He Who Deleverages Best: Presenting The 'Credit Intensity' Of Europe's GDP Growth

There exist those pathological Economics 101 acolytes who say that no matter what happens in the global economy, since it is all supposedly a closed system, whether one incurs leverage at the sovereign or private-sector level is largely irrelevant, and that is all translates into economic growth as long as the system is experincing a net leverage increase. Usually these same acolytes come up with economic theories which attempt to validate and justify infinite sovereign debt incurrence, usually to explain why socialism can be funded (if only in various formerly capitalist societies). At the heart of their thinking is the Kalecki profits equation which says that:

Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends


Or in other words, as long as the non-government sector is expanding its savings (reducing leverage), aggregate economic output remains the same as long as the government is doing the opposite. Of course, as we explained before this equality breaks immediately in a real world in which one evaluates the impact of asset age, amortization, depreciation and otherwise the impact of reality on profitability. But does that mean that every economics theory that says corporate deleveraging is offset by sovereign leverage is wrong? Not necessarily. it just says that there is far more to the final outcome than what an Neo-Keynesian Econ 101 textbook alleges.

To evaluate the impact of private sector deleveraging on economic growth/GDP in the context of a rapidly releveraging sovereign, we present the following analysis from Citi which observes various European countries and analyzes the "credit intensity" of GDP growth, or in other words which country has preserved, or even grown its GDP even as its private sector has seen substantial deleveraging. The results are interesting and may present a framework for evaluation the winners and losers in Europe in the era of "great sovereign leveraging", permitting a reverse engineering of the success stories, and applying their lessons to the losers.

Citi has compiled data analyzing private sector leverage and cross referenced it to countries who have seen massive sovereign debt expansion in the past 5 years, however offset with various degrees of private sector deleveraging. The results are as follows :

Given the persistent tensions from the financial sphere and the precarious situation of some banking systems, it is interesting to compare how much leverage has been accumulated in the last ten years in various euro area member states and how much economic activity was generated during the same period (see Figure 4). This allows us to measure the ‘credit-intensity’ of GDP growth. In particular, we concentrate on the last five years to see whether the relationships have evolved.

In peripheral countries such as Spain, the last two years (Q4 2009 to Q4 2011) saw a 16-point drop in the real credit outstanding without triggering a contraction in the level of economic activity. Over the same period, Ireland was perhaps the most successful peripheral country, with real credit outstanding shrinking by 57 points while the real GDP level rose by 4 points. In Portugal, while the reduction in real credit outstanding was more limited, worth 12 points in the last two year, the level of real GDP still declined, albeit by a modest 2 points. Italy is the only country within the peripheral group that experienced an increase in the amount of private sector real credit outstanding, with a gain of 5 points. Yet, the corresponding increase in real GDP was limited to just 2 points.


Core and soft core countries recorded GDP gains, with Finland (7pt) and Germany (6pt) clearly in the lead, compared to Austria (5pt), Belgium (4pt) and France (3pt). Interestingly, Belgium managed to grow its GDP despite experiencing a clear deleveraging phase. Note that Germany is the only euro area member state to have recorded an increase in its GDP level since 2002 while its level of private sector credit outstanding has declined during the last decade .

So while the occasional success story may exist, the danger is as always one of extrapolating into the future too far, especially a future in which private sector growth will very likely be even more constrained in the coming years. The danger is that expanding sovereign leverage will no longer be private sector offset, which it obviously is not in the general case, and will simply become a headwind to growth, at both the macro as well as micro levels.

Looking ahead to the next few quarters, there is a clear risk that banks operating in peripheral countries will either maintain tight lending standards or restrict lending even more in the event of further increases in the proportion of non-performing loans. Unless those countries implement sufficiently comprehensive structural reforms to lift potential growth, economic activity is at risk of contracting further in the coming quarters, increasing investors concerns about debt sustainability.