Anyone doubting that there is a material risk that that the next global economic recession will be of the more severe than normal variety has not been paying attention to the massive build-up in global debt levels over the past decade. Nor have they been paying attention to the unusually low interest rates at which all too much of this debt has been issued.
One would think that this toxic combination of unusually high debt levels and unusually compressed interest rate spreads should be keeping central bankers awake at night. This is especially the case considering our past painful experience with the bursting of credit bubbles. That experience should have taught us that it is precisely this combination of high debt and credit risk mispricing that has the potential to cause real financial market strain when credit eventually reprices to historically more normal levels.
To its credit, the Bank for International Settlements (BIS) has been very vocal about the risks associated with an excessive build-up in global debt levels. In its recently issued annual report, the BIS highlights that since the 2008 world economic and financial market crisis, the global debt stock has increased by more than $60 trillion to its present level of around $170 trillion.
The BIS also notes that in relation to GDP, overall global debt levels today are some 40 percentage points higher than they were on the eve of the 2008 Lehman bankruptcy. Troublingly, there has been a particularly large build-up in emerging market sovereign and corporate debt levels.
A further cause for concern is that there has been a marked deterioration in the quality of the debt that has been issued both in the advanced and in the emerging market economies.
According to a recent report by McKinsey & Company on "Rising Corporate Debt: Peril or Promise?" almost two-thirds of U.S. corporate debt has been issued by companies at a significantly high risk of default. Similarly, in large emerging market economies like Brazil, China and India, there has been a large amount of issuance by companies of dubious credit quality, with a significant part of that debt having been denominated in U.S. dollars.
All of this has to be particularly troubling considering that much of this debt has been issued at very low interest rates that do not nearly compensate the lenders for the default risk that they have been running. One example of the unusually low interest rates at which debt has been issued is the record-low interest rate spreads in the emerging market corporate debt market. Another is the similarly near-record low interest rate spreads in the U.S. high yield market.
With close to $2 trillion in corporate debt due to mature each year over the next four years, it is all too likely that we will get a sharp rise in the rate of corporate debt defaults as that debt matures. That, in turn, may trigger a significant debt repricing.
If such a repricing were indeed to occur, we would, to use Warren Buffett's phrase, find out which of the financial institutions had been swimming naked by having over-lent to corporations of dubious quality at interest rates that were far too low to compensate them for default risk.
Sadly, there is little that the world's central banks can do to dial back the global credit bubble that they have created by their many years of ultra-easy monetary policy and massive balance sheet expansion. However, one can hope that they are not unaware about the serious financial market risks that they have created and that they are not again caught flat-footed - as they were in 2008 - should those risks indeed materialize. If not, we should brace ourselves for another very rough ride in the global economy.