Covid-19 and government debt

29 May, 2020Simon Ling-Locke

Due to Covid-19, governments around the world are incurring huge debts. Simon Ling-Locke, Senior Lecturer at LIBF, looks at the impact of this and what the implications might be for the world economy.

Empty train seatsShock events are relatively short term. Shift events have an impact over a longer period of time.

The way that impacts revenue and costs is significant. According to a recent Resolution Foundation report, if the lockdown lasts about six months, the recovery phase could take two to five years.

So with Covid-19 we're looking at a shift event.

Across the world, the International Monetary Fund (IMF) estimated in April that costs of government support – including loans and guarantees – could add up to about to £6.4tr. But that number is likely to be revised upwards. 

Italy is heading towards debt levels of at least 155%, and Germany, perhaps 69%.

In the US, 33 million people signed up for unemployment benefit in just seven weeks. This will hugely affect both government expenditure and revenue from tax receipts.

In the UK we're heading towards debt levels of 96% of gross domestic product (GDP). According to the Bank of England, banks could face credit losses of around £80bn – roughly 45% of their capital buffers – dragging down their capital ratios.

They can withstand that, but are going to be much less willing to lend. And because they're the motor of recovery in terms of credit, economic growth is going to be slow.

That, in turn, will impact government debt.

Government debt crises

The past is a good barometer for the future.

Since it was first calculated back in the late 17th century, the UK’s debt to GDP has averaged around 100% – not so different to today.

The Industrial Revolution and fast growth in the UK took debt down very quickly after the Napoleonic Wars.

Just after the Second World War, UK debt to GDP levels were around 250%. But recovery spending ensured Western economies grew very quickly, which made the debt sustainable.

Looking at today’s situation, how is GDP likely to grow in the future?

The pain of sovereign debt

The other factor alongside growth is the willingness of governments – and effectively the population – to withstand pain.

We've seen countries default with much lower debt to GDP levels. A lot depends on the willingness of people to finance a high debt level.

Mask hanging off chairLook at Japan, for instance. It has a very high debt-to-GDP level, but a lot of it is financed domestically. For countries that have to rely more on foreign investors, debt is more problematic.

It means pain in terms of higher taxation and cutting back services.

When countries think about defaulting, they effectively close themselves off from foreign markets. That leaves them with no way to finance deficits except by printing money. Of course, if you start printing money in volume, inflation takes off and you've got an even bigger problem.

Will the EU and the €500bn Franco-German recovery plan help?

My fear is that what is acceptable to countries like Austria, Denmark, the Netherlands and Sweden is not going to be enough.

Greece has gone through years of recession, and debt to GDP is still very high at around 170%. You can see the political discontent. Italy has similar problems with a debt-to-GDP ratio of about 155%.

Some might say these things are self-generated, but much of it is beyond their capacity to fix.

If you don’t come up with better packages to deal with it and the markets believe it's half-hearted, we could be back to the sovereign crisis we saw in the early 2010s.

That could be a turning point for the euro. But hopefully, the politicians will work together.

Debt and emerging markets

But this is not just a Western issue. Some emerging markets are quite large and have very high debt levels. Others are badly affected by the current crisis because of low commodity prices.

Which brings us back to whether it’s a shock or a shift?

If we're talking about a shift, the income of some of emerging markets – which rely heavily on commodities – is going to be dramatically affected.

And if every country tries to protect their own economy, we could go back to the situation we saw in the 1930s, when protectionism led to a massive reduction in world trade. That would be a disaster for everyone.

There are no easy answers. A lot will depend on what governments, the World Bank and the IMF do.

But it will also depend on how much room they’re given, when you’ve got some inflexible world leaders who are unwilling to collaborate with the international community.

Simon Ling-Locke has three decades of banking experience at Barclays, Tokai and UFJ banks. He has worked in international markets including in syndicated loans, risk management and heading European leverage finance and corporate banking teams at UFJ. He also led training activities at the Loan Market Association.

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