Coronavirus has left economies across the world in suspended animation as governments attempt to contain the spread of the virus by pursuing draconian measures, with little concern for the economic fallout. Over the next weeks and months we will experience a precipitous fall in economic activity. The question is what the consequences for jobs and output will be after the pandemic is brought under control. Politicians are expecting a v-shaped recovery once furloughed workers return to work. Prime Minister Boris Johnson expressed confidence that the UK economy would come ‘roaring back’ once restrictions are lifted. But the problems go much further than the Coronavirus. Balance sheets from governments to businesses are historically weak. The Coronavirus will soon expose the debt bubbles that have been building up for decades. And while central banks will continue to bail out governments via their quantitative easing programmes (storing up more problems for the future), the most acute problems could be in the private sector, where many of businesses who will be hit by the Corona lockdown are already in a precarious position.
After more than a decade of super easy money provided by central banks the world is more leveraged than ever before. According to the Institute of International Finance the ratio of global debt to gross domestic product hit an all-time high of over 322% in the third quarter of 2019, with total debt reaching close to $253tn. Non-financial corporate debt reached $13.5tn, another record. In the US it now stands at 47% of GDP, an increase of more than half compared to 2008. And in a world where negative interest rates have become commonplace, investors have assumed more and more risk in the search for yield, lending money to less and less credit worthy companies. This is now being reflected in a more risky pool of corporate debt. According to the OECD, in the past 3 years 52% of new investment-grade rated bonds were rated the lowest BBB rating, compared to only 39% in the years leading up to the 2008 crash. In each ratings bracket, the average firm is more leveraged than then. Businesses owe more money and are less able to pay it back than ever before. And too much of the cheap debt was not invested in production capacity but instead kept ailing firms alive, preventing the capital reallocation that should have happened in a recession, and facilitated M&A activity and stock buybacks.
Many businesses will not survive the impact of lock-down and those who do will have their cash flow severely impaired by weeks and months of lost revenues. Many could face downgrades in their credit ratings. This is where the spike in BBB rated borrowing compounds the problems, as any downgrade would mean loss of investment grade ratings, leading to a sharp increase in borrowing costs as many investors are not allowed to hold non-investment grade debt and will be forced to sell. Many could struggle to service their debts and be forced into bankruptcy.
When central banks launched the then unprecedented measures of zero interest rates and quantitative easing in 2008 they were supposed to be temporary and reversible, but no exit strategy was presented at the time and a decade later it is clear that an orderly exit is impossible. Central banks have now responded to the Corona crisis the only way they know how, by pumping even more money into already super-leveraged economies. The Federal Reserve, the European Central Bank and the Bank of England have all committed to unlimited support, essentially writing a blank cheque to bail out financial markets. In an unprecedented action, the Fed will even be directly buying investment grade corporate debt. By offering unparalleled amounts of freshly printed money, the bet is that financial markets will stabilize despite the havoc being wreaked on the economy and continue to provide the funds to refinance the debt of an overleveraged corporate sector with little prospect of paying the money back. How long can this game go on? The world economy is a house of cards built on cheap debt. Coronavirus may be what finally sends it tumbling down.