All nations’ economic progress through time can be decomposed into four fundamental components:

1) Population growth — We have discussed this many times in different forms. Basically if you have more workers producing more goods the economy expands. The very nature of having more working bodies in a country like Bermuda, for example, magnifies the local economic benefit. This is to say, more workers earning money locally will have greater income to spend locally which will multiply incomes for all on the Island. It is this multiplier effect from increased aggregate demand from more workers which offers a virtuous cycle of growth. What really matters, however, for an economy’s standard of living is real gross domestic product (“GDP”) per capita. If GDP increases but the productive population that accounts for this rises by the same percentage, there is no reason to suppose the well-being of individuals will increase. Thus the importance of productivity.

2) Productivity — Paul Krugman, a Nobel Memorial Prize economist, has famously suggested: ”Productivity isn’t everything, but in the long run it is almost everything.” Underlying real productivity tends to trend upward as the envelope of human knowledge slowly expands, thereby enabling a higher quality and/or quantity of output for the same human and capital inputs. Enhancements in productivity generally come from technological advancement, such as computers and the internet, supply chain and logistical improvements, and increased skill levels within the workforce.

3) A high amplitude long-term credit cycle.

4) A lower amplitude short-term credit cycle.

We have touched on this briefly before when we wrote about Bermuda’s long-term credit cycle. It is important to note a few things about credit cycles. First, unlike the massive benefits that increased productivity provides, the long-term and short-term credit cycles do not create permanent growth. In fact they are inter-temporal in nature and simply shift or redistribute output through the dimension of time. Over-production or -consumption today has to be countered with under-production at some point in the future, and vice versa.

A very tangible example of this is the huge surge in commercial real-estate that has flooded Bermuda to the point where there is some excess 600,000 square feet (over-production) that will essentially require five to six years of growth to fill and virtually no further production (the subsequent under-production). If we quote Krugman again, “the credit cycle isn’t everything but in the short run it is almost everything”. In fact, over shorter periods the amplitude of the credit cycles can counter annual productivity gains of one to two percent.

Having established the broader economic growth paradigm let’s focus on Bermuda’s credit cycles.

The Long-Term Cycle

In assessing the local credit cycle and attempting to determine the longer term trajectory we need to first get a feel for where we have been and where we are likely to go. Over time, credit levels tend to mean-revert. This is simply a factor that debt assumed today needs to be repaid at some point in the future, at which point borrowing can commence again — i.e. the inter-temporal shift needs to cycle. As a result it helps to gauge this evolution. Chart 1 shows Bermuda’s total private credit as measured by loans and advances held at Bermuda’s banks.

We are using Bermuda dollar credit as it is more indicative of the local economy and would exclude external lending done by banks which have more global operations. As can be noted the trajectory of this has begun to turn decisively negative and has been contracting at an annual rate of about eight percent since 2011 (this compares to Bermuda’s long-term private credit growth of about seven percent since 1998). Clearly we are into the longer-term down cycle of credit creation. Where do we go? I would suggest over time we will revert to our longer-term average of credit as a percentage of nominal GDP of 72 percent from the current 83 percent (see chart 2).

If the annual rate of eight percent contraction would continue, we would get back here in two more years. I don’t, however, believe this is the case for the short-term.

The Short-Term Cycle

I would anticipate this rate of credit contraction to slow over the next few years as the prior few have actually witnessed some larger write-downs from big hospitality projects that are not likely to be repeated in scope. Standard and Poor’s recent rating report on the Bermuda banking industry suggests “full-cycle cumulative credit losses will be in the range of $1.0 billion to $1.2 billion” and anticipate this cycle will end in 2016. Acknowledging that half of these losses have already been taken, according to S&P, and assuming the mid-point of their estimate and the time frame of 2016 as the end of the short-term cycle, we can estimate that roughly $180 million of credit losses will need to be taken per year over the next three years. This equates to roughly three percent of GDP. It’s highly likely that S&P is late to the party again and therefore likely that their estimates are too high at this point. Most hospitality loans have already been written off at this point so major losses have already been taken. It would, however, be too optimistic to suggest that the residential local loan books at all local banks are all good at this stage. In the near-term, we would suggest that the credit cycle will likely still place a drag on growth. The faster overall leverage in Bermuda is reset, the faster the credit cycle resets.

Country credit levels

Private sector debt is important but the overall leverage of economy is important to assess as well. Bermuda, much like many developed nations, has simply substituted private debt contraction with public debt expansion. In fact when you look at overall private and public debt within Bermuda, not much in the form of deleveraging has occurred (see chart 3).

Total debt as a percentage of GDP has stabilised at about 115 percent of nominal GDP. Future contraction or the slowing of the rate of debt within the public sector (fiscal consolidation) is likely to exert more pressure on consumption and growth in the near-term and will exasperate the short-term credit cycle somewhat as well.

Overall, the short- and long-term credit cycles within Bermuda are not likely to offer much relief in assisting the local economy. In fact we still believe credit contraction (public and private) will exert a negative one to two percent drag on growth in the near-term. Growth will need to come from an expanding local working population or enhanced productivity.

Nathan Kowalski is the chief financial officer of Anchor Investment Management Ltd. Anchor Investment Management Ltd is licensed to conduct investment business by the Bermuda Monetary Authority. He can be reached via e-mail at nkowalski@anchor.bm