Drawn-out deleveraging is a bad sign

Every financial and economic crisis in modern history has been followed by a protracted period of deleveraging at the macroeconomic and often the corporate level. After five consecutive years of gross domestic product contraction and at least two-and-a-half years into an international bailout program, Greece has yet to experience deleveraging in full force, thereby raising concerns regarding its expected adverse effect on economic growth in the years ahead.

Deleveraging, that is the reduction in debt levels, is a common characteristic of economies in the aftermath of a financial crisis. Some identify deleveraging as the drop in the debt-to-GDP ratio while others prefer other indicators. Whatever the case, academic studies show such deleveraging processes do not start immediately after the event and last five to seven years on average.

Since the deleveraging process in a highly indebted country usually involves a heavy dose of austerity in the form of spending cuts and tax hikes and is occasionally accompanied by defaults, it results in severe recessions.

Greece lost access to market funding in April 2010 and entered into a bailout agreement with the European Commission, the European Central Bank and the International Monetary Fund a month later. Although some taxes had been raised prior to May 2010, the bulk of austerity measures, amounting to more than 30 percent of GDP, came afterward, but deleveraging is still not visible as far as the public debt ratio is concerned.

As a look at the country’s gross public debt level shows, it went up from 263 billion euros in 2008 and 300 billion in 2009 to 330 billion euros in 2010 and 357 billion in 2011 before falling to an estimated 347 billion last year on the heels of the PSI, the biggest sovereign debt restructuring in history.

Greece’s gross public debt is seen rising to 348 billion euros in 2013 and even more in the years to come, according to European Commission data.

Moreover, the more relevant public debt-to-GDP ratio has been rising steadily, from 113 percent in 2008 and 129 percent in 2009 to 148 percent in 2010 and 172 percent in 2011. The public debt ratio is estimated at 176 percent in 2012 and even higher this year and next.

The upward trend reflects the large contraction of the economy on the heels of the austerity program applied and to a lesser extent the primary budget deficit during the last couple of years.

These are not the only figures pointing to limited deleveraging in the Greek economy at best. As a matter of fact, one may argue that leveraging instead of deleveraging was the norm up until the end of 2010.

Total funding to the government and the non-financial sector as a percentage of GDP stood at 134 percent last November compared to about 148 percent at end-2011 and 141 percent at the end of December 2010. It had stood at 130 percent and 123 percent at the end of 2009 and 2008 respectively.

What is more, one would have expected households and companies to save more as they cut back on their spending and borrowing during the deleveraging process. However, total deposits and repos in the local banking system funded a smaller portion of loans from prior to the crisis through 2011. They constituted 98 percent of total funding to the economy in 2009 and 2008 but fell to 87 percent in 2010 and just 76 percent at the end of 2011 before climbing to about 81 percent last November.

Of course, one may argue that deposits should have been adjusted upward to take into account the amount of money withdrawn and kept in safes or under mattresses in fear of a possible Greek exit from the eurozone, or for other reasons. This should have improved the overall picture, but has been going on since 2010 and is difficult to estimate it.

By just looking at the figures cited above, one may argue deleveraging in the private sector started slowly in 2011 and accelerated in 2012, but is not yet evident in the public sector. The gross general government debt-to-GDP ratio is still rising despite an impressive improvement in the primary budget balance, where expenditure excluding interest payments on public debt appear to be just 2 billion euros more than revenues, compared to approximately 25 billion euros in 2009.

The above Greek indicators are not encouraging. History shows that the deleveraging process in economies coming out of a major financial crisis is usually linked to episodes of recession and slow growth rates.

Moreover, the smaller and more drawn out the deleveraging is, the longer and bigger the economic slump becomes – as the case of Japan indicates – while the bigger and sharper the deleveraging is, the better the economic performance gets during this period, as the banking crises in Finland and Sweden in the 1990s demonstrate.

Consequently, it looks as if Greek deleveraging has some, perhaps a long, way to go and history teaches that this does not bode well for the country’s economic growth during this period. Of course, the outlook could become more favorable if the country were provided with more public debt relief and a good deal of deposits returned to the banking system. However, this is no more than just a hope at this point.