History Suggests Recovery From Financial Crisis Will Be Slow and Painful

History Suggests Recovery From Financial Crisis Will Be Slow and Painful: "

Several sectors, including commercial real estate in several countries are at high risk of deleveraging, McKinsey says in new study.

The recent bursting of the great global credit bubble not only led to the first worldwide recession since the 1930s but also left an enormous burden of debt that now weighs on the prospects for recovery. Today, government and business leaders are facing the twin questions of how to prevent similar crises in the future and how to guide their economies through the looming and lengthy process of debt reduction, or deleveraging.

McKinsey Global Institute created an extensive fact base on debt and leverage in each sector of ten mature economies and four emerging economies. In addition, MGI analyzed 45 historic episodes of deleveraging, in which an economy significantly reduced its total debt-to-GDP ratio, that have occurred since 1930.

Key Findings:

• Leverage levels are still very high in some sectors of several countries—and this is a global problem, not just a U.S. one.


• To assess the sustainability of leverage, one must take a granular view using multiple sector-specific metrics. The analysis has identified ten sectors within five economies that have a high likelihood of deleveraging.


• Empirically, a long period of deleveraging nearly always follows a major financial crisis.


• Deleveraging episodes are painful, lasting six to seven years on average and reducing the ratio of debt to GDP by 25 percent. GDP typically contracts during the first several years and then recovers.

• If history is a guide, many years of debt reduction are expected in specific sectors of some of the world’s largest economies, and this process will exert a significant drag on GDP growth.

The right tools could have identified the unsustainable build-up of leverage in pockets of several economies in the years leading up to the crisis. Policy makers should work to develop a more robust system for tracking leverage at a granular level across countries and over time. One needs to look at specific metrics such as the growth of leverage, and the borrowers’ ability to service debt if there is a disruption to income or rise in interest rates. MGI found that sufficiently granular data do not exist today.

MGI’s analysis provides support for several of the current regulatory proposals, including improving the quality of bank capital through higher Core Tier I ratios, monitoring leverage as a proxy for asset bubbles, and creating better macro-prudential regulation to reduce systemic risk. However, the analysis raises questions about some aspects of the current regulatory agenda, such as limiting gross leverage ratios (which did not change appreciably in most banks).

Coping with pockets of deleveraging is also a challenge for business executives. The process portends a prolonged period in which credit is less available and more costly, altering the viability of some of business models and changing the attractiveness of different types of investments. In historic episodes, private investment was often quite low for the duration of deleveraging."