new economy

　　

The world economy has begun to recover simultaneously. However, if investment does not improve—especially in high-income economies—the recovery will be unsustainable. Huge debts are also threatening the sustainability of the recovery, as the Paris-based Organisation for Economic Cooperation and Development (OECD), which is composed mainly of rich countries, advocated in its latest Economic Outlook. This report is the final work of outgoing OECD chief economist Catherine Mann. The report suggests that you can breathe a sigh of relief, but you must never be complacent.

        The OECD predicts that the global economy will grow at 3.6% this year, higher than the 3.1% in 2016. In 2018, the global economic growth rate will reach 3.7%, close to the average growth rate from 1990 to 2007. Among the large economies of the Group of Seven (G7), only the United Kingdom is expected to grow at no faster than 2016 this year. China and India are setting the pace of global growth. The OECD monitors 45 economies that account for 80% of global output. No country’s economy is expected to shrink in 2017, 2018 or 2019.

         However, we have reason to question the sustainability of this growth rate. In the entire G7, the net investment rate is lower than before the financial crisis. Labor productivity is expected to improve to some extent, but it will still be far below the level of 1995-2007. Most importantly, high debt continues to pose a threat to recovery.

        Since the last financial crisis, the ratio of corporate debt to gross domestic product (GDP) has stabilized in some high-income countries, but continues to rise in other high-income countries (such as France). In the long run, the growth rate of corporate debt in the United States and the Eurozone exceeds the growth rate of productive capital stock. Some of these debts have been determined to be used to repurchase stocks to boost stock prices. The reason for this kind of financial operation is, on the one hand, the tax advantage of debt, and on the other hand, it is popular nowadays to link executive compensation to stock prices. In many high-income countries such as the United Kingdom and the United States, household debt levels are still very high.

    In emerging economies, at least household debt is not high. However, many economies have accumulated a large amount of corporate liabilities, most of which are foreign currency liabilities. At present, the ratio of China's corporate debt to GDP is higher than that of almost all high-income economies. Unsurprisingly, the corporate bond ratings of high-income countries and emerging countries have deteriorated.

        So, what are the risks associated with this debt that has been high and (in many countries) still rising? One is that capital is imprisoned in zombie companies. Most importantly, after a certain limit is exceeded, increasing credit usually reduces growth and exacerbates inequality. The more imminent risk is that higher interest rates may make current controllable debt uncontrollable. This may give birth to a second round of crisis. These crises are not so much new crises as they are the resurgence of the crisis that hit the US and European economies between 2007 and 2012.

        One of the reasons for believing that this will not happen is that the issuance of corporate bonds is replacing bank loans. Highly leveraged financial intermediaries such as banks have limited ability to withstand losses. The decline in the importance of such institutions should make these highly leveraged economies more resilient. However, the risk exposure of such institutions is still very large, especially the exposure to the overvalued stock housing.

    Greater reliance on bonds also brings risks. Emerging market economies face foreign exchange risks. In addition, if a large number of companies go bankrupt, their banks will also be adversely affected.

    A sharp drop in bonds may trigger a run on bond funds, leading to a temporary suspension of financing (including the required rollover). Therefore, the transition from bank loans to bond issuance will also bring risks to highly indebted economies.

    A crucial question is why interest rates may rise. The good reason is that economic growth is stronger, which should at least improve the prospects of many indebted companies and households. The bad reason is the soaring inflation. If central banks need to substantially tighten monetary policy, some debtors may be in serious trouble, as happened in the early 1980s.

    Tightening of monetary policy in response to soaring inflation could trigger a wave of defaults and an unexpectedly sharp slowdown in growth. The opposite worry is that central banks may not have enough leeway to deal with it. In short, high debt makes it more difficult to adjust monetary policy.

    Now that the world economy is recovering, deleveraging the economy is a top priority. A key change is the removal of tax incentives for debt. The stock-linked compensation system encourages excessive borrowing: the tax system in this area must be reconsidered. Increasing equity capital can reduce the vulnerability of banks. In addition, emerging economies should not encourage foreign currency borrowing.

         At the same time, every effort must be made to increase public and private investment. One of the most important areas for increased investment is housing, but don’t trigger the surge in Spain before the financial crisis. More broadly, if the economic recovery is to continue, it is important to drive the recovery through investment. Public investment must play a role in this, especially in improving infrastructure and supporting key technological advancements.

    Low investment and high debt are not the only constraints facing the world economy. Political risks are also high, as are the threats to free trade. But the top priority is to increase investment and reduce debt. As President John F Kennedy said in 1962: “Don’t wait until it rains to think of building a roof.” It is essential to clean up the unproductive private debt left over from the financial crisis and its aftermath. The transformation will not happen overnight. But we should eliminate the incentives for this dangerous behavior.