Don’t De-Leverage — If inflation is not transitory | by Ryan Gosha | The Capital | Jul, 2021


This is a general guide to post-pandemic business management.

How do you manage the company’s balance sheet in the post-pandemic era? Do you increase leverage, or do you de-leverage? The general advice is to de-leverage. Reduce debt. This is generally sound advice which is generally true in most economic environments.

I would like to posit a slightly different theory with regards to leveraging and deleveraging. The decision to leverage or de-leverage should be viewed in the context of the wider macro environment. It should not be solely based on the analysis of the company’s balance sheet. The decision matrix should incorporate national and global balance sheets. The company does not exist in a vacuum, it exists within an economic system.

It is an open secret that the economic system that we are living in is already leveraged to the hilt. Keynesians and MMT theorists tell us debt doesn’t matter, but we all know that debt matters, if it didn’t it there would not be a financial system to talk about because the global financial system is debt-based.

The corporate balance sheet should be managed with the same degree of seriousness that managers exude for the profit and loss. Business managers scan the external environment when they make sales forecasts and budgets.

Any post-pandemic approach to business management should take the prevailing high debt levels as a given factor, that is, something not to be debated. It is an economic reality that the company lives in. The financial system is hinged on interest rates; thus, the business manager should develop or adopt an interest rate outlook. This is no longer the prerogative of bankers and financial analysts alone. Most importantly, the business manager has to ponder on the inflation question more seriously. Lastly, the business manager should look at the corporate balance sheet and then decide to leverage or to deleverage.

Notice the sequence of events here. The business manager should descend down into the corporate balance sheet but coming from outside. The starting point is not the balance sheet of the company he manages. The starting point is the global financial system, the national financial system, and the leverage levels prevalent in that system. Interest rates and inflation follow. The company’s balance sheet is the last thing to consider.

The factors to consider are listed below:

  • prevailing debt levels
  • inflation outlook
  • interest rate environment
  • the company’s balance sheet

Why is this approach important now? Because the post-pandemic period is going to be different from the pre-pandemic period with regards to the financial system. We cannot wish things away. The pandemic changed the settings of the financial system.

The global financial system is leveraged to the hilt. Global debt is currently above 356% of GDP. What does this mean? This means that the world is due for deleveraging. A deleveraging event of the magnitude required causes an economic depression, not just a recession.

Ray Dalio explained this well in his theory of business and economic cycles. A deleveraging event basically means corporates, individuals, and nation-states reduce debt levels. They pay off debt. Paying off debt is generally not good for the economy because it destroys money. Most of the expenditures in the economy are financed by debt, thus when economic units stop taking in more debt, it reduces demand for goods and services, which reduces incomes for people that sell goods and services (i.e., everyone).

Few people are able to purchase a house on a cash basis, they get a mortgage, that’s debt. How many people use their credit cards at restaurants? That’s debt. Clothing, food, groceries, cars, consumer durables such as fridges, etc are all financed by debt in most economies.

The corporate balance sheet is laden with debt. Most companies rely on debt to stabilize their working capital and have long-term debt on their capital structure. Financial corporations have the highest levels of debt in the economy.

When all these players stop taking new debt and start paying off debt, incomes fall, and when that happens, the debt ratios don’t really fall. A downward spiral emerges. Central bankers don’t want this downward spiral to happen because it’s bad for everybody.

Why is this important to you as a business manager? The point to take home is that the global financial system is highly leveraged, but those in charge will not allow a natural process of deleveraging to take place. This means that deleveraging will have to happen via other means, such as inflating the currency away.

This builds up from the prevailing debt levels discussion above. Global debt is too high to ever be repaid without crushing the financial system. Debt that is too high to ever be fully repaid will never be fully repaid.

It’s easy to illustrate this. Let’s say, Dave, a factory worker in Johannesburg, South Africa, is deemed liable to $1 trillion dollars by a court to an aggrieved party. He signs an acknowledgment of debt for this amount, but he only earns $10,000 per annum and has no assets. Clearly, the debt is too large to ever be repaid by Dave, even if he is given a hundred lifetimes to pay it off.

The only way for Dave to pay this off is for him to be given the ability to print money, so he can print a trillion dollars and use it to pay off the debt. Printing money is inflationary, always. Any economist that tries to explain that it’s not always inflationary should be arrested and tried for deliberately misleading the public.

Key points regarding inflation can be summarized as follows:

  • the world is sitting on so much debt
  • the debt can never be repaid
  • the world is due for deleveraging
  • the natural process cannot be allowed to take shape because it dooms us all
  • thus, the only alternative is to inflate the currency

The monetary and fiscal responses to the pandemic were eventually going to lead us to higher inflation. In fact, the overleveraging was present before the pandemic, thus currency debasement was an eventuality.

It took 18 months for inflation to start showing its ugly head. It was obviously going to be a feature once economies started opening up. Now economies are opening up and inflation is rising.

The narrative from central bankers is that inflation is not here to stay, it is transitory. By this, they mean, inflation won’t be a problem. It will not exist for long.

The business manager should deleverage. Things will get back to normal and it will be business as usual. Debt ratios need to fall. It will be bad to keep high debt levels on the balance sheet.

The system will not be under existential threat. The actions of the manager matter more than the system. Increasing leverage in such an environment will be suicidal.

Inflation can only be transitory if governments and central banks around the world are determined not to resort to the easy way of fixing things. The inflationary pressure that has started can be contained if:

  • Interest rates are raised
  • central banks contract the money supply
  • governments roll back on stimulus packages and other debt-financed programs

The resulting scenario from these three factors is somewhat of an austerity. As a business manager, high-interest rates will mean a higher cost of borrowing for your business. High-interest rates generally go hand in hand with decreasing asset prices. You do not want to be the guy that borrows now, the interest rates go up, and whatever assets you added on the balance sheet at a high price are subsequently slashed down in price. As an individual, you would not want to be the guy who bought the house for $1m when the interest rate was 5%, and then a year later the interest rate increases to 8% whilst the value of the house declines to $700,000.

Most assets have currently priced-in inflation. If inflation is only transitory, it follows that these assets are overpriced, and a correction is needed. If the business manager believes that inflation is transitory, he or she should dispose of assets at the top and de-lever the balance sheet. Disposing assets now means you are taking the highest price that asset can ever get because it will be followed by a correction. If you really want the asset, you can buy it back later at a lower price. This is very true for the liquid investments held on the company’s balance sheet.

Deleveraging now means avoiding paying high-interest rates soon that cripple the company’s cashflows.

If interest rates rise, lending standards are stricter, and the money supply is constricted, asset values drop sharply but the nominal value of debt does not drop. You still owe the bank a million dollars even though the house is now only $700k. On the corporate balance sheet, you will have to revalue your assets at some point in time and reflect those write-down losses the P&L. But the liability remains on the balance sheet, it still has to be repaid. Since money is harder to get (i.e, it is a deflationary environment), in real terms, the value of the liability has effectively increased.

In a deflationary environment (deflating asset values, declining spending due to tighter availability of credit, declining incomes), the first ones to de-lever are the first ones to benefit.

This unveils a new reality, the post-pandemic reality. An extreme example of this is Zimbabwe. Things won’t necessarily go the Zimbabwean route of massive hyperinflation for most countries. Those who speak of hyperinflation don’t really know what they are talking about. It’s all fearmongering.

Inflation is a reality, globally, but suggesting that hyperinflation would be the ultimate deleveraging event for countries such as the mighty USA is disingenuous.

If inflation is not transitory, the business manager should not rush to de-lever the balance sheet. In times of high and rising inflation, lenders lose out. This means that borrowers gain, a lot. The reasoning behind this is simple. If the currency is being debased, debt that is denominated in the currency is also debased.

If you owe the bank a million dollars and inflation is at 5% per annum, in real terms the debt you owe is losing value by 5% every year. This means that, at the end of the year, the real value of that debt is equivalent to 950,000. After 5 years the real value is $770k and after a decade it is $598k. After two decades, the real value is $358k and after 30 years the real value is only $214k. After 3o years, debt has lost 80% of its value.

The figures are illustrated below.

Illustration of debt losing value at 5% inflation rate

Clearly, the lender loses out. An inflation rate of 5% is not unthinkable for the US economy. The same inflation rate is within the target band of the South African Reserve bank.

The borrower is benefiting. Even though the nominal amount of the debt has not changed, the real value has changed a lot. When the million was borrowed it could buy a house that was valued at a million dollars. Fast forward 30 years, that same million dollars can only buy 21% of that same house, i.e., it is way too short to buy the house.

Lenders get punished, and for that reason, they do not want to lend at low interest rates. But interest rates cannot be allowed to rise because those who control rates are trying to steer the economy in a direction that avoids massive defaults that cripple the system (i.e., the government, and other players cannot afford to borrow at higher rates).

Only the ones with the ability and capacity to borrow get to benefit from inflation. For this reason, those who don’t have the borrowing capacity complain a lot about inflation.

However, if you are a business manager running a business that has the capacity to borrow, you should borrow as much as you can if you believe inflation is not transitory. Lever up the balance sheet to the hilt. Inflation screws everyone except the borrower.

You borrow $100m dollars in 2022 when the size of the loan is half of your annual revenue. Fast forward a few years of massive inflation, that loan will be equivalent to half a day of sales.

Borrow money and use it to buy assets that act as inflation hedges (i.e., that increase in value as fast as they print new money).

This builds upon the ‘inflation-is-not-transitory’ point. The world is sitting on so much debt that interest rates cannot rise up significantly without triggering a tsunami of defaults.

If you are an entity that has $100m worth of debt paying 5% per annum, the interest payments total $5m per year. If the rate goes to 10%, the company has to pay $10m in interest. Let’s say the company was generating a Net profit of $1m before the rate hiking cycle. Now this company has to find $4m to be able to service its debt. This company was over-leveraged before the rate hike and is driven into default by the rake hike.

This is the state of finances for a significant number of corporations, individuals, and governments. The message to the business manager is that it will be very difficult to raise rates, and if they do so, it could trigger defaults that in turn trigger a financial crisis followed by a depression. Thus, inflation could run high, and the central bankers can fail to do anything meaningful about it.

The business manager should then be informed that whilst interest rates can rise in response to inflation, they cannot rise very much. The rate hiking cycle runs into limits, beyond which any further hike can cripple the financial system.

Interest rates that are imprisoned and inflation that is not transitory are a perfect condition for the business manager not to deleverage.

If you are in South Africa, say in 2023, facing an inflation rate of 10% per annum and the interest rate is struggling to rise beyond 7% such that your borrowing rate is 9.5% (prime plus 2.5%), you have effectively been given free money. The benefits you harvest from inflation outweigh the interest cost.

Negative real rates could be a reality in the post-pandemic business environment. Only those with the ability to borrow can benefit from that, and only a few would be willing to lend under such conditions, thus the business manager has to make the decision to lever up way before real interest rates dive into the negative territory.

The last place to look at is the company’s balance sheet. Once inflation is deemed as something that is not transitory, the decisions become apparent, but the company’s balance sheet still has to be considered because the company can only benefit from borrowing in an inflationary period if it survives long enough to harvest the benefits of inflation.

Excessive leveraging, especially for debt that includes margin calls, can result in liquidation if something goes wrong and the company defaults. In short, the business manager should ensure that the company takes up as much debt as possible but also survives long enough to enjoy the inflation shows.

  • Central bankers can print as much money as they want but they cannot print houses, gold, experienced workers, land, food, accountants, engineers, etc.
  • The damage is already done — all the money printed into existence during the pandemic cannot be easily withdrawn from circulation because economies have not yet recovered. All the talk of recovery is merely nominal GDP figures, real GDP and job numbers are still down. All of the new money has to circulate and bid prices upwards.
  • The pandemic set a precedent for the existence of a welfare state. People now require and demand help from the government. Governments cannot reverse socialism now without invoking social unrest. All of this spending cannot be funded by taxes anymore, governments have to borrow (lever-up) and that debt has to be monetized at some point, thus inflation is here to stay.
  • Hyperinflation, as the ultimate deleveraging event, can cure the system in a very short space of time, meaning post hyperinflation, there will be very little inflation to talk about, thus inflation would have been transitory indeed. Hyperinflation is feared and unwanted by those who oversee the financial system because it involves destroying the system and then rebuilding it afterward. Since hyperinflation is not wanted, walking inflation (3–10%) will likely be the norm for countries referred to as emerging markets. Developing countries that are not referred to as the emerging markets will likely endure galloping inflation (above 10%) whilst the rest of the developed world would play between the upper band of creeping inflation (3% and below) and the lower band of walking inflation.

Ciao

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