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Declines in external debt elevates concern for global recovery

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The decline in external debt exposures of G7 and emerging countries could come at the cost of economic growth, according to Hennessee Group, an adviser to hedge fund investors.

The decline in external debt exposures of G7 and emerging countries could come at the cost of economic growth, according to Hennessee Group, an adviser to hedge fund investors.

Hennessee voiced concern in early 2009 that the global financial crisis could enter a new and more dangerous phase, one that could push several international countries to the brink of failure and further hinder the global economic recovery.  Of particular concern was the dramatic growth in external debt exposures of G7 and emerging countries and the increasing risk of another outright failure similar to that of Iceland when it had a debt to GDP ratio exceeding 900 per cent. 

Hennessee research now indicates that this risk has begun to subside as the majority of countries have experienced a decline in their overall external debt exposure in recent months after reaching all time highs in 2008. 

However, it now believes this development could come at the cost of economic growth as the majority of the decline in external debt has been due to a dramatic drop off in bank lending to foreign institutions. 

Charles Gradante, co-founder of the Hennessee Group, says: ‘While the decline in external debt, particularly for countries like the UK, is a positive development and is likely to reduce the risk of another Iceland, we fear the primary driver behind the external debt reduction, specifically the drop off in external bank lending, could ultimately slow the pace of the global economic recovery.’

The Hennessee Group believes it is essential to global growth that banks resume prudent external lending to businesses and individuals to further alleviate the financial crisis and promote economic growth.

In its February 2009 research paper, the Hennessee Group highlighted numerous countries, particularly in the eurozone, that appeared to be building uncomfortably high external debt levels in recent years relative to their economic output. The bright spot, at that time, was the low level of US external debt to GDP output (84 per cent).   

The Netherlands reached an external debt to GDP ratio of approximately 328 per cent, while Ireland had a similar exposure ratio to that of Iceland, a staggering 900 per cent. The UK’s debt to GDP ratio reached 456 per cent while Switzerland’s rose to 433 per cent. 

Gradante says: ‘We believe the build up in external debt was both alarming and unsustainable, particularly for many European countries, and that if the trend continued we could be at risk of a major systemic event. Since our initial analysis, the majority of countries have started to reduce external lending. The UK has decreased its external debt by nearly USD3.5trn from its high of USD12.1trn in the first quarter of 2008. While we believe this is a positive development from the perspective that it alleviates our initial concern regarding another Iceland; a closer look at the underlying numbers has revealed a new concern. The vast majority of the reduction is due to a decline in external bank lending, which we believe will present additional challenges going forward. Of the USD3.5trn decline in the U.K. external debt, USD2trn can be attributed to a drop off in external bank lending. This could present additional challenges to an economic recovery.’ 

Hennessee Group believes this new trend is not just a problem isolated to the UK but rather a worldwide issue.

In a recent press release by the Bank for International Settlements it stated: ‘After a relatively small change in total outstanding stocks in the third quarter, banks’ external claims shrank by 5.4 per cent in the fourth quarter of 2008 (USD1.8trn at constant exchange rates), to USD31trn. This was the largest reduction ever recorded.’

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