Global balance sheet shrinks after 30 years of growth – McKinsey

• Global balance sheet lost $20trn by Q3’22

• Growth accelerated during pandemic

• Global net worth was $610trn end ‘21

After what has been nearly three decades of continuous growth with particularly sharp acceleration in the intense two years of the COVID-19 pandemic, the global balance sheet, which takes stock of the wealth and health of the global economy, has shown its first overall shrinkage in 2022, according to a report by McKinsey Global Institute (MGI).

The global balance sheet is arrived at from examining the assets and liabilities of households, corporations, governments and financial institutions and the MGI report says after growing faster than global gross domestic product (GDP) for nearly three decades, this year, “early signs of a possible inflection point appeared, with greater volatility in the components of the global balance sheet.”

In an MGI discussion paper, “Global balance sheet 2022: Enter Volatility”, experts at the institute stated that by the third quarter of this year, amid geopolitical and economic turbulence, all three interlocking balance sheets shrank relative to GDP.

They noted that rising interest rates and inflation in the first three quarters of 2022 led to volatility and a pause in the multi-decade rise of the world’s balance sheet.

“As inflation and interest rates rose, global equity and bond prices declined by about 30 and 20 percent in real terms, respectively. Real estate values grew more slowly than inflation and fell in nominal terms in several markets. Despite higher inflation, debt continued to grow slightly faster than GDP at par values (but declined in market values),” the MGI experts wrote.

A lot of factors that gave rise to the expansion of the world’s balance sheet size for nearly three decades have turned for now in 2022, the report declared.

Specifically, it acknowledged that significant changes in key macroeconomic indicators occurred in the first three quarters of the year; and providing background context for the development, the report noted thus:

“In the third quarter of 2022, global interest rates increased by three percentage points, which is the highest year-on-year increase in more than 40 years. Inflation also reached heights last seen in 1982, with an annual increase of 7 percent. Equities and debt also decreased sharply, as leading equity market indexes fell 30 percent in real terms, the second-greatest decrease since 1980, behind only the global financial crisis in 2008. Major bond indexes dropped 19 percent and ended the third quarter of 2022 notably lower than at any point in the past two decades. Housing prices turned sharply, declining for the first time in ten years by one percentage point after an 8 percent increase in the previous year.”

By the third quarter of this year, according to the report, the global balance sheet had lost $20 trillion in financial assets and liabilities outside the financial sector as investors became wary of debt, real estate prices levelled off, and the valuation of equity and debt securities declined, all on the back of inflation and interest rate shock.

The MGI report further disclosed that debt on the global balance sheet kept expanding by 0.2 times GDP, even while the market value of mostly government and corporate debt fell by eight percent (excluding financial corporations) as interest rates rose, at par values.

“The balance sheet declined relative to GDP, due to decreases in equities, debt securities, and real estate (in some countries), versus a nominal growth in GDP driven by high inflation rates during 2022,” the MGI experts wrote.

They added that the financial cyst and financial-sector balance sheets contracted by about 40 percent and 30 percentage points of GDP, respectively, in the first three quarters of 2022, adding that net worth then fell by 10 percentage points of GDP.

On a sampled country by country assessment, the report found that the balance sheet contracted in most countries with real assets and net worth in Australia and Sweden feeling the most impact.

“While broad patterns in the global balance sheet were consistent in 2022, the magnitude of change differed across countries. Australia, Canada, and Sweden, where real estate markets had long been considered to be ‘overheated,’ experienced the largest declines in real estate worth relative to nominal GDP. By contrast, rising mineral prices contributed to positive change in net worth in Australia (alongside infrastructure and machinery) and Canada,” the report explained.

But the shrinkage in the global balance sheet this year is coming after decades of growth and an acceleration in the two years during the height of the COVID-19 pandemic.

Global balance sheet had expanded “inexorably from 2000 to the end of 2021”, the report stated, noting specifically that real assets and net worth, financial assets and liabilities held by households, governments, and nonfinancial corporations, and financial assets and liabilities held by financial corporations each grew from about four to more than five times GDP. “Global net worth was $610 trillion at the end of 2021,” according to the report.

It explained that only one-fifth of wealth growth came from savers channelling money into new investment, with asset price inflation on the back of low interest rates contributing close to 80 percent.

On the flipside, the report stated that liabilities and debt in China, Europe, Japan, and the United States were higher relative to GDP at the end of 2021 than at the time of the 2008 global financial crisis, noting that, “ for every dollar of net investment, $1.90 of additional debt was created outside the financial sector.”

The MGI report found that during this long period of growth, across countries, most of the growth was driven by real estate, debt, and US equities.

“While there were large differences among the 30 countries covered in the magnitude, timing, and composition of growth in assets and liabilities, the direction of travel, the rapid expansion relative to GDP, and the strong role of real estate were near universal. Households, particularly in Canada, Denmark, the Netherlands, Sweden, and the United States, also experienced rapidly rising equity and pension wealth. Growth in debt relative to GDP was fastest in China, France, and Greece; relative to net investment, it was highest in Portugal, Italy, Greece, and the United Kingdom at factors of 4.1, 3.9, 3.8, and 3.8, respectively,” the report stated.

Accounting for the accelerated growth in global balance sheet during the pandemic, the report notes that in 2020 and 2021, the intense first two years of the pandemic when governments launched large-scale support for economic activity, households globally added $100 trillion to global wealth “on paper” as asset prices soared and $39 trillion in new currency and deposits were minted.

It added that as a result of this, global wealth relative to GDP grew faster than in any other two-year period in the past nine decades, noting that debt and equity liabilities increased by about $50 trillion and $75 trillion, respectively, as governments and central banks stimulated economies.

“The creation of new debt accelerated to $3.40 for each $1.00 in net investment,” said the MGI report.

And looking ahead to 2023 for the health and wealth of economies, the report notes that public- and private-sector leaders and financial authorities would need to consider closely monitoring and managing the balance sheet to achieve positive economic outcomes, adding that the forces of secular stagnation could mean that after a brief intermezzo in 2022 and part of 2023, the balance sheet will resume its rise, adding to wealth but also to concerns about balance sheet health.

“Alternatively, the world could step up efforts to boost productivity growth and reallocate capital to productive capital formation in order to grow out of a supersized balance sheet. If the world does not go down either of these two routes, an unwinding of the balance sheet via inflation—as in the 1970s—or via more sustained asset price corrections, deleveraging, and debt write-offs, as happened during the global financial crisis, may result,” the report warned.