Seeds of the next debt crisis
II used to be that pushing public debt beyond 90% (of GDP) could hurt growth and increase the risk of crisis. Today, economists are not so sure.
In a world of ultra-low interest rates, governments around the world are piling-up on debt. Today, it is argued that so long as sovereign bond yields remain below economic growth rates, higher public debt levels may even be desirable. It’s like governments are able to issue debt without needing to pay for it later. The economy will take care of it.
Today, that’s already happening in the West. EU and governments in France, Italy, Spain and the UK are pencilling in large budget deficits for the coming years that will push their national debt close to 100% of GDP (debt ratio) or much higher.
EU has just set out a US$2 trillion Covid-19 response plan. Japan recently announced a Us$120bil fiscal stimulus to shore-up growth despite a public debt ratio of 240%. US has embarked on a borrowing boom, driving the 2020 budget gap above US$1 trillion and total government debt ratio above 105%. Be that as it may, there is concern; high public debt still carries many risks.
Seeds
Debt reduces the room for fiscal manoeuvre in the event of a downturn. The European Commission warned eight member states in November 2019 that they risked breaching the bloc’s rules, requiring those with a debt ratio above 60% to gradually reduce it.
Traditionally, economists worry that high public debt soaks up funds that otherwise will be used for private investment, thereby lowering a nation’s capital stock and productive capacity, while driving up interest rates.
However, today, very low interest rates globally suggest there is ample capital relative to demand. Funds available for private investment aren’t really being crowded out, so the costs traditionally associated with high government debt aren’t as high as previously thought. Indeed, higher public debt can offer advantages:
(i) satisfies a growing demand among investors for safe assets;
(ii) substitute for a lack of policy ammunition among central banks, which have already cut interest rates close to zero or below; and
(iii) fund public investment in infrastructure, education, research and development, and climate change mitigation, which eventually elevates potential growth.
But the danger is that low interest rates reflect slow growth, which makes it harder for countries to escape from under a mountain of debt:
(a) high debt nations are less able to respond forcefully to economic shocks, by raising spending or cutting taxes;
(b) history shows that high debt becomes problematic as countries continue to raise more debt;
(c) advanced economies face a substantially higher risk of entering a crisis if sovereign debt owed to foreign creditors exceeds 70% of GDP (30% for emerging markets – EMS),
(d) crucially, government bond yields often remain low for long stretches before shooting-up at the onset of a crisis. It suggests governments should be wary of high public debt even when borrowing costs seem low. Lest we forget, the two European economies with the slowest growth rates (Italy and Greece) started out with the highest public debt; Ireland (which entered the financial crisis with low government debt) was quick to bounce back; and
(e) Harvard’s Rogoff & Reinhart found that countries with public debt ratio above 90% typically had slower economic growth. The Institute of International Finance (IIF) reported that the global debt ratio hit an all-time high of over 322% in third quarter 2019, with total debt reaching some US$253 trillion. Overall, debt creates fragility. The implication is that if the virus continues to spread, any fragilities in the financial system have the potential to trigger a new debt crisis. Corporate debt
Financial conditions have since tightened for weaker corporate borrowers, despite recent declines in bond yields and borrowing costs. Their access to bond markets has become more difficult. This is particularly important because much of the debt build-up has been in the non-financial corporate sector, where the current disruption to supply chains and reduced global growth imply lower earnings and greater difficulty in servicing debt.
In effect, the coronavirus raises the extraordinary prospect of a credit crunch in a world of ultra-low and negative interest rates (NIRS). Risks have been building in the financial system for decades. From the late 1980s, central banks (especially the Fed) conducted what came to be known as “asymmetric monetary policy.”
Here, they supported markets when they plunged, but failed to dampen them when they were prone to bubbles. Excessive risk taking was the natural consequence. Central banks’ quantitative easing (QE) since the global financial crisis (involving purchases of government bonds and other assets) in effect, reflects a continuation of this asymmetric approach. The resulting safety net placed under the banking system is unprecedented in scale and duration.
Continuing loose QE has brought forward debt financed private expenditure, thereby elongating an already protracted cycle in which extraordinary low or NIRS appear to be less and less effective in stimulating demand. In addition, much of the debt focus in the private sector has not been as previously on property and mortgage lending, but as credit to corporates.
The Organisation for Economic Cooperation and Development (OECD) reports that at the end of 2019, global outstanding stock of non-financial corporate bonds reached an alltime high of US$13.5 trillion, double against end-2008. The rise is most striking in US, where the Fed estimates that corporate debt has risen from US$3.3 trillion before the global financial crisis to US$6.5 trillion at end2019. Worse, much of the debt is concentrated in old economy sectors, which are less cash generative than the FAANG Big Techs. Debt servicing is thus more burdensome.
Further, OECD notes that compared with previous credit cycles, today’s stock of corporate bonds has lower overall credit quality, longer maturities, inferior covenant protection and higher payback requirements. Longer maturities are associated with higher price sensitivity to changes in interest rates. So, together with declining credit quality, that makes bond markets more sensitive to changes in monetary policy.
Moreover, much of this debt has financed mergers and acquisitions and stock buybacks. Executives have a powerful incentive to engage in buybacks despite very full valuations because they boost earnings per share (by shrinking equity capital) and thus, inflate performance related pay.
Indeed, such financial engineering is a recipe for systematically weakening corporate balance sheets. Unfortunately, this huge accumulation of increasingly poor quality corporate debt is likely to exacerbate the next recession.
“War” debt
An astonishing deterioration in the public finance is unfolding. US is set to run a deficit of 15% of GDP this year – it rises as more stimulus is needed. Across the rich world, the International Monetary Fund (IMF) estimates that gross government debt will rise by US$6 trillion, to US$66 trillion by end-2020 (from 105% of GDP to 122%).
Long after the Covid-19 wards have emptied, the load will still be there. But be realistic. In OECD, national debt simply means a country in effect owes money to itself. Debt may be high, but what matters is the cost of servicing it. And, as long as interest rates are low, this is still cheap.
In 2019, US spent 1.8% of GDP on debt interest (less than it did 20 years ago). In 2019, Japan’s gross public debt was already 240% of GDP. But there are new signs that it’s not sustainable. Seriously, when countries print their own money, central banks can hold down interest rates by buying bonds, as the Fed has done on an unprecedented scale. Indeed, it bought more Treasuries in five weeks nett, than were issued in the year to April.
Just now, there is no risk of inflation, and oil prices have since collapsed. Most worry governments will borrow recklessly; others are too timid for fear of rising debt. As I see it, inadequate fiscal support today risks pushing the economy into a spiral of decline. But the US has strong internal defences against an outright debt crisis. That’s because US dollar is the world’s main reserve currency; and all its debt is denominated in US dollars – its own currency!
Nations with surpluses want to own US bonds. But other rich countries do not have that luxury. Italy’s towering debt and membership of the eurozone condemn it to live with the perennial threat of a financial panic without European Central Bank’s support.
Governments have to walk a treacherous path between stimulus today and prudence tomorrow. Success is not guaranteed. The politics of deficit reduction can be toxic. The pandemic “war” will increase calls for lavish spending, not belt-tightening, especially on medical and health services. Ageing populations mean that there will be surging demand for pension and health spending in the 2030s and 2040s. There will be less spare cash to fight future crises, such as climate change or even another pandemic.
Faced with this daunting reality while in the throes of the pandemic, the withdrawal of emergency support would be self-defeating. Modestly higher inflation will help, by boosting the nominal growth rate. When it exceeds the interest rate, existing debts shrink relative to GDP. Unfortunately, central banks have recently undershot their inflation target. EMS’ debt
The kindling for another EMS debt crisis
has been accumulating for years. Investor thirst for higher returns has allowed smaller, lesser-developed and more vulnerable “frontier” nations to tap bond markets at a record pace in the past decade. IIF estimates their debt burden has climbed from less than US$1 trillion in 2005 to US$3.2 trillion, equal to 114% GDP of frontier markets.
Today, EMS as a whole owes a total of US$71 trillion. China is their largest creditor. G20 has since agreed to temporarily freeze about Us$20bil worth of bilateral loan repayments for 76 poorest countries. Private sector creditors, however, can only make a series of ad hoc debt standstills and restructurings.
Holdouts will always be there (involving the exchange of a country’s old bonds for new ones – often worth less, with a lower interest rate or longer repayment times). In the end, policymakers must start to grapple more forcefully with EMS’ travails, given the danger that their severity is likely to reverberate across the global financial system.
Indeed, it can quickly escalate from a health crisis to ultimately, a solvency crisis. Political stability will be the last domino to fall. But my biggest concern is that this pandemic will become much deeper and more prolonged than people anticipate. This leaves a lot of room for the other shoe to drop in a global crisis.
Complacency
What I worry is that central banks’ ultraloose monetary policy has fostered what economists call “disaster myopia” – or complacency, a prerequisite of financial crises. The greatest complacency today is over inflation and the possibility that central banks will inflict a financial shock by raising interest rates sooner than most expect.
Of course, this myopia is understandable because of the coronavirus and deficient demand in debt laden advanced economies. Hence, central banks’ recent difficulties in meeting inflation targets.
At the same time, tightening labour markets have not led to increased wage inflation. Looks like the traditional relationship between falling unemployment and rising price inflation has broken down. What’s really of concern is the deflationary impulse that’s still at work in the global economy, causing growth to be both anaemic and debt dependent. With the central banks’ unconventional measures becoming less effective, there are pressing questions about:
(i) how to respond to stagnation when interest rates are close to zero, and where a more activist fiscal policy has become necessary;
(ii) whether in the light of the debt buildup: regulatory response to the last financial crisis has been sufficient to rule out another systemic crisis; and
(iii) whether the increase in banks’ capital did really provide adequate buffer against the losses that will result from widespread mispricing of risk.
Here, history helps. The 1930s and early 1970s was one period relatively free of crisis. The regulatory response to the 1929 crash and the subsequent banking failures was so draconian that banking was turned into a low-risk, utility-like business. But the progressive removal of this regulatory straitjacket paved the way for the property-based crises of the mid-1970s, Latin American debt crisis of the 1980s, more property-based crises of the early 1990s, and so on.
Despite the plethora of reforms since 2008, given the very rapid changes in financial structure, once again regulators can be left behind. The new reality will catch them wrong footed via regulatory arbitrage. Sure, it is not possible to predict the trigger or timing of the next financial crisis.
Notwithstanding coronavirus, I doubt a full-blown crisis is imminent. But the potentially unsustainable accumulation of public sector debt and of debt in the non-financial corporate sector highlight serious vulnerabilities: not just in China, India and EMS, but also in the US, Europe, Japan and the UK. When coronavirus is long gone, I worry that’s when systemic trouble steps in.
What then are we to do
OECD estimates rich countries are set to take-on at least US$17 trillion of extra public debt as they battle the consequences of the coronavirus pandemic and weak global demand. Government liabilities are expected to rise from 109% of GDP to 137% this year (i.e. the current level in Italy).
This implies a minimum of US$13,000 per person across the 1.3 billion people living in OECD. Such high levels of public and private debt raise questions about their sustainability.
Many still believe that undue debt build-up threatens to undermine private sector spending, creating a drag on growth. Present economic strategy using lots of “helicopter” money is, honestly speaking, going to bring about a huge fiscal problem in the future. At this time, there is no good, sensible alternative answer.
Central banks’ purchases of government and corporate debt in unlimited quantities can help to lighten the load to finance budget deficits and help to keep interest costs lower, an attempt to keep inflation from falling far below their target.
As I see it, there are limits to the deficit governments can run, without resulting in inflation. A sure way out is by raising taxes and cutting spending; but few want to go down this route after almost a decade of tightening public spending. Further, the negative consequences for growth could easily outweigh the benefits.
The most important thing is to get the economy grow faster than the rate debt is rising; and get jobs created. In the end, the best policy lies in the “delicate” art of debt “forgiveness” and restructuring. Done properly, it will be in the interest of debt holders who can still lose, but not as much as they would if they clung on to the hope that the debts will ultimately be repaid.
Former banker, Harvard educated economist and British Chartered Scientist, Prof Tan Sri Lin See-yan of Sunway University is the author of Trying Troubled Times Amid Trauma & Tumult, 2017–2019 (Pearson, 2019). The views expressed are the writer’s own.