18 December 2020
Author: Gavyn Davies, Executive Chairman
Early in the Covid-19 pandemic, it became clear that the global economy would require a massive extension of public and private debt to avoid an extraordinarily deep and persistent depression.
Because this unprecedented explosion in debt provided a “bridge” over the collapse in world output, corporate bankruptcies and economic hardship for households have been significantly mitigated.
In light of the progress 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 largest wave in 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 per cent in 2019 to a record 365 per cent in 2020. The IIF concludes starkly: “more debt, more trouble”. Financial markets have ignored these warnings. Global equities have reached new highs and credit spreads have been narrowing, almost as if extreme debt is a good, not a bad, economic development.
It is a stretch to share this optimism over the long term. As the World Bank explained in December 2019, previous waves of debt have frequently ended in global financial meltdowns, including in Latin America in the 1980s, Asia in the mid-1990s and US housing in the 2000s. The World Bank says another wave of emerging market and global debt started in 2010, but this has shifted to an entirely new level this year.
Is this a serious near-term threat to the stability of financial markets? Here, the verdict seems more encouraging.
Macroeconomic conditions offer some support for higher debt ratios. The forces of secular stagnation have created a further excess of global savings over investment, reducing equilibrium real interest rates and inflation. This has encouraged central banks in advanced economies to purchase about 63 per cent of the rise in their government debt, mitigating the risks of funding crises.
The safety net offered by central bank support, notably by the US Federal Reserve, has been greatly extended compared with previous crises. Market-maker of last resort functions have prevented liquidity problems that would otherwise have tightened global financial conditions. These actions have made debt crises far less likely.
The immediate provision of large-scale dollar swaps to emerging economies has reduced the severity of dollar shortages. Many emerging market central banks have started their own quantitative easing, despite weakening currencies that might trigger inflation.
The Fed has also provided direct lending to corporates, state and local governments, and households, supported by capital injections from the US Treasury. Although these facilities have not been greatly used, they have been a game changer by providing a backstop for credit markets, unlocking trillions of dollars of private sector lending.
Economist Paul Krugman has correctly compared the effect of these initiatives with the “whatever it takes” speech of Mario Draghi in 2012 when he was president of the European Central Bank, which effectively ended the euro crisis by promising unlimited central bank intervention if needed.
While Treasury secretary Steven Mnuchin has now started to withdraw this support in defiance of unambiguous advice from the Fed, it seems probable that expected new secretary Janet Yellen will keep the facilities operating by using the Exchange Stabilisation Fund in any new emergency.
A final contrast with the 2008 financial crisis is that households now account for a much smaller fraction of the extra global debt, and the banking sector seems better capitalised and less leveraged. But global debt should not be treated as a homogenous commodity. Its distribution is perhaps more important than its total and, clearly, some categories should cause concern. These include US corporate debt, already a headache, and now greatly increased in the consumer sectors most damaged by Covid-19. Small and medium-sized companies are facing severe bank funding stress, especially in the EU.
China has also been a dominant contributor to the 2020 debt surge, and the authorities are trying to dampen a property boom by restricting credit growth, thus slowing the expansion in GDP. Other emerging market debt is clearly a potential problem, especially in the low-income group.
A far more dangerous, systemic debt crisis probably requires a reversal of secular stagnation, and a rise in world inflation, forcing the Fed to tighten monetary policy significantly. Luckily, that still seems a very long way off.