Sovereign debt crises are coming: EAU

May 28, 2020 (MLN): A report by Economic Intelligence Unit that was published recently says that the coronavirus pandemic is a game-changer for the global economy. According to its contents, the years 2020 and 2021 will be lost years for growth.

‘Tackling the pandemic will require extraordinary fiscal efforts, in the light of lower fiscal revenue and much higher healthcare and social expenses. Governments in most developed countries have also concluded that an increase in public expenses, and, therefore, public debt levels, is preferable to the widespread destruction of productive capacity during the epidemic. As a result, public debt levels will increase sharply this year’ the report said.

Public debt is piling up

For the most reliable sovereigns, the cost of servicing higher levels of public debt will not be an immediate cause for concern. However, governments will eventually have to confront the debt pile-ups. To curb fiscal deficits, governments in most developed countries will not be able to pursue spending cuts. Austerity absorbs political capital, and there might not be enough left to pursue such a plan, especially given that the last period of belt-tightening was so recent for many countries. Governments are also unlikely to be able to make the sorts of savings that could meaningfully reduce debt stocks. In many economies, the public sector is much smaller than before the 2008-09 financial crisis. Cuts to healthcare spending, for instance, are unlikely, as the epidemic has brought to light the stress that health systems are under because of recent austerity measures.

Governments have little fiscal room for manoeuvre

Rather than dramatically cutting spending, governments are likely to look at the other side of their balance sheets and consider raising fiscal revenue. Among advanced economies, the trend over the past 40 years has been one of lower corporate and personal income taxes. Demographic changes were already going to force governments to reverse this eventually; the coronavirus crisis might mean that they will have to do it sooner. However, it is not clear whether governments will be able to raise taxes quickly enough for such measures to be sufficient. Investors’ appetite for increased amounts of sovereign debt may also wane.

Sovereign debt crises could flare up again in the euro zone

Most developed countries, especially those that have been able to borrow in their own currency and have deep domestic capital markets, will not face sovereign-debt issues. However, not all countries enjoy such favourable conditions. As a result, some developed countries might, in the medium-term, find themselves on the brink of a debt crisis. This is compounded by the fact that many of the European countries that are among the worst affected by the epidemic, such as Italy and Spain, already had weak fiscal positions before the coronavirus outbreak. South European states are still recovering from years of austerity, combined with high levels of public debt, ageing populations (which are more vulnerable to severe forms of the coronavirus) and persistent fiscal deficits. The European Central Bank would act swiftly to contain the fallout, but a debt crisis in any of these countries would create massive turbulence on financial markets. In turn, the crisis would quickly spread across the globe.

Multilateral assistance will give poor countries some breathing space

Poorer countries would be among the hardest hit in such a scenario; their indebtedness has risen sharply over the past ten years. In an effort to mitigate the economic impact of the pandemic, multilateral financial institutions, together with the world’s wealthiest countries, have offered substantial financial support to help to ease the financial burden on low-income and emerging-market economies. The IMF, the World Bank and other multilateral development banks have ramped up their emergency funding support, debt relief is on the agenda and the G20 is offering substantial financial support by suspending debt repayments. These efforts will give the world’s poorer countries some short-term breathing space, as well as freeing up resources for them to beef up healthcare spending and implement economic stimulus and relief programmes.

What will China do?

China’s major role as a creditor will complicate restructurings. China is the largest single lender to lowincome countries and emerging markets in general. Many emerging markets have developed a high financial exposure to China through credit facilities and loan arrangements often linked to commercial projects, secured at market rates and backed by collateral. A report published in June 2019 by the Kiel Institute for the World Economy estimated that developing and emerging market countries owed about US$380bn to China at the end of 2017, compared with US$246bn owed to the group of 22 Paris Club members. The amounts outstanding—and wider exposure to China—have increased further in recent years, given the financing pledges made by China, especially in African countries. Whether China will agree to renegotiate loans that it has extended to poor countries remains unclear. China might accept to rollover part of the debt. If debt is not restructured or repaid, however, China might look to seize some assets from its creditors, as it did with a port in Sri Lanka in 2018. In the mediumterm, this will only increase the dependency of poorer countries on China.

Large-scale debt relief faces major challenges

Attention could turn to more widespread debt restructuring and debt relief as the coronavirus crisis unfolds in the developing and emerging worlds. Steps in this direction would require the leadership of the G20, the backing of multilateral financial institutions and, crucially, the full engagement of China. Adding private creditors to the mix would provide a substantial boost, but this is unlikely. It is also unclear whether private investment funds would accept debt restructurings, and if so on what terms. The current fractious nature of global geopolitics, as well as historical precedent, suggest that any debt restructuring or write-offs are more likely to occur on a case-by-case basis rather than as a broad-brush policy. Protracted and messy debt restructurings would make sovereign debt crises even worse. This would send the global economy into another, possibly much deeper, recession.