Global Economic Perspectives：The credit cycle and private deleveraging in the euro area

Deutsche Bank Research Eurozone Economics Date 9 May 2016 Global Economic Perspectives The credit cycle and private deleveraging in the euro area ________________________________________________________________________________________________________________ Deutsche Bank Securities Inc. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 057/04/2016. Peter Hooper Chief Economist (+1) 212 250-7352 peter.hooper@db.com Michael Spencer Chief Economist (+852 ) 2203 8303 michael.spencer@db.com Mark Wall Chief Economist (+44) 20 754-52087 mark.wall@db.com Torsten Slok Chief Economist (+1) 212 250-2155 torsten.slok@db.com Matthew Luzzetti Economist (+44) 20 754-73288 matthew.luzzetti@db.com  With the ECB's policy easing increasingly targeted at the credit channel, we analyse the euro area credit cycle, assessing the dynamics of private sector credit and debt ratios, taking stock of the deleveraging progress made and attempting to project the likely path in the coming years.  The euro area has achieved only marginal private sector deleveraging. At 162% of GDP, private debt is less than 5pp below recent highs and above 2007-08 levels. Considerable progress has been in the crisis countries of Spain, Ireland and Portugal where private sector debt ratios have fallen by between 35pp and 75pp of GDP, in each case reversing close to 40% of the post-2000 increase.  The euro area is in the passive deleveraging phase of the credit cycle – where rising nominal GDP outpaces growth in credit. With a recovery reliant on credit and nominal growth still modest, we would expect debt ratios to bottom out during the next two years. If the historic credit impulse relationship holds, then despite expecting sustained current account surpluses the IMF's medium-term GDP forecasts imply the private debt ratio could hit new highs in 2019.  Low interest rates help alleviate the risks from high debt, as does the deleveraging progress among the crisis countries and the fact that the recent credit expansion is in countries that did not see a credit boom pre-2008. Policy needs to further limit the risks. One way is by raising inflation and potential GDP growth. Another is to improve the system's capacity to absorb higher debt by developing capital markets, improving insolvency frameworks, etc. Euro area private debt-to-GDP ratio could hit new highs by 2019 1351401451501551601651701751802003200520072009201120132015201720192021Euro area private sector debt ratio (household andnon-financial corproate sectors), % of GDPProjection based on credit flows implied by IMF GDP growth forecasts Source: Deutsche Bank, ECB, IMF 9 May 2016 Global Economic Perspectives: The credit cycle and private deleveraging in the euro area Page 2 Deutsche Bank Securities Inc. The credit cycle and private deleveraging in the euro area Credit channel the key to ECB’s easing policy The ECB’s recent monetary policy easing has become increasingly focused on boosting growth through the credit channel. The new set of TLTROs (TLTRO2) starting in June 2016 is designed to both i) ensure ample liquidity for euro area banks to ensure smooth transmission of monetary policy and ii) incentivise banks to lend more by allowing banks to borrow at the negative depo rate over the next 4-5 years as long as they can meet not particularly onerous lending targets. Meanwhile, corporate bond QE, also due to start in June, although limited in size, potentially allows the ECB to directly finance euro area corporates in the capital markets. It is in this context that we analyse the euro area credit cycle, assessing the dynamics of private sector credit and debt ratios for the euro area in aggregate and individual countries, taking stock of the deleveraging progress made and attempting to project the likely path of the euro area credit cycle and private sector debt in the coming years. Before we move into the analysis of the euro area performance, let us take a quick theoretical look at a typical credit cycle and how the different economic variables perform during its different stages. The dynamics of the credit cycle Let us consider an economy where the credit cycle is the single cause of the business cycle. We begin with a period of a credit boom as accelerating credit growth pushes GDP growth slightly above potential (Years 0-2 in Figure 1). Figure 2: The phases of the credit cycle C ycl e p h aseC re d i t g ro w t hG D P g ro w t hC re d i t Im p u l seD e b t R at i o sY e ar # i n F i g u re 1Credit boomPositive and acceleratingAbove trendPositiveRising 0 - 2SlowdownPositive but slowingBelow trendSlightly negativeRising (sharply)3 - 4 Rece