Sea of debt

When the global pandemic struck in 2020 the world was brought to a standstill. Government lending and support was swift and unprecedented in its levels but at what long-term cost?


By any measure the COVID-19 pandemic has created an economic as well as a human calamity that is measured in a global sea of debt, worse in some countries than others, that will take at least a decade to reduce to normal levels. Alarmist? Not in the view of IMF managing director Kristalina Georgieva, who in late 2020 used that very term ‘economic calamity’ in a briefing that spelt out the economic damage in hard numbers.

“We have seen global fiscal actions of $12trn. Major central banks have expanded balance sheets by $7.5trn,” she said, citing the various rescue measures launched since the pandemic first hit in early 2020. And there’s more to come. “[The IMF] expects 2021 debt levels to go up significantly – to around 125 percent of GDP in advanced economies, 65 percent in emerging markets, and 50 percent in low-income countries,” predicted Georgieva. That is why, as we see, the IMF managing director wants a combined pre-emptive action to forestall what she calls a “lost decade.”

The latest figures (see Fig 1) confirm that pessimistic viewpoint. The EU alone will pump $876bn in the form of grants and loans to member countries under a programme called Next Generation EU that, it is hoped, will tide them over for the next few years. As international economist Jean Pisani-Ferry, a senior fellow at Brussels-based think tank Bruegel, pointed out in Project Syndicate, this is the first time that the EU has borrowed to finance expenditures. As such, it is a measure of the enormity of the problem. To put these sums in perspective, the global fiscal actions alone cited by the IMF managing director are not far short of the annual GDP of the US, while the EU’s $876bn rescue package amounts to nearly three percent of the entire bloc’s GDP.



Even so, to take just the EU’s emergency package, it tells only a fraction of the whole story. Between the 27 member countries, the average fiscal support doled out to prop up the respective economies is expected to reach 7–12 percent of their national GDP. And, adds Pisani-Ferry, “significantly more is in the pipeline.” Although the French economist, an expert on public policy, sees a risk in the way the EU’s package may be distributed – for instance for political rather than economic purposes, these hand-outs could make the vital difference in struggling countries.

Innovative fiscal response
And, as the IMF and other authoritative sources warn, this sea of debt is widening all the time. In the US alone, about $3trn will eventually be spent on wide-ranging programmes of economic support including the CARE Act that subsidised those thrown out of work as literally millions of businesses were forced to shut down. As the chairman of the US Federal Reserve, Jerome Powell, explains: “[It was] by far the largest and most innovative fiscal response to an economic crisis since the Great Depression.”


Beyond the United States, the accumulated fiscal response has turbocharged debt levels around the world (see Fig 2). As the graph also reveals, the pandemic hit many countries that were already vulnerable. About half of low-income nations and several emerging ones were, judges the IMF, “already in or at high risk of a debt crisis and the further rise in debt is alarming.” The looming fear is that many of these countries could be hit by a second wave of economic distress. The IMF cites the risk of “defaults, capital flight and fiscal austerity.” Just one of these is the collapse in remittances – money sent home by migrant workers to support their families living in low and middle-income countries.

The World Bank expects the amount of remittances to fall substantially through 2020 and 2021 because there has been a collapse in offshore work, for instance in the cruise ship and construction industries, farms and factories abroad.

Remittances are not pocket money – they prop up many countries. In 2019, a record year, they totalled $548bn in low and middle-income countries, $12bn more than all foreign direct investment flows, according to the World Bank. In the Pacific and East Asia region, China and the Philippines are the biggest beneficiaries of remittances, but poorer countries all over the world will suffer from the decline in remittances.


IMF Managing Director Kristalina Georgieva
IMF Managing Director Kristalina Georgieva


Adding to the nightmare
“The impact of COVID-19 is pervasive when viewed through a migration lens as it affects migrants and their families who rely on remittances,” said Mamta Murthi, vice-president for human development and chairwoman of the migration steering group of the World Bank. Nobody disputes that these unprecedented pay-outs are not necessary. In most countries they saved – or at least delayed – countless thousands of firms from going bankrupt with devastating social consequences.

The pandemic shock was essentially a case of a natural disaster hitting a healthy economy

Indeed a late-2020 survey by the Fed showed that households were coping, with 77 percent of adults saying they were “doing okay” or “living comfortably,” solely because of CARE and similar support programmes. Still, as experts point out, the consequences of this spreading sea of debt are profound for investors, the banking industry, sovereign governments, the vast world of commerce, and individuals.

Taking the banking industry first, although it has stood up remarkably well in most jurisdictions, it remains one of the hardest-hit, facing years of negative interest rates that will deter depositors, as well as fast-rising credit risk in what has become a deeply disinflationary environment. “For bankers, negative interest rates just add to the nightmare of squeezed margins and profits under pressure,” points out the editor of The Banker, Brian Caplen.

Although negative interest rates are not exactly new, they remain an experiment. Denmark is one country that has kept its key policy rate negative since 2012 in the wake of the financial crisis, and Sweden has done so between 2015 and now. The eurozone has broadly held negative rates since 2014 and the European Central Bank believes they have helped foster more favourable economic conditions.

Greater long-term risk

But that’s just Europe. On a wider scale the jury is out. Nobody knows exactly what effect global negative interest rates will have in terms of investment, bank profitability, inflation, savings, exchange rates, stock markets, long-term borrowing rates and other elements of the broader financial markets.

“[Negative interest rates] are a panacea at best and they may prove costly in the long run if the greater risk they promote turns into a financial crash,” concludes Caplen.

The once mighty greenback has already become a concern. As the pandemic tightened its grip in the US and employment collapsed, Americans had to dig deep just to make ends meet, with severe consequences. Notwithstanding CARE and other federal support, in the second quarter of 2020 the country experienced the most sudden plunge in domestic saving on record – in fact since 1947 – that hammered the dollar’s real effective exchange rate (REER), a vital measure for trade, competitiveness, inflation and monetary policy.

As American economist Stephen Roach, a senior fellow at Yale University’s Jackson Institute for Global Affairs, pointed out in Project Syndicate: “The US dollar has now entered the early stages of what looks to be a sharp descent.”

The economist expects the REER to fall by as much as 35 percent by the end of 2021, which would mark the beginning of the end of the greenback as the long-standing safe-haven currency, a position it has occupied pretty much since World War Two. Two alternatives would be the euro and the renminbi.

The blame lies largely on the pandemic. As Jerome Powell told an audience of business economists in October 2020: “As the coronavirus spread across the globe, the US economy was in its 128th month of expansion, the longest in our recorded history – and was generally in a strong position.”

Indeed, unemployment was running at 50-year lows and, contrary to left-wing critics, all workers were taking home higher real wages, especially those in the lower-paid jobs. The banks were strong with much more robust levels of capital and liquidity than they held in the aftermath of the financial crisis. “The pandemic shock was essentially a case of a natural disaster hitting a healthy economy,” concluded Powell, echoing the verdict of economists in most other countries, notably in the western world.

Debt-related vulnerabilities

Fortunately, the world’s biggest banks are not in the precarious state they were when they entered the havoc of 2008. “Banks internationally are in a much stronger position than they were prior to the Great Financial Crisis (GFC),” points out Michele Bullock, assistant governor, financial system at the Australian Reserve Bank, in a review of the industry before the pandemic hit. “Regulatory reforms over the past decade have ensured that banks have increased the amount of capital and liquidity they hold.”

The latest pandemic-triggered sovereign debt has been piled on top of the money printed in the immediate wake of the great financial crisis of 2008

It should be noted though that the non-bank sector has been steadily eating the lunch of the traditional banking industry ever since the GFC. At the peak of the last crisis, the non-bank sector controlled assets of $98trn, seemingly an impressive gain. Today though, this upstart competition has nearly doubled assets under control to a staggering $180trn. Most observers expect this number to keep rising.

But the pandemic has affected those sectors with pre-existing, mainly debt-related vulnerabilities. As Bullock points out, corporate debt in many countries was high. Sovereign debt in Europe was also high. And the low profitability of banks in some countries poses a risk to financial stability.

As a result of the hit taken by the private sector, banks in many countries will probably be hit by write-offs of bad debts and non-performing loans (NPLs), according to Moody’s in a mid-October 2020 report. In a dismaying review of the situation, the rating agency expects UK banks to see the biggest jump in NPLs as real GDP contracts in 2020, while US banks like Citi and JP Morgan (JPM) have high exposure to unsecured personal loans and credit cards (see Fig 3).

The result? “The current recession is likely to exacerbate these issues and potentially impact the financial system’s ability to cushion the shock,” Bullock warns. As it happens, the Australian banking system, which weathered the GFC reasonably well, is both profitable and heavily capitalised.

Bloated balance sheets
The high sovereign debt by historical standards that the Bullock cites is a direct result of the GFC. As the governor of the Bank of England, Andrew Bailey, told the Jackson Hole conference in late August 2020: “There has been a large and sustained expansion of most central bank balance sheets in the past decade.” Like the latest torrents of printed money, central bank’s greatly bloated balance sheets were designed to preserve financial stability, more particularly to prop up a number of big banks.

And those balance sheets were still bloated ahead of the pandemic. “Thus the level of reserves required by the banking systems in the major economies is persistently higher, though it is not straightforward to determine exactly how much higher,” said the governor, citing the influence of a number of factors that can change over time.

The overall result is that many governments entered the pandemic with higher government – or sovereign – debt. And they had to print money all over again in the first big test since GFC. Bailey added: “Monetary policy has had to respond to an unprecedented shock and for many central banks the main tool to date has been further quantitative easing, in an unprecedented scale and pace of purchases.” In a nutshell, the latest pandemic-triggered sovereign debt has been piled on top of the money printed in the immediate wake of the GFC.

Alarmingly, corporate debt was hitting record levels when the pandemic hit with serious implications for emerging economies. In fact, the entire issue of corporate debt is being studied at the highest levels in central banking including by the Financial Stability Forum.

According to a World Bank study released in late 2020, corporate debt in economically weaker countries has shot up from 56 percent of GDP to a sky-high 96 percent. Although the authors point out that “debt financing offers many advantages,” it has regrettably served to “amplify solvency risks for firms in emerging economies and their exposure to changes in market conditions. The economic downturn triggered by the COVID-19 pandemic has only heightened these concerns.”

In plain speak, too many companies in lower-income economies are wildly over borrowed. Worryingly, much of that debt falls due in the next two or three years.

Potential turning point
The overall picture for less economically robust countries is grim. Indeed the accumulated damage is so profound that the IMF’s Georgieva believes the world faces a turning point in economic management similar to that which preceded the Bretton Woods agreement in 1944, a landmark arrangement between all the allied nations of World War Two. A response to the devastation and misery left by the war, the basis of Bretton Woods was that each nation’s central banks would co-operate by maintaining fixed exchange rates between their currency and the dollar. They also agreed to avoid mutually damaging trade wars, similiar to those most recently initiated by Donald Trump.

The wealthier western nations have sufficiently strong economies to get out of jail, although most forecasters say it will take about a decade

“Today we face a new Bretton Woods moment,” said Georgieva prophetically. “A pandemic that has already cost more than 1.3 million lives. An economic calamity that will make the world economy 4.4 percent smaller this year (2020) and strip an estimated $11trn of output by next year (2021). And we have untold human desperation in the face of huge disruption and rising poverty for the first time in decades.”

As the IMF president put it, there are two “massive tasks”: one is to fight the crisis and the other is to build a better tomorrow.

Solely because of a totally unprecedented global rescue mission, we have a sea of debt but, at least so far, no debt crisis. As the IMF noted in a blog in late 2020, the debt crisis has been staved off by “decisive policy actions by central banks, fiscal authorities, official bilateral creditors, and international financial institutions in the early days of the pandemic.” The IMF was in the middle of these actions, pumping about $31bn in emergency funding to 76 countries including 47 of the low-income ones. In addition, the World Bank’s Catastrophe Containment and Relief Trust offered medium-term debt-service relief to the poorest nations. And yet, this may not be enough. “These actions, while essential, are fast becoming insufficient,” the blog warns.

The wealthier western nations have sufficiently strong economies to get out of jail, although most forecasters say it will take about a decade. The looming concern lies with the poorer nations. This is why the IMF and other agencies have mounted a campaign that aims to achieve nothing more nor less than the reform of the international debt architecture, more particularly where sovereign debt contracts are concerned. This would take the form of an “orderly debt restructuring” that essentially means a generous programme of debt relief on sovereign bonds for relatively impoverished nations.


Nobel Laureate Joseph Stiglitz
Nobel Laureate Joseph Stiglitz

The day after tomorrow
It’s been done before in Latin America. But this kind of restructuring is complicated and sometimes murky, as current attempts to sort out delinquent nations such as Ecuador and Argentina are showing. The problem is that much official – that is, sovereign – debt is now held outside the long-standing procedures established by the Paris Club, an informal group of officials from the main creditor nations. Consequently, many actual and potential creditors are in the dark about such basic things as how much a country owes or on what terms.

This is one reason why the IMF wants cleaner contracts that spell out the true situation. And with a debt crisis in the offing, the federation is making a case for clauses that, in the event of natural catastrophes or other heavyweight economic shocks, automatically trigger lower debt repayments or freeze payments altogether.

Will this happen? It may have to, according to the IMF, if the world wants to “prevent and, if necessary, pre-empt another sovereign debt quagmire” that could trigger “large-scale defaults that would severely damage economies and set back their recoveries for years.”

Looking on the brighter side, some, like Nobel Prize-winning economist Joseph Stiglitz, joins the IMF managing director in seeing opportunities in the current havoc. Calling for a “comprehensive review of the rules of the economy” in the recovery process, he wishes for, among other things, monetary policies that deliver full employment of all groups, better balanced bankruptcy laws instead of creditor-friendly ones, and more accountability for bankers “engaged in predatory lending.”

These may happen, but one thing is certain: as the sea of debt recedes the world will not be the same as before.