Debt Market Blowout?
When the world was in the midst of lockdowns during the Covid-19 pandemic governments were simultaneously printing money and running up large deficits to avert the economic crises that may have damaged their economies whist they were at a standstill. This combination of monetary easing (along with low administered rates) and fiscal largesse helped prevent the onset of a depression at the time. But the time is rapidly approaching when we learn that there are costs to be borne from these policies and this article considers the problem of debt and inflation currently blowing up globally.
What the world did- in effect, was to borrow against future productive capacity to tide over a production shortfall. This was absolutely the correct thing to do even if some criticism can be levelled against the targeting of the beneficiaries. But it left the world at record levels of per capita indebtedness. Granted, that indebtedness was backed by the central banks adding to fiat currency, but the methodology is now proving unsustainable and is unwinding at a rapid pace, possibly to become an uncontrolled one.
Whilst the debt was being run up central banks had added record amounts of liquidity into the banking systems and dropped their administered rates. They were also buying the government debt and expanding their balance sheets. Much of OECD debt was being issued at and trading at negative yields. This could not last and the pace of it unwinding is the narrative that the central banks have lost control over. Inflationary pressure is back with a bang. What started off as a rise in prices because supply chains were disrupted and delivery (i.e., transportation) costs soared has now spread to food, commodity and energy prices and has become pervasive and persistent.
The US March numbers came in showing an annual rise of 8.5%- a level not seen since 1981 when the then Fed Chairman Paul Volcker, hiked rates to 20% in June 1981. Of course, no one in their right minds is expecting US administered rates to anywhere near there but it does show the huge gulf in the medicines being administered. A look at the graph below:
Fig 1. The rapid rise of inflation: outstripping expectations
Source: Bloomberg
highlights the rapid rise in prices in terms of both speed and geographical spread. Asia was not considered to be susceptible to the price rise given the fact that the region is overall a net food exporter and isn’t facing any wage pressures like the US nor the energy dependence on Ukraine and Russia like Europe. But actuals outstripping expectations for all the Asian economies suggest that the war in Europe has hit them rapidly.
It is now no longer because of the pandemic (though pandemic related issues are likely to rise again with parts of China again in lockdown) but now because of the Russia-Ukraine war. Oil, wheat, gas and nickel prices are particularly affected and this is driving inflation across a broad spectrum- commodities, energy and food. The consequences are global and they are spreading from the real world to affect the financial markets: Sri Lanka has just announced that they are suspending (read, defaulting on) all foreign currency denominated debt repayments in order to conserve foreign currency to pay for oil and agricultural commodities. They have US$51 billion of external debt and this default arises out of the worst economic crisis to hit the island nation in 70 years. Sri Lankan inflation has hit 20%.
Russia has also defaulted on its external debt payments because it is unable to access it’s USD and Euro holdings thanks to OECD sanctions. They have made the payment in Russian Roubles in its stead but this has been marked as a ‘selective default’ by S&P since the Roubles are unconvertible at this point. Russia has US$ 40 billion in outstanding external debt. Although this is a technical default since Russia is willing to but unable to pay in USD and/ or EUR it adds to a financial markets problem: the re-pricing of risk for sovereign debt. This means that countries will face rising borrowing costs as the risk premia for debt climbs.
The scenario then currently looks like this: inflation is pushing up costs globally faster than expected; central banks have been coordinating an expansive fiscal/ monetary strategy with low administered rates but now are forced to focus on this rising inflation threat; rising rates and tightening monetary/ fiscal strategies will now suddenly come into play pressuring growth; yield curves will go higher as debt starts to become more expensive; this could push more countries to the Sri Lanka situation; this would raise risk premium and make debt even more expensive for Emerging Market economies further stifling growth opportunities. The danger in this scenario is the vicious cycle of higher prices pushing up rates which push up borrowing costs and kill growth, forcing countries to default on their loans since they can’t afford to service them- thus driving borrowing costs even higher.
We aren’t at that tipping point yet but the inability of central banks and governments to control the supply side shocks that keep impacting prices from happening is baking in inflationary expectations. And this, as any economist will tell you, only serves to drive prices higher as wage demands then start to rise lifting aggregate demand in the economy. Corporations have already started exerting pressure by raising the costs of goods as a response to higher input costs.
Given the high leverage ratio of most economies and the inability to control inflation at this point the danger is arising fast of debt defaults as economies struggle to cope with the stagflation effects of high inflation and low growth. In history we have seen that governments have often used inflation as a way of eroding the value of their outstanding debt. This may not be a purposeful strategy now but it looks like the net result may be the same: a spell of high inflation, high rates and low growth coupled with an anaemic stock market and troubles in the debt markets.