that is 20% higher than in France or the UK and three times that of German firms. Those debt loads may inhibit the ability of Spanish companies to invest and generate new growth.

The historic episodes in Sweden and Finland show six markers that countries are ready for the second phase of deleveraging: the banking system is stable and banks are lending; there is a credible plan to reduce government debt; structural reforms are in place; exports are rising; private investment is recovering; and housing is stable. Today, no country has reached all six. The US has neither adopted a long-term plan to address government debt, nor has its housing market stabilized; home prices continue to fall in some regions and housing starts are one-third of their long-term average. The UK has a debt plan and a healthier housing market, but has yet to see non-financial corporations begin to invest in expansion.

In Sweden and Finland, structural reforms were critical to unleashing growth. Both countries joined the European Union in 1995, which helped attract new domestic and foreign investment and set the stage for stronger export growth. Sweden enacted a variety of reforms in retail and banking to make those sectors more competitive. Today's deleveraging economies have similar opportunities. The US, for example, can attract more foreign investment by speeding up regulatory processes and can raise its export volume by making it easier for tourists and foreign students to enter.

For emerging economy globalizers doing business in today's deleveraging economies, the watchword is patience. The path from excessive debt to robust growth is a long one with many twists along the way. Overall, one should expect restrained demand in the next few years; when consumers do open their wallets, they will use more cash and less credit and will seek value products. There will be pressure on margins in consumer and business-to-business sectors, so now is a good time to raise the bar on productivity. Finally, remember that it is often in times of slow growth that market leadership changes—the companies that invest ahead of robust demand materializing can capture share.

Richard Dobbs, Susan Lund and Anu Madgavkar : Dobbs is director of the McKinsey Global Institute (MGI), McKinsey's business and economics research arm, and a director of McKinsey based in Seoul; Lund is director of research and a Washington, D.C., partner at MGI; and Madgavkar is senior fellow with MGI leading MGI teams based in India.

This article originally ran in Mint.

MGI In the news
Article - McKinsey Quarterly

Culture for a digital age

Article - McKinsey Quarterly

The CEO’s guide to competing through HR