The Risks of the Covid Global Debt Bridge
The author is president of Fulcrum Asset Management
At the start of the Covid-19 pandemic, it became clear that the global economy would require a massive expansion of public and private debt to avoid an extraordinarily deep and persistent depression.
Because this unprecedented explosion of debt provided a “bridge” over the collapse in global production, corporate bankruptcies and household economic hardship were significantly mitigated.
In light of the progress made on vaccines, investors can be more confident that the end of the debt bridge is in sight. Nevertheless, this year’s surge in borrowing has been called the biggest wave of a great “debt tsunami”.
The Institute of International Finance recently reported that the ratio of global debt to gross domestic product will rise from 320% in 2019 to a record 365% in 2020. The IIF concludes bluntly: “more debt, more problems “. Financial markets ignored these warnings. Global equities hit new highs and credit spreads narrowed, almost as if extreme leverage was good economic development, not bad.
It is exaggerated to share this optimism over the long term. As the World Bank explained in December 2019, previous waves of debt have often resulted in global financial meltdowns, including in Latin America in the 1980s, Asia in the mid-1990s, and the US housing sector. in the 2000s. The World Bank says another wave of emerging market and global debt began in 2010, but it has reached a whole new level this year.
Is this a serious short-term threat to financial market stability? Here, the verdict seems more encouraging.
Macroeconomic conditions offer some support for higher debt ratios. The forces of secular stagnation have created a new excess of global savings over investment, reducing equilibrium real interest rates and inflation. This encouraged central banks in advanced economies to buy about 63% of their rising public debt, mitigating the risks of a funding crisis.
The safety net offered by the support of central banks, notably by the US Federal Reserve, has been greatly extended compared to previous crises. Market-maker-of-last-resort functions avoided liquidity problems that would otherwise have tightened global financial conditions. These actions have made debt crises much less likely.
The immediate supply of large-scale dollar swaps to emerging economies has reduced the severity of dollar shortages. Many central banks in emerging markets have launched their own quantitative easing, despite the weakening of currencies which could trigger inflation.
The Fed has also provided direct loans to businesses, state and local governments, and households, backed by capital injections from the US Treasury. Although these facilities have not been widely used, they have been a game-changer by providing a safety net to credit markets, unlocking trillions of dollars in loans to the private sector.
Economist Paul Krugman correctly compared with the effect of these initiatives with Mario Draghi’s “whatever it takes” speech in 2012 when he was President of the European Central Bank, which effectively ended the euro crisis by promising an intervention unlimited from the central bank if necessary.
With Treasury Secretary Steven Mnuchin now beginning to withdraw that support in defiance of unambiguous Fed advice, it seems likely that expected new secretary Janet Yellen will keep the facilities running using the Exchange Stabilization Fund in the event new urgency.
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A final contrast to the 2008 financial crisis is that households now account for a much smaller fraction of the additional global debt, and the banking sector appears to be better capitalized and less leveraged. But global debt should not be treated as a homogeneous commodity. Its distribution may be larger than its total, and clearly there are some categories that should be cause for concern. These include US corporate debt, already a headache, and now sharply increased in the consumer sectors most affected by Covid-19. Small and medium-sized enterprises face serious difficulties with bank financing, especially in the EU.
China was also a major contributor to the debt spike in 2020, and authorities are trying to rein in a property boom by limiting credit growth, thereby slowing GDP expansion. Other emerging market debt is clearly a potential problem, especially in the lower income group.
A much more dangerous systemic debt crisis likely requires a reversal of secular stagnation and a rise in global inflation, forcing the Fed to tighten monetary policy significantly. Fortunately, that still seems a long way off.