COVID-19 and the Looming Debt Bomb

By one measure, March 2020 introduced a new reality to the world’s financial markets. Roughly six weeks into the new year, investors woke to news of the COVID- 19 virus and its resulting supply chain disruptions, factory closures, regional quarantines, and manufacturing employee furloughs. Before investors and the markets could digest this news, the pandemic expanded worldwide to compound those earlier actions, leading to mounting economic losses and further massive supply-side shock.

As disturbing as these immediate effects may be, they hide a less recognized but potentially more critical bit of news. As industries grapple with their increased near-term financial fragility, the potential for an unprecedented debt crisis and a broader long-term financial collapse is coming into focus. Corporate leaders are furiously working to restore supply chains and to rehire employees, and politicians and public health officials are struggling to contain COVID-19. The necessity of addressing the immediate crisis has limited all efforts to solve deeper financial and debt problems.

In the aftermath of the 2008 financial crisis, companies everywhere, including across all of the Asian markets, accumulated massive amounts of debt. The rationale for that debt at the time was readily understood, i.e. companies had no option but to either assume the debt or go out of business. The people that were entrusted with resolving this problem have known since its inception that some unforeseen disruption, regardless of how minor, could lead to further instability.

Hindsight makes it easy to criticize political and corporate leaders for “kicking the can down the road” and delaying any attempts to retire even a portion of the accumulated debt. The recent 12-year economic expansion, however, created an environment of steadily rising asset prices. Higher-valued assets coupled with the loose monetary policies in leading world economies made corporate debt look very attractive. The debt-to-equity ratios that companies reported never set off any alarms because as debt and equity rose in lockstep, their ratios changed very little, if at all.

Analysts were aware of these rising debt levels, but they were all too happy to look past them and to focus instead on bloated asset values. Investors were satisfied to book substantial capital gains and placed no pressure on corporate management to take down the accumulated debt. Elected officials boosted their popularity with claims that their policies were responsible for economic growth in both developed and developing markets. Except for a few dissenting voices in the wilderness, all of these groups ignored a fundamental financial market truth: no asset bubble can last forever.

The United Nations Conference on Trade and Development (UNCTAD) was one of the more credible dissenting voices making the argument that accumulated debt would eventually disrupt the global economy and financial system. UNCTAD recognized that as recently as 2018, the total accumulated debt in developing economies was more than double the aggregate gross domestic product of those economies. That debt level was at its highest historical point at that time, and it has shown no signs of going down since then.

When accumulated debt was allocated among different industry sectors, UNCTAD noted that almost 75% of that debt in developing economies was private debt that had been taken on by non-financial corporations, including energy, industrial, and utility companies. UNCTAD surmised that foreign lenders and finance entities had arranged for most of that debt. The result is that except for China, a substantial portion of private non-financial corporate debt in developing economies is held by foreign creditors as short-maturity international bonds in currencies other than the currency of the debtors.

UNCTAD’s analysis was specific to conditions in 2018. The situation in 2020 is that due dates are looming for sovereign-debt repayments. Emerging and developing economy debtors that maintained foreign-exchange reserves to hedge one aspect of the debt risks have watched much of their capital flow away accompanied by a precipitous decline in the value of those reserves.

Correcting these problems would not be a simple matter under even the best circumstances. As a result of the COVID-19 pandemic, corporate debtors are now facing the situation under the worst circumstances. Asia’s developing and emerging economies, in particular, have enhanced vulnerability to the problem. Many of those economies are financially and economically integrated with China, which was the first country to experience COVID-19’s massive dislocations. After China shuttered its factories and walled off whole regions, suppliers in those economies reduced exports of raw materials and intermediate assemblies. The bottom dropped out of travel and tourism, leaving hotels empty and forcing airlines to cancel flights on many profitable routes. While all of this was happening, there were no changes to the historically high debt levels and repayments that were coming due.

As these first few dominos were falling, crude oil prices have gone into a tailspin and equity markets have lost much of the value they created since the 2008 financial crisis. The developing economy companies that took on a massive amount of debt no longer have capital buffers to fall back on.

If there is any ray of good news in this situation, it is that business and political leaders are rapidly coming to an agreement that they need to coordinate their efforts to combat the economic effects of the COVID-19 pandemic. This will require, in part, incentives to resolve, write off, and restructure debt and central bank or private capital sources to finance it.

There is a historical precedent for this response in the post-World War II restructuring of Germany’s debt. In 1953, twenty external creditors agreed en masse to write off almost half of Germany’s pre-war and post-war debt and to refinance the balance with low-interest loans that included repayment grace periods. Other covenants in the debt restructuring agreements allowed Germany to withhold payments until it ran a trade surplus and limited those repayments to a percentage of export earnings.

Unfortunately, none of this will give individual investors, and particularly investors that have substantial holdings in developing markets that have high debt exposure, any immediate relief. Individual investors can only fall back on their own efforts to hedge their risks until the COVID-19 crisis subsides.