Debt and Deflation

The primary reason being cited for current global deflationary concerns is the commodity glut and the slowdown in China.

These two are related – a China slowdown certainly leads to a fall in demand for commodities and a temporary oversupply. Except that the oversupply seems to be persistent rather than temporary. Everything from energy (crude oil, natural gas, coal) to base metals (iron, copper) has seen tremendous price falls – and no immediate signs of recovery are in sight.

And there is an equally persistent oversupply of manufactured goods, such as steel, causing a deflation in a lot of producer and consumer goods prices the world over – primarily stemming from overproduction in China.

The causes for the persistence of these two deflationary-trends are very similar in nature.

Commodities

Economics dictates that when prices are low, producers should be cutting down on production so that a reasonably profitable equilibrium (for the producers) is reached, conditional on the demand. This has been happening, but certainly not at a pace to prevent further price falls or to avoid threats to the balance-sheets of firms operating in these sectors. The question is, why?

One of the reasons, as noted by the FT, is the financialization of the commodities industry. In short, this means that future sales of commodities were effectively “securitized” into debt that financed massive expansion projects by energy and mining companies. This works fine when commodity prices are high (and stable) but less so when we are in a world that looks like the current one.

If you have taken on a lot of debt, you need to continue servicing that (or face the consequences of a total funding loss/bankruptcy when all your long-term debt becomes current and the creditors take control of your firm’s future cashflows and any upsides to such cashflows – also known as “equity”).

And the only way you can do that is through the cashflows of the commodities you produce – you continue extracting oil and natural gas, you continue to mine for copper and iron ore – and you use the cash, meagre as it may be, to pay down your debt. This, in turn, leads to a continued oversupply of commodities, which eventually leads to headline deflation/disinflation.

China

Something similar is happening in China.

State-owned enterprises (SoEs) are the main producers of steel and related goods in China. Many of the SoEs are poorly managed and are heavily debt-laden. Of course, mush of the debt is of a financial variety. But, being state-owned enterprises, there is another kind of liability that impedes these firms from cutting down on production.

This is the liability of keeping citizens on the payroll to avoid widespread unemployment from spreading in a populace largely engaged in manufacturing or related industries. Not doing so may have far-reaching political consequences.

So servicing financial as well as socio-political contracts is what keeps the oversupply from subsiding via “natural” economic forces.

This also has broader consequences – the state needs to fund the losses of the SoEs in some manner – this means either taking on more debt on its own balance-sheet or monetizing it through the central-bank (PBoC). Both of these lead to an eventual devaluation of the renminbi in real-terms making Chinese exports even less pricey resulting in further deflationary pressures on the rest of the world.

Debt is an “unnatural” contract

I have argued before that non-callable fixed-nominal debt is an “unnatural” contract – “unnatural” in the sense it causes undue frictions in the market, especially if revenues are facing a downward shock due to cyclical macroeconomic reasons rather than company-specific ones.

Two market quirks make it more so:

(a) the inability to buy off your own debt in the secondary market, if it is not being traded – this is especially true for loans (a cool example of where this is not the case and it has led to tremendous stability, despite huge leverage, is the Danish mortgage market)

(b) all of your debt (including long-term) becoming immediately payable  as soon as a single credit event occurs (although this may vary by legal jurisdiction as well as by contract-specifics) – this kills off more (operationally) viable businesses than you think.

Certainly, bankruptcy laws help but most restructurings and bankruptcy proceedings are drawn-out processes – again impeding the price-stabilization process, especially if the company keeps operating in order to preserve asset-value for creditors and keep employees on the payroll.

Conclusion

A well-functioning market economy relies on contracts. And poorly-designed contracts can throw a spanner into the works. Poorly designed-debt frameworks can make disinflation/deflation persistent leading to the phenomenon now well-known as a “balance-sheet recession”.

We have seen how demand-side debt (i.e., with households/consumers being highly leveraged) led to an exacerbated recession and price-falls as aggregate demand fell during the financial crisis.

Supply-side debt, similarly, causes downward price-pressure through oversupply of goods and services which continue to be produced at unprofitable price-levels in order to generate cashflows to service debt. We are seeing this right now with the commodities glut and oversupply of manufactured goods from China. This is also what happened in the case of 1990s/2000s-Japan where unviable and complex keiretsu structures kept on operating (partly to preserve the traditional lifetime employment/”salaryman” way of life).

We need better debt-contracts that do not aggravate troughs in the macroeconomic cycle. And this needs to start with better, more fungible debt-origination – fewer loans, more tradeable debt, efficient exchanges, inflation-linked nominals and less arduous bankruptcy/restructuring procedures.

As far as servicing “socio-political” debt is concerned, unemployment benefits along with making job-search more efficient and skill-enhancement less costly may help. These may be better options than letting operationally unviable state-owned firms live on for the sake of keeping unemployment low.