The debt and deleveraging drag

By Richard Dobbs

The global financial turmoil of the last month has demonstrated that we are not yet back to “normal” after the crisis. Indeed, global debt levels and the deleveraging process will be a drag on Korean and global growth until at least 2015.

Since 1990, debt levels around the world have grown at annual rates around 2-5 percent faster than GDP, fuelling global growth but in an unsustainable way. Korea really benefited from this growth in debt as it has fueled a global consumption and trade boom. As one of the world’s preeminent supplier of electronic components, automobiles and ships, the decade up to the crisis was “party time” for Korea.

But now the global economy faces the morning after the night before. As a result of the borrowing binge, debt levels around the world are now at an all time high – if we exclude periods at the end of major wars. These debt levels exist in different pockets depending on the country.

So in the U.K., U.S., Spain, Canada, and Korea, the debt is high in the household sector. In Japan and Italy, the debt is very high in the government sector. And in Spain, Korea, the UK and France, debt is high in the non-financial corporate sector.

Government debts are a particular worry as the problem will get worse as the aging of the population in most countries increase government deficits by around 5 percent of GDP per year over the next 20 years unless taxes are raised or entitlement programs curtailed.

While the Korean people worry about not having sufficient funds in the National Pension Scheme, most other countries do not even have a pension scheme at all, and instead rely on today’s taxes to pay today’s pensions. These future obligation needs to be considered as the equivalent to additional debt levels.

We will see Governments default either on their obligations for future pensions and social security, or even on their total government debt. So while Greece might have successfully negotiated a reprieve, the reality is that the country cannot afford to repay their debt and deliver on their pension and social security commitments even with extreme austerity programs.

New MGI analysis shows that debt levels in major economies have now stabilized and in some cases have started to decline – but only slightly. Korea is leading the world in this deleveraging process. And we are seeing the impact on this in the relatively anemic level of domestic demand in Korea. But our research shows in most other countries around the world, the deleveraging process has not yet begun.

MGI studied around 50 previous crises and the deleveraging process. And the message is bleak. After a crisis that occurred in a single country or a few countries, it typically took 3-5 years to complete the deleveraging process.

During this period economic growth was very slow – and worse than during the earlier years of the crisis. But this might underplay what we face as this crisis is worse as it’s global.

After the IMF crisis, Korea’s economy benefited from strong demand elsewhere supporting an export led recovery. There are few countries that will be able to provide this boost to crisis hit countries this time.

Despite Korea’s excellent recovery so far, the economy faces substantial domestic and global risks from debt levels and deleveraging. Korean corporations and policy makers need to keep an eye on signs of turbulence and stress test their financial position for a downside case.

They need to be ready to seize the opportunities turbulence will bring. But as the last month has shown, above all they must not be complacent that we are “back to normal”.

McKinsey Global Institute’s research on Debt and Deleveraging is available for free from www.mckinsey.com/mgi