By Ray Chipendo and Simba Chimanzi. The last op-ed we released a few weeks ago titled “when financial stability and economic growth seem to conflict” drew interesting comments directed on the subject of “bank deleveraging.” Despite finding the op-ed’s language too technical, the ordinary readers’ comments were quite informed.
In response, using simple language, we thought we could share our version of how the credit crunch came about and how it hassled to high non-performing loans(NPLs) that now threaten an economic downturn. We also thought of taking the same opportunity to express our thoughts on how policy makers can deleverage banks with minimum harm on the productive sector.
Deleveraging is a process of reducing debt holdings from a highly leveraged position where debt has turned toxic. Deleveraging can be at an individual level, company level, bank level and even country level. In practice, leverage is the proportion of your assets or income to the amount of debt you hold. As Michael Milken, the god father of high yield bonds once explained: risk has nothing do with the absolute size of credit but leverage. So, even if debt levels are to remain unchanged, falling incomes and shrinking asset sizes can plunge an individual, bank, company or government into financial distress. This useful insight is the starting point to understand rising NPLs.
Credit cycle spiral
Excessive borrowing creates credit cycles. The high economic growth of the “post dollarization” years led to heightened optimism which laid a runway for aggressive lending. As individuals trickled back into jobs, and factories reopened, most people began to feel good about the future. By 2010, banks had reintroduced lending to households to buy cars, houses and other durable goods. Companies followed by setting out ambitious growth plans for which they borrowed heavily to finance. In our recent market outlook report, we revealed this leveraging behaviour. For example the median company’s debt/equity ratio for ZSE listed companies rose from 4% in 2009 to 12% in 2010 while the mean ratio jumped from 18% to 52%.
During this phase, the economy was growing at more than 10%; stock market was double the size it is today and the residential house market was red hot buoyed by a reintroduction of mortgage finance and Diasporas buying domestic property with the prospect of returning home. Overcome by the desire to participate in this great boom, banks might have relaxed lending rules to accommodate a bigger chunk of borrowers.
Just to digress a bit to provide you with a context, Howard Marks does a good job of simplifying stages of a credit cycle bubble. First stage occurs when a few people notice that things may be getting better and therefore raise credit to finance projects and buy assets in anticipation of growth. Second stage is when most people believe and realise things are getting better and start to raise and borrow significant credit. Last stage is when everyone’s uncle and cousin figure out that things will forever be great. At that point, no one wants to miss the party. Greed and fear of missing out lead banks and investors to fund projects and consumption not worth of being financed – albeit at high interest rates.
With easy credit, asset (real estate and stocks) prices rise; people feel more confident about their wealth. With the economy humming at its highest, banks grow more optimistic of the future and feel comfortable of borrowers’ ability to pay back loans. Normal credit checks point to rising incomes and collateral supported by artificial asset prices. As long as optimism remains in the air, borrowers and lenders continue creating credit with the belief that rising incomes will enable them to pay back their debts. These are the events that prevailed in 2010 and 2011. Drunk with euphoria, and without someone checking time, the party goes on and on. No one has the incentive to stop the music.
Bitter spot- high leverage and slower growth
But it takes a small bit of negative news to stop the music. Except that the music record does not abruptly stop, it screeches to a stop in a domino-effect way. The negative news jolts borrowers and lenders into reality and cause panic. In our case we believe the downward spiral was triggered by two bits of negative news: An improperly articulated indigenisation law that scared foreign investors which in turn woke us up to the reality that we were sitting with a debt maturity wall that could not be refinanced.
With the panic button set, foreign investors started to pull back capital nervous that it was no longer safe to keep money in the economy. With more than 50% of the capital on ZSE coming from across the border, withdrawal of capital sent stock prices tumbling. The same fate hit the real estate market. Individuals and businesses that held stocks and properties begin to feel less wealthy and vulnerable. As assets (and accompanying income) upon which loans were created started to deplete, banks grew edgy and got worried about recouping their loans. They demanded higher interest rates and stringent requirements to lend out any further loans. Recently the central Bank Governor expressed concern over banks’ reluctance to issue loans to businesses.
You will appreciate that most companies that hold bank loans do not really settle them in cash when they fall due, instead they simply roll them over. In other words they either ask the same bank or another bank to provide a new loan preferably at a lower interest rate to pay the overdue one. As shown in the diagram above, our study of balance sheets of listed companies revealed that most of the loans held by companies were falling due between 2013 and 2015 – 2014 has the highest wall of maturity for business loans. If you take the average business loan to have a 5year horizon, we can reason that the large size of loans falling due in2014 consists of debt that was raised in 2009 and 2010 – a time when the economic euphoria was at its peak- not a coincidence!
In order to refinance the large size of loans falling dues in 2013 and 2014, the credit market needed to operate at the same excitement level it was operating in 2009/10. But with banks becoming more stringent in lending, it meant that some of the businesses that qualified for loans 4-5years ago could not get refinanced. As we witnessed in 2013, a sizable number of companies fell into liquidation. We presume most of these liquidations had to do with failure to refinance loans than inability to meet interest payments. This industrial carnage has continued in 2014, with more companies being sunk by creditors.
Unintended consequences – further spiralling down
As companies began to notice liquidations rise and credit tightening, they started to hold onto the little cash they have and shelve plans to expand and invest in new capacity. Our recent market outlook supports this observation. In the report we show that companies have increased cash holdings in both absolute and relative terms using measures. Please see graph below. Restricted capital expenditure plus liquidations mean more and more people lose their jobs hence less spending and further job cuts. This downward spiral self-fuels leading to prolonged decline in income which leads to less and less spending which in turn means government collects less money through taxes and companies sell less products and services.
Most companies, as we have seen, respond by cutting prices to stimulate demand. But as we are witnessing in the latest financial reports of listed companies, price decreases are no longer stimulating spending. As companies cut down prices, revenues are falling too. This has resulted in bad deflation – something that most Zimbabweans battle to grasp given their recent and unpleasant experience with inflation. With economic growth slowing a nasty combination of deflation and a recession is no longer a distant possibility.
What might have begun as a confidence issue has cascaded into a real economic problem. As companies face falling revenues and incomes, many start to miss interest payments.
We believe it is this combination of (a) an inability to refinance maturity wall of loans and (b) increasing inability to meet interest payments that has spiked up the size of non-performing loans. With each day the state of NPLs is getting worse. The Central bank governor recently announced that the NPLs rate had gone up to 20% as of October 2014.One outcome is sought – banks need to feel more comfortable to lend again. In order to get that they need to deleverage or cure NPLs.
Options for deleveraging
Ray Dalio, founder of Bridgewater Associates provides a simple to understand view on how deleveraging can be achieved. As pointed out above, if credit crunches (credit cycle troughs) are left unsolved they can lead to a depression- a protracted series of recessions. Dalio explains four ways in which an economy can come out of the situation similar to which Zimbabwe is in:
- Austerity– austerity mostly comprises government initiated spending cuts, frugality and tax increases to reduce fiscal deficit while enabling government to spend in areas that stimulate economic growth. Recent tax introductions and increases on mobile calls, alcohol and cigarettes have been introduced to help reduce government fiscal deficits. Though an austerity helps a government to reduce its debt, its net effect is a reduction in spending. One man’s spending is another man’s income. Higher taxes squeeze households and businesses which limit spending.
- Wealth transfer –according to Dalio, to stimulate growth and spending among individuals, sometimes government will take the proactive role of redistributing wealth. The goal is to move money from the wealthy (where it is currently locked up in unproductive assets such as property) to the lower income groups who will readily spend it on consumption which hopefully stimulate further spending and investment. But this approach often leads the wealthy to hide their money or move their wealth out of the country. Without a middle class or a visible wealthy class (where wealth is accessible) it is difficult for government to initiate such programs. A likely target would be Diasporas. If the economic situation gets worse, we may see some sort of tax on remittances.
- Printing money–printing money helps to make money cheap, reduce interest rates and allow banks to increase loans. But since we do not own a currency this option is out of the way. The Americans may not be too pleased if we try to print their greenbacks. And we also know that printing our own dollar at this moment is not such a great idea. The Finance minister has shelved the idea for what he calls a considerable amount of time.
- Debt restructuring– deleveraging occurs when banks and borrowers agree to alter terms of loans that are turning bad. Options include lengthening the loan duration to push out repayment dates and give the borrower some space to breath. Alternatively, the size of the loan can be cut, an unpopular move for banks. But eventually that is what ZAMCO will do to the loans. The last option would be to reduce interest rates. Our research has shown that there are companies that have loans with interest rates north of 20%. Presumably such loans were questionable in the first place hence the high rates. That is one self-defeating aspect of finance – if you have a business which is a marginal performer, why push it into bankruptcy by high interest rates?
Breaking the downward spiral
As can be deduced from the above, debt restructuring is the only practical option that can haul the economy out the credit crunch. But where do you start fixing? We start at the same place it all started – confidence. Credit cycles are mostly driven by fear and greed, which all demonstrate varying levels of confidence. When banks feel confident they become comfortable to lend money at fair rates. When companies are confident that they can access capital and successfully sell their products, they begin to hire more workers and build bigger factories that stimulate households’ spending which fuels the economy.
We believe banks, borrowers and the central bank can work out something by restructuring defaulting loans to make them affordable and payable. The following steps will help attain the stability we desire.
- Loan durations– inadequate refinancing for the loan maturity wall was in our view one of the triggers of defaults and liquidations. Banks need to consider extending the maturities of loans that are falling due. If we did not have the same size of loans falling due in this period, it is possible that the credit crunch would not have been as severe as it is today. The current market atmosphere is not ready to refinance loans of this magnitude.
- Interest rates – some of the high interest rates charged to businesses have fast tracked defaults. Restructuring of rates is required. If banks are to preserve the integrity of their loans whose underlying assets are companies currently threatened by liquidation, they should consider cutting rates. To the extent that industry is supported by financial sector, the latter is also dependent on the productive sector.
- Interest rate guarantees – Similar to US government’s “Build America” bonds, central bank/treasury should consider providing certain interest rate guarantees on some of the loans to cushion banks and prop up confidence. The guarantees will act as an insurance to banks and inject confidence in the financial sector. A consistent program will pull some of the loans out of “Non-Performing Loans” bracket.
In implementing these reforms, it is important to remind ourselves that industry and financial sector are interdependent and equally important.
In the long run…
For the long term, after a successful deleveraging, Dalio had this advice for individuals and policy makers:
- Do not have debt rise faster than income – Debt burdens will need to be paid at some point in the future. If you fail, they will crash you.
- Do not have income/spending rise faster than productivity otherwise you become uncompetitive.
- Do all that you can to raise your productivity because in the long run that is what matters most. Policy makers have to obsess with turning Zimbabwe into an efficient, cheaper and faster place to do business and live.
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Ray Chipendo is Head of Research at Emergent Research. Simba is a Research Analyst. They are contactable on email@example.com and firstname.lastname@example.org