The fallout of excessive debt

The fallout of excessive debt

The fallout of excessive debt is in play and the thin veil of a democracy is beginning to reveal its imperfections.

“If you want a picture of the future, imagine a boot stamping on a human face,” George Orwell A Final Warning

When the right to peaceful assembly, freedom of expression, voting is made illegal when these basic human rights are suppressed (with state-sponsored violence against its own people) then that state is no longer operating within the framework of a democracy.

So could these disturbing images of Catatonia’s referendum be time slipping into the future, a boot stamping on a human face? Another EU crisis could be looming.

The fallout of excessive debt, aided and abetted by years of the central bank’s emergency monetary policy in the wake of the financial crisis of 2008 is rearing its head.

We could already be witnessing the side effects of years of monetary easing and the perils of financing the day-to-day running of a country through growing debt levels rather than revenue.

Excessive public deficits tend to lead to political instability.

Lending to heavily indebted countries is a short-term fix. The cash injection through loans has enabled periphery countries of Europe to pay their bills (pay interest on their existing debt) and keep their street lights on. Moreover, the creditors continue to enrich themselves on sovereign interest payments.

However, in the long run servicing a debt with more debt is unsustainable.
Think about it. Greece has already received endless bailouts to prevent it from defaulting on its sovereign debts.

Meanwhile, as excessive debt sucks ever more blood (income) from the citizenry through higher taxes to finance the ballooning interest payments this leads to political instability and resentment.

Governments then respond by imposing further austerity and tax hikes (to services the debt) which fractures the social cohesion of the nation. So the glue that keeps a nation united becomes unstuck at its weakest point whether it be a race (ethnicity) or class division or geography based on autonomous regions within that nation.

Spain’s interest payment on the national debt is more than what the Iberian nation spends on education and research and development combined in one year. Moreover, Catalonia is a critical contributor to Spain’s economy, representing 20% of Spain’s GDP Spain’s 2013 GDP of $1.04 trillion euros ($1.17 trillion).

So what is driving Catalan self-determination?

Financial interests. The autonomous region believes that it is paying out more than what it receives from the central government in Madrid. Put another way, the fallout of excessive debt is like a boot on the nation’s head.

But that is the macro story of the fallout of excessive debt there is a micro story too.

Leveraged loans to corporations are up by 53 this year, which is a level higher than 2007. In other words, corporations are highly leveraged with a high debt to income ratio.

So what does this mean for corporate investors?

Highly leveraged businesses (these are companies with high debt ratios) are more sensitive to the rate hike and an economic downturn. Hence heavily indebted companies are the first to go bankrupt when the economic environment becomes more challenging.

Recently, the International Monetary Fund (IMF) highlighted the problem.

The IMF’s recent global stability report stated that US companies are leveraged higher than ever before and added that an economic downturn or high-interest rates could lead to the bankruptcy of 20% of US corporations.

The fallout of excessive debt is also visible on asset prices. Stocks are at a historic price to earnings ratios. Once upon a time (when the fundamentals and price discovery mattered) the captains of industry would raise shareholders’ value by increasing market share through either innovation, building new products, conquering new territories. But in the recent era of the central bank’s easy money policy (for those high-up the food chain) money was cheap.

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So the captains of industry figure that they can become heroes in shareholders’ meetings (increase the stock price and create shareholder wealth) by borrowing all that cheap money to buy their own company’s stock. Capex spending was too much hard work and there was a risk that all that productive investment may not pay off. So stock buybacks became Wall Street’s new aphrodisiac-investors were guaranteed that it would jack-up stock prices.

A financial landscape littered with zombie companies is yet another fallout of excessive debt which has been spurred by the central bank’s easy money policies. Many companies exist today not because they have viable business models. They are not profitable because they sell products and provide services that the market wants and are able to carve out a profit. Instead, they survive on an artificial cheap money life-support system. The valuation of Snap chat is 50 billion USD. But what does this company make? Has it made a profit?

It is true to say that the greatest monetary experiment in the history of finance, an unprecedented amount of monetary easing did prevent the financial system and economies from an imminent collapse back in 2008.

But what if in the long run, the side effects of the medicine ends up killing the patient?

G7 sovereign debt is at an all-time high and it is fueling political instability, households and business are also highly leveraged and a move to monetary policy normalization could trigger a depression.

So will the system be able to survive the fallout of excessive debt?
Time will tell.