BIZweek n°280 6 mar 2020
BIZweek n°280 6 mar 2020
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  • Parution : n°280 de 6 mar 2020

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  • Editeur : Capital Publications Ltd

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VENDREDI 06 MARS 2020 BIZWEEK ÉDITION 280 The seeds of the next debt crisis The shock that coronavirus has wrought on markets across the world coincides with a dangerous financial backdrop marked by spiralling global debt. According to the Institute of International Finance, a trade group, the ratio of global debt to gross domestic product hit an all-time high of over 322 per cent in the third quarter of 2019, with total debt reaching close to $253tn. The implication, if the virus continues to spread, is that any fragilities in the financial system have the potential to trigger a new debt crisis. In the short termthe behaviour of credit markets will be critical. Despite the decline in bond yields and borrowing costs since the markets took fright, financial conditions have tightened for weaker corporate borrowers. Their access to bond markets has become more difficult. After Tuesday’s 50 basis-point cut, the US Federal Reserve’s policy rate of 1.0-1.5 per cent is still higher than the 0.8 per cent yield on the policy-sensitive two-year Treasury note. This inversion of the yield curve could intensify the squeeze, says Charles Dumas, chief economist of TS Lombard, if US banks now tighten credit while lending has become less profitable. This is particularly important because much of the debt build-up since the global financial crisis of 2007-08 has been in the non-bank 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. Global debt hits a record high $in 250 200 150 100 50 2000 01 02 03 04 05 06 07 08 09 1 Source IIF e or ACTA PUBLICA COVID-19 With debt levels already at a record high, coronavirus raises the risk of a credit crunch in a world of low interest rates Share of GDP (%).". I 12 13 14 15 16 17 18 19 Policymakers Policymakers in advanced countries in advanced have over the countries past week made clear have their over readiness the to past week pursue an made active fiscal clear and monetary their response readiness to the disruption to pursue caused by the an virus. active Yet such fiscal and policy monetary activism carries a longer-termresponse risk of to entrenching the disruption the dysfunctional monetary caused policy by that the virus. contributed to the original financial crisis, as wellas exacerbating the dangerous debt overhang that the Yet global such economy policy now faces. activism carries a longer-termrisk of entrenching the dysfunctional monetary policy that contributed banks — to and the especially original the Fed — financial conducted what crisis, came to as be well known as « asymmetric exacerbating The risks have been building in the financial system for decades. From the late 1980s, central the monetary dangerous policy », whereby debt they supported overhang markets that when they plunged global but failed economy to damp now them down when they were prone to bubbles. Excessive risk taking in banking was the natural faces. consequence. The central banks’quantitative easing since the crisis, which involves the purchase of government bonds and other assets, is, in effect, a continuation of this asymmetric approach. The resulting safety net placed under the banking system is unprecedented in scale and duration. Continuing loose policy has brought forward debt financed private expenditure, 350 300 250 200 150 100 50 The risks have been building in the financial system for decades. From the late 1980s, central banks — and especially the Fed — conducted what came to be known as « asymmetric monetary policy », whereby they supported markets when they plunged but failed to damp them down when they were prone to bubbles. Excessive risk taking in banking was the natural consequence. The central banks’quantitative easing since the crisis, which involves the purchase of government bonds and other assets, is, in effect, a continuation of this asymmetric approach. The resulting safety net placed under the banking system is unprecedented in scale and duration. Continuing loose policy has brought forward debt financed private expenditure, thereby elongating an already protracted cycle in which extraordinary low or negative interest rates appear to be less and less effective in stimulating demand. William White, who while head of the monetary and economics department at the Bank for International Settlements in Basel was one of the few economists to predict the financial crisis, says the subsequent great experiment in ultra-loose monetary policy is intensely morally hazardous. This, he argues, is because unconventional central bank policies may « simply set the stage for the next boom and bust cycle, fuelled by ever declining credit standards and ever expanding debt accumulation ». A comparison of today’s circumstances with the period before the financial crisis is instructive. As wellas a big post-crisis increase in government debt, an important dif- Cont’d on page 5 4
VENDREDI 06 MARS 2020 BIZWEEK ÉDITION 280 ference now is that the debt focus in the private sector is not on property and mortgage lending, but on loans to the corporate sector. A recent OECD report says that at the end of December 2019 the global outstanding stock of non-financial corporate bonds reached an all-time high of $13.5tn, double the level in real terms against December 2008. The rise is most striking in the US, where the Fed estimates that corporate debt has risen from $3.3tn before the financial crisis to $6.5tn last year. Given that Google parent Alphabet, Apple, Facebook and Microsoft alone held net cash at the end of last year of $328bn, this suggests that much of the debt is concentrated in old economy sectors where many companies are less cash generative than Big Tech. Debt servicing is thus more burdensome. America's mounting corporate debt US non-financial corporate debt habil Mes (% of GDF) 1960 1970 1980 1990 2000 2010 Source  : US board of Governors of the Federal Iteserve System D FT The shift to corporate indebtednessis in one sense less risky for the financial system than the The shift to corporate indebtednessis in one sense less earlier surge in subprime mortgage borrowing because banks, which by their nature are fragile risky because for they borrow the financial short and lend long, system are not than as heavily the exposed earlier to corporate surge debt as in subprime investors, mortgage such as insurance borrowing companies, pension because funds, mutual banks, funds and exchange which traded by their funds. nature are fragile because they borrow short and lend long, That said, banks cannot escape the consequences of a wider collapse in markets in the event of are not as heavily exposed to corporate debt as investors, a continued loss of investor confidence and or a rise in interest rates from today’s extraordinary such low levels. as Such insurance outcome would companies, lead to increased pension defaults banks’funds, loans together mutual with funds and shrinkage exchange in the value of traded collateral in funds. the banking system. And asset prices could be vulnerable even after the coronavirus scare because the central banks’asset purchases drove investors to That said, banks cannot escape the consequences of a search for yield regardless of the dangers. As a result, risk is still systematically mispriced wider around the collapse financial system. in markets in the event of a continued loss of investor confidence and or a rise in interest rates from The OECD report notes that compared with previous credit cycles today’s stock of corporate today’s bonds has lower extraordinary overall credit quality, low longer levels. maturities, Such inferior covenant an outcome protection — would lead to increased defaults on banks’loans together with shrinkage in the value of collateral in the banking system. And asset prices could be vulnerable even after the coronavirus scare because the central banks’asset purchases drove investors to search for yield regardless of the dangers. As a result, risk is still systematically mispriced around the financial system. The OECD report notes that compared with previous credit cycles today’s stock of corporate bonds has lower overall credit quality, longer maturities, inferior covenant protection — bondholder rights such as restrictions on future borrowing or dividend payments — 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. Current market volatility is further exacerbated by banks’withdrawal from market-making activities in response to tougher capital adequacy requirements since the crisis. In a downturn, some of the disproportionately large recent issuance of BBB bonds — the lowest investment grade category — could endup being downgraded. That would lead to big increases in borrowing costs because many investors are constrained by regulation or self-imposed restrictions from investing in non-investment grade bonds. The deterioration in bond quality is particularly striking in the $1.3tn global market for leveraged loans, which are loans arranged by syndicates of banks to companies that are heavily indebted or have weak credit ratings. Such loans are called leveraged because the ratio of the borrower’s debt to assets or earnings is wellabove industry norms. New issuance in this sector hit a record $788bn in 2017, higher than the peak of $762bn before the crisis. The US accounted for $564bn of that total. 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 in the equity market because they boost earnings per share by shrinking the company’s equity capital and thus inflate performance related pay. Yet this financial engineering is a recipe for systematically weakening corporate balance sheets. 120 100 80 60 40 ACTA PUBLICA threat since the crisis. Corporate debt has risen faster than GDP in several major economies Contribution from honds/loans to corporaterte growth (quarterly% change f rom Q12018 to 01 2019) Bonds Loans 4 020 growth Demography is also relevant. Charles Goodhart of the London School of Economics and PhilippErfurth of Morgan Stanley have argued that low and negative interest rates 7 are not the new normal because the world is on the cusp of 6 a dramatic demographic shift. A decline in the working population relative to the retired population potentially returns 5 I 4 3 bargaining power to labour. Combined with a decline in 2 household savings because elderly populations have become 1 0 less thrifty, they say, this makes it almost inevitable that real -1 interest rates will reverse trend and go backup. -2 Nor, in the shorter term, is it clear that the relationship Italy UK Spain China France Japan Germany US -3 between unemployment and wage inflation has really broken. Chris Watling, founder of Longview Economics, says Source IMF @FT the sogginess of wage data in the US is substantially to do with the oil-producing states, which suffered a marked slowdown last year as a result of the fall in crude prices in late Otmar Issing, former chief economist of the European Central Bank, says prolonged low central Otmar Issing, former chief economist of the European 2018. Non-oil wage inflation has remained in a relatively robustuptrend as unemployment rates have fallen. bank interest rates also have wider consequences because they lead to a serious misallocation Central of capital. This Bank, helps keep says unproductive prolonged « zombie » banks low and central companies — bank those that interest cannot rates also meet interest have payments wider from consequences earnings — alive. The IMF’s because latest global financial they stability lead report to a serious misallocation of capital. This helps keep unproductive whether the regulatory response to the great financial cri- A pressing question, in the light of the debt build-up, is amplifies this point with a simulation showing that a recession half as severe as 2009 would result in companies with $19tn of outstanding debt having insufficient profits to service that « zombie » debt. banks and companies — those that cannot meet sis has been sufficient to rule out another systemic crisis interest payments from earnings — alive. The IMF’s latest and whether the increase in banks’capital will provide an Overall, this huge accumulation of corporate debt of increasingly poor quality is likely to global exacerbate financial the next recession. stability The central banks’report ultra-loose amplifies monetary policy this has also point fostered with a adequate buffer against the losses that will result from widespread mispricing of risk. simulation what economists call showing disaster myopia that — complacency, a recession in a word, half which is as a prerequisite severe of as 2009 financial crises. The greatest complacency today is over inflation and the possibility that central would result in companies with $19tn of outstanding debt History matters here. The one period in the last 200 years banks will inflict a financial shock by raising interest rates sooner than most expect. having insufficient profits to service that debt. when banking was relatively free of crises was between the This myopia is understandable and not just because of the coronavirus. Since the financial crisis the Overall, debt laden advanced this economies huge accumulation have suffered from deficient of demand. corporate Hence the central debt of increasingly banks’recent difficulties poor in quality meeting inflation is likely targets. to At the exacerbate same time tightening the labour next recessponse to the 1929 crash and the subsequent banking fail- 1930s and early 1970s. This was because the regulatory resion. markets The have not central led to increased banks’wage inflation, ultra-loose leading many monetary economists to policy assume the has also ures was so draconian that banking was turned into a lowrisk, utility-like business. It was the progressive removal of fostered what economists call disaster myopia — complacency, in a word, which is a prerequisite of financial crises. this regulatory straitjacket, which began in the 1970s, that The greatest complacency today is over inflation and the paved the way for the property based crises of the midpossibility that central banks will inflict a financial shock by 1970s, the Latin American debt crisis of the 1980s, more raising interest rates sooner than most expect. property based crises of the early 1990s and the rest. This myopia is understandable and not just because of While there has been a plethora of reforms since 2008 the coronavirus. Since the financial crisis the debt laden — though conspicuously not including the removal of the advanced economies have suffered from deficient demand. privileged tax status of debt relative to equity — the operations of the likes of Goldman Sachs, Barclays or Deutsche Hence the central banks’recent difficulties in meeting inflation targets. At the same time tightening labour markets Bank could scarcely be called utility-like. And when very have not led to increased wage inflation, leading many economists to assume the traditional relationship between falling regulators are often left behind by the new reality and wrong rapid changes in financial structure are taking place, as today, unemployment and rising price inflation has broken down. footed by regulatory arbitrage. Clearly there is stilla deflationary impulse at work in the It is impossible to predict the trigger or timing of a financial crisis. And it seems unlikely that a full-blown crisis global economy, causing growth to be both anaemic and traditional relationship between falling unemployment debt dependent. Yet inflation may not be quiescent for as is and imminent, rising notwithstanding price inflation coronavirus. has broken But the potentially unsustainable accumulation of public sector debt and long down. as markets assume. One reason is that with the central banks’Clearly unconventional there is stilla measures deflationary becoming impulse less at effective, work in the of global debt in economy, the non-financial causing corporate growth to sector be highlights serious be vulnerabilities, quiescent for notably as long in as China markets and other emerging there both is anaemic a pressing and question debt about dependent. how to Yet respond inflation to stagnation assume. when One interest reason rates is are that close with to the zero, central together banks’with unconventional may not markets, but also measures in the US becoming and UK. And less the continental a growing consensus, helped by coronavirus, that a more European banking system is conspicuously weaker than that effective, there is a pressing question about how to respond to stagnation when interest rates activist fiscal policy may be necessary. of the US. are close to zero, together with a growing consensus, helped by coronavirus, that a more With the rise of populism there are growing calls for Against such a background, the conclusion has to be that activist fiscal policy may be necessary. monetary finance of increased fiscal deficits — that is, direct With financing the rise of government of populism deficits there by are central growing banks calls of for marked monetary that if finance something of increased can’t go on fiscal for ever, then it will of the late Herb Stein, the American economist who re- the deficits kind currently — that happening is, direct financing Japan. Monetary of government finance has deficits stop. by When central coronavirus banks of the is long kind gone, currently that will be when systemic trouble of high starts. inflation and while its been happening a precursor in of Japan. high inflation Monetary and finance while its has proponents been a precursor argue proponents that the risks argue can that be contained the risks provided can be the contained quantity provided the quantity of such finance JOHN is PLENDER of controlled such finance by is independent controlled by independent central banks, central central banks, bank independence has been increasingly Financial Times central bank independence has been increasingly under 4 March 2020 under threat since the crisis. The rising debt burden Total outstanding non-financial corporate bond debt (Stn) US Europe China Other source  : OECD Fr 2008. 2019 14 12 10 a 6 4 5

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