By Michael Pomerleano
In Growth in a Time of Debt, presented at the AEA 2010 Annual Meetings in Atlanta (www.aeaweb.org/aea/conference/program/retrieve.php?pdfid=460) Carmen Reinhart and Kenneth Rogoff study the link between different levels of debt and countries’ economic growth over the last two centuries. The paper reviews 200 years of economic data from 44 nations and reaches the conclusion that countries that are as highly indebted as the UK and US will, at the end of the crisis, grow at sub-par rates. While there is a discontinuity in the data (growth is affected only over a certain debt threshold) the findings are ominous. One explanation is fairly straight forward: more resources are diverted away from the private sector. Governments do not create, but consume wealth.
A second, more subtle explanation focuses on the massive transfer of private debt onto government balance sheets. The message is fairly simple. The nationalisation of private debt injects considerable inefficiency into the economic system, inhibiting Schumpeter’s process of Creative Destruction that is essential in a market economy and needed to maintain the private sector. In short, the recent massive bailouts by national authorities of their financial systems in some countries amount to nationalising private sector debt with fiscal resources. In countries without fiscal headroom and lacking reserve currencies, such as Hungary, Romania and Ukraine, the IMF jumped to the rescue with sovereign lending that has basically nationalised the losses of the private sector – what Joe Stiglitz calls ‘Ersatz Capitalism’: the privatising of gains and the socialising of losses.
Unfortunately, we are only at the beginning of the cycle of corporate distress. The slow pace of economic recovery throughout the world is likely to be insufficient to save many highly leveraged companies and poorly performing companies, and corporate defaults are likely to stay high. For instance, a CGFS report on Private equity and leveraged finance markets (CGFS Publications No 30 July 2008 http://www.bis.org/publ/cgfs30.htm) notes that the credit market turmoil since mid-2007 has substantially affected the terms and conditions of funding in leveraged finance markets. “Rising investor risk aversion, growing pressure on bank balance sheets and a loss of confidence in structured credit products have sharply reduced demand for leveraged loans“. Should it imply that government interventions should continue? Absolutely not!
In the US the verdict on saving “national champions” in the auto industry – Chrysler, GM – is not yet in, but the process of nationalising private debt was used in Mexico, Argentina, Turkey, and more recently in Hungary, Romania and Ukraine. The history of government intervention does not inspire confidence. Mexico’s Bank Savings Protection Fund (FOBAPROA), for example, witnessed massive disappearance of assets as well as failure to identify assets due to inadequate documentation. The resolution process has been extremely slow. Turkey’s asset management company is still unable to quantify the stock of assets that it holds. The Indonesian Bank Restructuring Agency (IBRA) only disposed of a small percentage of its holdings. By contrast, there have only been two isolated and qualified success stories: Danaharta in Malaysia was successful, and the Korea Asset Management Corporation (KAMCO) was successful to a lesser extent.
Another example of a massive transfer of private debt to the national balance sheet without nationalising the private sector was of course in Japan in the aftermath of the asset bubble. For the better part of the 90′s the Japanese government extended forbearance to a banking system that in turn extended forbearance to the corporate sector through the infamous “evergreens”. Japan’s financial system struggled with non-performing loans. The forbearance and continuing partial recapitalisation of the banks, without decisive measures to attack the core problem ‑ a distressed private sector – ended transferring the debt to the national balance sheet. The outcome is well known. Japan has one of the highest public debts in the world, and the corporate and banking restructuring process was partial. Japanese banks are some of the most undercapitalised banks in the world.
As part of the wider effort to improve the stability of the international financial system in the aftermath of the East Asia Crisis, the World Bank is leading an initiative to identify principles and guidelines for sound insolvency systems and for the strengthening of related debtor-creditor rights in emerging markets (www.worldbank.org/ifa/rosc_icr.html). A joint initiative of the World Bank and the International Monetary Fund, Report on Standards and Codes (ROSC), assesses the insolvency standards at each step in the credit process, including access to credit, companies in financial distress, and formal systems for resolution and recovery. The findings are striking. For creditor rights, about half of the emerging markets assessed are operating more or less at a functional level, while the rest fail to meet standards in most areas. Most systems involved in the legal frameworks for insolvency are not working effectively, rehabilitation procedures for companies undergoing restructuring are not much better and institutional and regulatory frameworks are worse. There is enormous need for greater capacity to oversee corporate restructuring in court systems and regulatory bodies. The findings document weak treatment of employee rights and social protection of labour, the lack of access to financing, and tax provisions that penalise restructuring as major obstacles to successful corporate workouts.
What is the solution? First, it would be far more appropriate not to recapitalise banks and introduce a hard budget constraint that forces banks to restructure their private sector clients. Equally, it would be far more appropriate, as in the case of the previous Ukraine restructuring, for countries to declare a standstill and restructure their debt, as opposed to forfeiting prospective growth. Second, emerging markets and developed countries alike are well advised to improve the infrastructure for corporate restructuring as opposed to taking private debt on sovereign balance sheets.
Of course the nationalisation of private debt in order to preserve financial stability raises ethical questions such as whether it is morally acceptable to in-debt middle class citizens for the sake of saving large banks. This is a normative issue not addressed here.
Michael Pomerleano was visiting scholar at the Asian Development Bank Institute in Tokyo
