A CLOSER LOOK INTO THE DRIVERS OF THE NORWEGIAN ECONOMY’s RECENT GROWTH SUCCESS

In this post I present some hard data from the Norwegian economy, which in the recent decades show high correlations between total debt growth and the oil price. Presently the total debt growth from some sectors runs at an annual rate above 8% of GDP.

I also present my thoughts and observations about historical developments and what may lie ahead.

The economic undertows now suggest for a sharp downturn in the Norwegian economy. A deep look into the public data from Statistics Norway (SSB) reveals that it was the growth in debt, primarily acquired by the Norwegian households, that was and still continues to be a major and less acknowledged contributor to the recent growth success of the Norwegian economy.

The primer for the strong nominal growth in debt was likely the growth in the oil price starting back in 2004. The oil price has remained at a structurally higher level at around $100/bbl.

Developments in the Norwegian economy have been tightly linked to movements of the oil price and the value of petroleum exports.

• It is widely recognized that the growth in the oil price spurred more investments for exploration and developments for petroleum from the North Sea.
• With the increased Norwegian North Sea petroleum activities followed an acceleration in households, non financial and municipalities debt growth.

Norway had a long history of running a balanced trade account and with increased incomes from petroleum exports during the recent decades, a big trade surplus.

As the data on imports are not broken down by sectors, there is good reason to believe that a major portion of the import growth originates from purchases of goods and services for the petroleum industry.

The value of Norwegian petroleum exports is now expected to decline in the near term with the decline in production, primarily of crude oil and by the end of this decade also natural gas.

Anyhow the data were whipped around for confessions, it turned out the Norwegian economy now appear to approach a major turn around.

Note to reader: This post is lengthy (and rich with descriptive charts!) and may be perceived as hard to digest, however it is my hope and belief that hose who take the time and read it, give it some reflection and make their own queries, may be rewarded with some improved and valuable insights into the recent workings and drivers for the Norwegian economy. Readers may use the opportunities to post questions/comments (automatic shut off after 14 days) or contact me using the spam protected E-mail: rune [dot] likvern [at] google [dot] com

Directly and indirectly around 90% of the profits from the Norwegian petroleum sales are transferred to and invested by the Norwegian Government Pension Fund Global (GPFG, a sovereign wealth fund). This monetary surplus does not directly enter the Norwegian economy.

Indirectly a regulation in effect allows the government for an annual expenditure of maximum 4% of the market value from this sovereign wealth fund to be allocated for government spending.

The chart shows that the growing oil price was the driver for more investments in development of discoveries and increased exploration activities.

Developments of petroleum discoveries in the North Sea are characterized by long lead times and financially heavy front loaded (capital intensive). When the development of a discovery has been sanctioned, any reversing of the decision becomes like turning a heavily loaded supertanker plowing the waters at full speed. The development will move forward despite any swings and outlooks for petroleum prices.

In the post “A closer look at some recent developments offshore Norway“ I presented how some of the recent Norwegian petroleum developments had fared both with regard to expected production and financially.

In the continuation of reading this post, keep also in mind:

Demand is not what one wants, but what one is willing and capable of paying for.

DEBT GROWTH FOR HOUSEHOLDS, NON FINANCIAL AND MUNICIPALITIES

Debt growth has closely followed the oil price and started to accelerate with the oil price in 2004 (refer also to figure 2) reaching 14 – 15% of GDP (and also of total debt) during 2007 and 2008.  The collapse of the oil price in the second half of 2008 in the wake of the Global Financial Crisis (GFC) led to a deceleration in debt growth primarily from households and non financial, refer also to figures 4, 5 and 6. As the oil price again grew towards $100/bbl in 2011, debt growth accelerated again and has as of recently stabilized around an annual rate of 6% of total debt (above 8% of GDP).

In 2008 total debt for households, non financial and municipalities grew at a rate of around 14% of GDP and presently runs above 8% of GDP.

Debt is useful when invested in productive undertakings (for capital formation) and also for financing major purchases. At some point the usefulness of more debt diminishes.

CORRELATION ANALYSIS

For what it was worth, developments in total debt growth and oil price were subject to an extensive correlation analysis spanning various periods shown in figure 4. For the period Jan 89 – Sep 13 the correlation of total debt growth (households and non financial) with the oil price had a high correlation of 0.76. As the periods analyzed were shortened (using Sep 2013 as an end point) the correlation weakened and presently it is difficult to find any correlation between debt growth and the oil price. This may also be perceived from figure 4.

What now keeps the debt growth at high levels may of course be a combination of several factors, but the high oil price still ensures high investment levels for petroleum exploration and developments together with healthy profits from sales of petroleum.

It may be that the prospects for continued elevated petroleum investments for the foreseeable future instills confidence with the households who then continue to take on more debt within their capacities.

Requirements from the Norwegian regulatory authorities with regard to the banks’ equities (capitalization) will at some point introduce a ceiling to how much Norwegian banks may be allowed to lend to businesses and households. There are limits both to the debt carrying capacities from the entities that borrows and those who lends. As of now and in theory it appears that Norwegian households still have remaining capacities to take on more debt.

NORWEGIAN HOUSEHOLDS

The growth in house prices also introduced the opportunity for early entrants for using the increased market value of their home as collateral to take on more debt that could be used to finance cabins, bigger cars, boats, travels etc. (what in general is referred to as consumption). Norwegian households on average and annually have spent 12 – 15 % more than their disposable incomes during the recent 15 years, confident that continued growth in home prices, wage growth and low interest rates should facilitate future debt services and reliably honor their financial obligations.

Note how household debt growth in 2004 started to accelerate simultaneously with the growth in the oil price and the debt growth for non financials, see also figures 4 and 6.

Household debt growth decelerated with the Global Financial Crisis in 2008. This deceleration in debt growth also affected housing prices as less money was lent into existence to support and bid up prices.

With the growth in the oil price in 2010/2011 came a new cycle of debt growth from households that helped bid up home prices.

The mechanisms supporting and bidding up home prices in Norway are the same as those at work in the US housing market which led to a decline in home prices as the bubble burst in 2007.

Who temporarily gains from these (pyramid like) conditions?

Short answer; Everyone.

The households experience the temporarily illusive effect of wealth growth created by increased purchasing power from acquiring more credit/debt. The home construction and furnishings businesses gains from increased demand and sales. The government from increased employment and collected taxes and duties from all these activities and transactions which grows their revenues and makes it possible to finance popular promises. The financial institutions gain from growth in the demand and the expanded base for their main product; debt. The wage earners from wage growth created from more money in circulation.

A home is the biggest purchase in their life for a major portion of the population. It is commonly perceived as an investment, but in the real world most homes are merely objects of consumption.

Who will for a long time be left holding the bag when the bubble bursts?

Short answer; Everyone.

The economic laws governing the Norwegian economy are identical to those governing  the US, UK, Greece, Portugal and many more. There are of course both structural and real differences between economies.

A lower debt growth followed with the probabilities for deleveraging is the fuel for deflationary contraction.

Lower debt growth introduces less demand for homes (as fewer will have the capacities to bid and most importantly, to pay). Lower demand for homes translates into lower construction activities, increased unemployment, lower demand for furnishings and other goods and services and thus becomes contagious for several sectors of the economy.

The government will see their revenues decline from lower debt growth (and even more if households start reducing their total debt). At the same time a growing unemployment will call for increased benefits and thus increased government expenditures.

In the wake of lowered debt growth home prices will decline and some late entrants could find themselves underwater (more mortgage than equity from the market value of their colatteraled home).

Perhaps there is some solace to be found from George Carlin’s (maybe somewhat cynical) view on a house:

”A house is just a place to keep your stuff while you go out and get more stuff.”

NORWEGIAN NON FINANCIALS

With a growing oil price more debt was assumed by non financials (businesses) to create growth to meet an increased demand for goods and services, primarily created by petroleum related activities. Note the steep acceleration in debt growth from 2004 (look also at the development for the oil price in figure 4) and also how non financial grew their debt at an astonishing annual rate of 20%  from 2006 until the oil price collapsed in 2008.

What followed after the oil price collapse is interesting; the non financial momentarily started deleveraging. With some time lag the growth in the oil price from 2009 created a secondary high in 2012 for the debt growth, followed by deceleration and now the debt growth appears to have stabilized at an annual rate of 4%.

Non financial is primarily businesses (inclusive oil companies, oil service companies and exclusive financial institutions) were encouraged by the higher investment levels created from the higher oil price to increase their borrowing in a bid a meet increased demand for their products and services. This helped employment stay at high levels and also contributed to a healthy wage growth.

A healthy wage growth for employees increases their debt servicing capacities and the prospects of servicing more debt and its future down payment thus fueled more borrowing from households (see also figure 5 above).

Non financial (businesses) will not grow their debt if they do not see outlooks for financial growth (profits) that justifies buying more debt.

Even if the government requests the financial institutions to reserve debt capacities for businesses, this request carries little value if the businesses do not see any potential for future financial growth.

Note the decline in investments in figure 2 from 2009 to 2010 with the deceleration in debt growth for the same period in figure 3 and further the deceleration in debt growth for households in figure 5 and non financials in figure 6.

Figures 4 and 6 show that non financials (businesses) just after the oil price collapsed in 2008 started rapidly lowering their debts which cause deflationary undertows.

One indicator for how businesses perceive future developments could be if more asset sales are carried out as a mean of reducing the total debt overhang (or leverage), this is often presented as “targeting financial performance”.

NORWEGIAN MUNICIPALITIES

Increased tax revenues from the aggregate of activities caused from growing amounts of debt in other sectors also results in a growing income base for municipalities that allow for more debt (increased leveraging) to be acquired to finance popular promises like schools, nursery homes, community centers, infrastructure, pensions etc. as it is expected that future revenue growth and levels will allow to service more debt.

Municipalities debt growth appears with some time lag to roughly follow the debt growth from other sectors.

The media (from what I have seen and so far) recently reported about one municipality that needed to go deeper into debt just to pay for pension promises.

Even if the municipalities’ annual debt growth has declined from 14% in 2010 to recently around 8%, it does not require a PhD in mathematics to understand that even the lowered debt growth is not sustainable.

Municipalities have also to balance their budgets and as figure 7 shows in recent years this was achieved by taking on more debt. A general economic slowdown will also affect the municipalities’ incomes and erode their debt carrying capacities, leaving them to look for and manage areas that can take cuts in their budgets and thus scaling down on promises made.

THE OIL PRICE

The dynamics now at play for the oil price has (as I see and have seen it) remained the same since 2010 as illustrated above. I expect this dynamic to be prevalent in the near future and hold now a decline in the oil price (absent any major geopolitical disruptive event) as most likely.

The trajectory of the oil price towards its high in 2008 has the characters of a bubble buoyed also by the influence of speculative forces which thus was predestined to blow. And it did!

The chart above also describes an interesting trend since 2010, the “highs” are becoming lower and the “lows” higher, suggesting the converging of what the producers need to profitably develop new discoveries with what the consumers can afford.

Presently many oil companies have bet their financial future on consumers’ abilities to continue to go deeper into debt in order to buy the more expensive oil (from more exotic areas like the Arctic) which will allow the oil companies to retire the debts acquired for the developments of these sources.

THE EXCHANGE RATE FOR THE NORWEGIAN KRONE IN 2013

Fiat money is all about trust, faith and the ability to enforce its value. An economy showing strong organic growth may see that its currency strengthens (gains) relative to those of its trading partners. The oil price has been very stable in 2013 moving in a band between $100 – $110/bbl.

As the production and sales of petroleum constitute a big portion of the Norwegian economy it should be expected that the exchange rate for the Norwegian Krone should have remained pretty stable.

It turns out the Norwegian Krone in 2013 has lost somewhere between 10 – 15% of its purchasing value relative to the currencies of its most important trading partners, refer also to figure 9 below.

The chart above begs the question;

Is the present weakening of the Norwegian Krone of a cyclical or structural character?

A currency’s movement is also a reflection of expectations from investors and other affected market participants. Someone (upon seeing the chart above) suggested that it could be that the outside world gradually have come to realize what all the true drivers behind the Norwegian growth success were. Meaning that all the economic growth was not organic, but supercharged during several years from growing amounts of debt. These same market participants know what happens as the growth in total debt slows down and eventually reverses.

Many of these investors/market participants have likely and recently seen this movie play out in a theater nearby.

SO WHERE DO WE GO FROM HERE?

What occurred to me from doing the research/analysis for this post (actually a process through several years) supplemented by several enlightening lengthy discussions with many international experts, is how responsive the financial system/parameters in Norway have been for movements in the oil price. This responsiveness could become amplified as households, non financial (businesses) and municipalities approach their debt carrying capacities at a time when Norwegian petroleum production by historic levels still is relatively high albeit in terminal decline.

Financial systems are virtual and thus highly responsive, meaning that changes occur rapidly.

Then add that humans are what they are, meaning that the psychology of crowds is a potent and unpredictable force.

The Norwegian economy, now buoyed by high petroleum exports and activities related to petroleum acts no different from any other modern economies. The Norwegian economy is governed by the same laws and mechanisms as any other advanced economy.

I have previously posted my forecasts on Norwegian crude oil and natural gas  production which show that I expect the production and thus exports are both in terminal decline.

(The posts are in Norwegian and anyone not fluent in Norwegian that take any interest is advised to use Google translate (or similar) for a close readable proxy in their native).

Gross Domestic Product (GDP) is widely used to reflect the health of an economy and is expressed below.

GDP = Consumption + Investments + Government expenditures + Exports – Imports

(I , and many others look at the present GDP metric as greatly flawed, but for what it is worth it will be referred to in what follows.)

Growth in GDP was, besides the growth of petroleum exports, petroleum activities and government expenditures, primarily facilitated by growth in consumer debt which supercharged consumption. Norwegian households has been and is the sector with the fastest debt growth in both nominal and relative terms, albeit now at a slower rate, but still above what is expected for growth in households disposable income.

Deleveraging (reducing total debt overhang) is by definition deflationary.

A decline in total exports would ceteris paribus (all other things remaining equal) reduce the GDP. Then throw in the prospect from reduced investments and consumption from lower growth in debts which leaves only growth in government expenditures to sustain or grow the Norwegian GDP.

This is where the proverbial rock gets closer to the hard place.

As all sectors start to reduce their assumption of debts (and probably starts deleveraging), the government’s income will decline, while expenditures are more likely to grow (from higher unemployment and benefits paid). Add in the potential from reduced trade surpluses (primarily from declining revenues from petroleum exports) leaves primarily government expenditures to grow to make GDP grow.

The sovereign wealth fund (GPFG) leaves now a little room for increased government spending, but the sovereign wealth fund is also subject to changes in its market value from international financial developments.

Finding themselves in a reality with declining incomes and growth in expenditures, the government may solve this through a combination of measures; increased taxes (direct and/or indirect; this does not solve the fundamental problem as this is mainly shifting some of the same money from private consumption to government spending), reductions in the promises made (lowering public entitlements [health care, pensions, education, public employees’ wages etc.] all presented behind some edible rhetorics) and temporarily take on more debt (Norway’s sovereign debt is presently relatively low) betting on a future resumption of economic growth.

So how was all this facilitated?

The recipe for effective control of collective behavior is through “perception management” (targeted use of the mass media) has been known for a long time and improved for a century;

“Men (people) are rarely aware of the real reasons which motivate their actions.”

– Edward Bernays, “Propaganda”, 1928

SUMMARY

What has been shown in this post is how a near quadrupling of the oil price during a few years in the previous decade set in motion a chain reaction in Norway that increased borrowing from all presented sectors. Debt is a potent steroid for economic growth and is assumed with the expectation that financial growth over time will ease the burden of servicing it and diminish its relative influence on future financial capabilities.

As this growth in debt slows and/or reverses for any reason or combination of reasons, the debt overhang becomes a liability that in aggregate has the potential to create a strong, lasting and self reinforcing deflationary contraction.

Apart from production and sales of petroleum the Norwegian economy was and has increasingly become more dependent on primarily the households’ continued willingness and abilities to take on more debt for consumption.

I chose to name this blog “Fractional Flow” as this also aptly describes what happens when growth in credit/debt reverses. GDP growth has for decades been turbocharged with high amounts of debt and GDP is all about the (credit) flow.

Credit/debt acts as lubricants for an engine (economy) and if the engine sees its flow of lubricants dry up (declining credit/debt) it risks a seizure.

As this debt expansion comes to a halt (or reverses) the Norwegian economy will shrivel, despite the continued high petroleum related activities and production.