Protecting an economy from a pandemic isn’t cheap.
Officials, mainly from rich countries, are spending and lending more than $5 trillion to keep their nations from tumbling into an economic black hole caused by the novel coronavirus. Governments will be supporting legions of unemployed and under-utilized workers indefinitely, at the same time that tax revenues are drying up as economic activity plunges. To pay for it, these countries are having to borrow a bunch of money.
Rich nations were saddled with quite a bit of debt even before the Covid-19 crisis. Their ratio of net debt to gross domestic product was at about 77% last year, according to the International Monetary Fund. The IMF forecasts that number to shoot up to 94% in 2020. Their debt burden is soaring at the same time GDP is contracting.
Most economists are sanguine about the explosion in debt from developed countries. “Borrow big but spend it wisely,” said Andrew Cole, a fund manager in London at Pictet, which oversees $537 billion of assets. “You need to spend it in a way that you can reap some economic benefit from it, or raise your growth rate in years ahead.”
Debt ratios have been worse—Britain’s debt to GDP was around 270% when it emerged from World War II. By the 1980s it had dropped to less than 50%. Thanks to low interest rates (especially relative to inflation) and an expanding economy, the UK managed to lower its debt burden. “They grew their way out of it,” said Paul Krugman, the Nobel Prize winning economist, in a conference call hosted by the New York Times. “When you look at the interest rates at which [the US is] able to borrow, which are ridiculously low, we ought to be relaxed about this.”
Central banks are going to buy a lot of their governments’ debt. The US Federal Reserve’s assets are skyrocketing, and the balance sheets at the European Central Bank and Bank of Japan look pretty similar. Around the world, central bank asset purchases are expected to reach $6 trillion this year, according to Fitch.
People often call it money printing, but that’s not exactly right. When the Fed buys Treasury bonds or the Bank of England buys gilts, they create money to buy their government’s debt from banks, and that new money ends up as bank reserves. If the lender doesn’t use those reserves to make loans, the money doesn’t go into the rest of the economy. These central bank purchases also prevent government borrowing from crowding out lending to private businesses.
“It’s been the medicine we’ve had for certainly the last decade and my guess is we continue to get it,” Cole said.
Thanks to swelling balance sheets at central banks like the Fed and ECB, interest rates are expected to stay contained. And despite all the so-called money printing and immense amounts of government borrowing, institutional investors actually expect price increases to be even more subdued in the coming years.
You can gauge this by looking at the 10-year US Treasury breakeven inflation rate. This measure shows the difference between 10-year government bond yields and Treasury securities that are linked to the inflation rate (Treasury Inflation Protected Securities). The breakeven rate shows professional traders and investors are betting inflation will decline. A similar measure for euro zone government debt shows those investors are also pessimistic about prices and wages rising in Europe any time soon.
“If anything, the risk is deflation,” Krugman said.
The picture is a lot different in emerging markets. These countries aren’t going on spending sprees like nations in advanced economies, but they’re expected to suffer as much if not more. Because their currencies can be less stable and may have a smaller base of investors, these nations often have to borrow in dollars or some other foreign tender. This means their central banks, which may lack credibility with investors, can’t act as a shock absorber during a disruption.
Some of them are getting hit with a triple whammy—lockdowns are sapping economic activity, and the crash in oil and commodity prices is depriving them of vital export revenue. To make matters worse, investment tends to flee emerging economies during a crisis and flow back into advanced economies that are seen as safer and more stable. Borrowing costs have risen in the likes of Brazil, making the country’s debt burden more expensive to service at the same time its GDP is shrinking. Rich nations like Germany, meanwhile, pay nothing to borrow.
As the fiscal situation for pretty much all sovereign borrowers deteriorates, rating companies have been slashing their credit grades. Fitch has downgraded 13 countries as of April 3, which is more downgrades than it made in all of 2019.
Investors tend to look past downgrades when it happens to the highest rated countries. The UK’s ranking was cut one step to AA- in March and bond traders hardly took notice. Investors may regard heavy spending during a crisis as a good thing: It could be seen as an investment in the country’s future, hopefully helping industries and workers to bounce back more quickly.
But it doesn’t always work out that way for nations with lower ratings—particularly those on the edge of losing their investment grade status. Some portfolio managers are only allowed to hold securities that are ranked “investment quality”—for Fitch and Standard & Poor’s, that refers to bonds that are rated BBB- or above (AAA is highest grade). Everything below that is considered junk, or speculative quality, and typically comes with higher borrowing costs.
Italy is one of the countries on the edge of getting stuck with a junk rating, and Pictet’s Cole said he was particularly pessimistic about the country’s prospects. “It’s putting a huge strain on the political status quo in Europe,” he said in a phone interview. While the ECB has kept the country’s borrowing costs contained, Italy’s 10-year bonds yield more than 2 percentage points than German securities. Italy also has one of the highest debt burdens in the world, and it’s at the mercy of a central bank that has to consider the needs and interests of the entire euro zone—including mighty Germany.
“It’s going to lead to another European crunch point,” Cole said. “Who is going to pay the price?”