Question

The Global Financial Crisis

12. How big is the OTC market?

13. According to McKinsey, why is our economy recovery so slowly? Who else is in trouble?

14. What does history teach us about deleveraging?

Answer 1

12. In the chart below the grey line shows how the size of the OTC market would be if compression hadn't taken place and cleared double counting is allowed, the theoretical notional would be around $857trn, whereas compression has reduced the total BIS reported notional to $384trn.

At that time prior to the financial crisis of 2008, the OTC market was an informal network of bilateral counterparty relationships and dynamic, time-varying credit exposures whose size and distribution tied to important asset markets. International financial institutions increasingly nurtured the ability to profit from OTC derivatives activities and financial markets participants benefitted from them. In 2000 the authors acknowledged that the growth in OTC transactions "in many ways made possible, the modernization of commercial and investment banking and the globalization of finance."

13. The rapid expansion of the past five decades will be seen as an aberration of history, and the world economy will slide back toward its relatively sluggish long-term growth rate.

The problem is that slower population growth and longer life expectancy are limiting growth in the working-age population. For the past half-century, the twin engines of rapid population growth (expanding the number of workers) and a brisk increase in labor productivity powered the expansion of gross domestic product. Employment and productivity grew at compound annual rates of 1.7 percent and 1.8 percent, respectively, between 1964 and 2014, pushing the output of an average employee 2.4 times higher. Yet this demographic tailwind is weakening and even becoming a headwind in many countries.

Global employment growth has been slowing for more than two decades. By around 2050, our research finds, the global number of employees is likely to peak. In fact, employee headcounts are already declining in Germany, Italy, Japan, and Russia; in China and South Korea, they are likely to begin falling as early as 2024. While there is significant scope for policies that boost labor-market participation among women, young people, and those over the age of 65, that will be far from easy. Employment growth could double, to 0.6 percent, in the countries we studied: the G19 (the G20 without the European Union as a composite member) plus Nigeria—economies that account for 63 percent of the world’s population and 80 percent of global GDP. But that will happen only if each gender and age group, throughout these countries, closes the employment gap with the high-performing economies. In any case, even a doubling of employment growth won’t fully counter the erosion of the labor pool.

So productivity growth must drive the expansion of GDP in the longer term. Indeed, it would have to reach 3.3 percent a year—80 percent faster than its average rate during the past half century—to compensate fully for slower employment growth. Is this possible? Actually, our case studies of five sectors (agriculture, automotive, food processing, healthcare, and retailing) found scope to boost annual productivity growth as high as 4 percent, more than enough to counter demographic trends.

14. analysis of deleveraging episodes since 1930 shows that virtually every major financial crisis after World War II was followed by a prolonged period in which the ratio of total debt to GDP declined significantly. The one exception was Japan, whose bursting asset bubbles in the early 1990s touched off a financial crisis followed by many years when rising government debt offset deleveraging by the private sector. The “lost decade” of sluggish GDP growth that followed is a cautionary tale for policymakers hoping to somehow avoid the painful process of deleveraging.Debt grew rapidly after 2000 in most mature economies. Although the United States is often assumed to be the most profligate borrower, by 2008 several countries—including France, South Korea, Spain, and the United Kingdom—had higher levels of debt as a percentage of GDP (Exhibit 1). Of course, such aggregate measures of leverage are not by themselves a reliable guide to the sustainability of debt. Swiss households, for example, have sustainably managed very high levels of leverage for a long time because they possess high levels of financial assets that can be drawn on to repay debt and because Swiss banks have conservative lending requirements. DELEVERAGING, history tells us (via McKinsey research) is set to be the main economic trend for years to come. But a new paper by Anat Admati and her co-authors shows (amongst lots of other things) that the term is pretty unhelpful.

Whichever the type, good or bad, lower leverage should reduce risk: equity buffers are bigger and the likelihood of default is lower. The benefit should be lower borrowing costs. But a new tranche of data for British firms released today shows that this is not always the case. The problem is set out in three charts that use this, and other data, below. The first shows that, since mid-2008, firms have cut more debt than they have raised equity. Balance sheets are smaller and activity is lower, suggesting British firms are stuck in one of Richard Koo's balance sheet recessions. Adding to the misery, firms' newly beautified balance sheets have not led to cheaper borrowing. In fact (second chart) rates on new borrowing have been increasing, despite a fresh round of quantitative easing. The likely reason (third chart) is that banks' own debt costs—as proxied by CDS premia—are on the rise again. That makes lending more expensive to do, and so banks—themselves trying to deleverage—pass the cost on to their customers. So British firms are experiencing ugly deleveraging: all the pain with none of the gain.