INTRODUCTION TO FINANCIAL CRISIS

In the last century, the world economy has witnessed several financial debt crises that involved, if not all, at least a considerable number of major corporate and sovereign players, the causes of which have largely been either continued irrational or risk accumulating activities, major sudden shocks or both.

The prelude to a financial crisis can reasonably be found in defaults on debt payments on large scales which lead to liquidity crunches, bankruptcies and the subsequent disasters.

 The Global Financial Crisis of 2007-08 is a famed example of how debt defaults led to bankruptcies on a scale that created a global financial crisis. However, in the decades before 2007-08, there were quite a few similar financial upheavals caused by debt accumulations for developing countries which proved unsustainable for them.

In 2020, we probably face the build up to an even larger crisis that spans sectors and which, far from damaging the globe via a chain reaction from one or two influential economies, has directly hit every sovereign stakeholder.

The corona virus pandemic has rendered supply chains, job markets and numerous industries dysfunctional for months on end; a terrible blow to income generation from core sectors. With restrictions on international trade and human mobility all around, the freeze inactivity is unprecedented in contemporary history.

That being the obvious state of affairs, it is crucial that we examine the situation in the debt markets for the current period and the near future.

CURRENT STATE OF GLOBAL DEBT

Source: Global Debt Monitor, IIF

Global Debt is currently at $255 trillion, and 322% of global GDP with $10 trillion added to each sector. It is $87 trillion more than the debt at the time of the 2007-08 crisis

HOUSEHOLD DEBT

As per the IIF’s report, global household debt is at a record high of $47 trillion dollars which accounts for 60% of global GDP and is $12 trillion higher than the debt accumulated in the run-up to the 2008 financial crisis.

The defaults on debt payments in 2020 and in 2021 are going to be massive as a large number of debtors have lost employment or been unable to avail of their income source. The number of unemployed is estimated at 25 million, exclusive of the underemployed. The income loss is estimated to go as high as $3.4 trillion, which would imply a substantial amount of debt default.

SOVEREIGN BORROWING

Debt accumulated by governments around the world has been the greatest contributor to total debt accumulation; the amount in 2019 rose to $70 trillion from $35 trillion in 2007. Fiscal measures by countries to prevent freezing of the economy require injections that have greatly increased the debt burden.

As per the IIF, Spain, the UK, Japan, France, Italy, and the U.S. have seen a rise of over 40 percentage points in their Debt to GDP ratio.

Across emerging markets, the rise has been over 25 percentage points in South Africa, Chile, Brazil and Argentina while Turkey and India saw a modest drop.

CORPORATE DEBT

The imminent threat of insolvencies and defaults by companies has led to a massive selloff of corporate bonds with investors having withdrawn $34 billion from corporate bond funds with a rise in borrowing costs of 10% since Mid-February.

The same has also led to heavy credit downgrades especially for small-cap firms across the world.
Sharp deteriorations are being seen by firms in the energy, transportation and entertainment sectors; the ones which have been hit the most by the pandemic.

EMERGING MARKETS

The Debt-to-GDP ratio for Emerging Markets has reached 220% of GDP, up from 147% before the pandemic with the total debt exceeding $71 trillion. The fall in output due to constraints on sectors such as entertainment, transportation and retail which are major contributors to the same, is a plausible explanation for the same.

THE NEAR FUTURE: ECONOMIC REVIVAL

While central banks have set interest rates to remarkable lows and trillions of dollars of fiscal stimuli are being initiated and transferred, the question is regarding the impact of these measures and whether they will ease the economic conditions or make them all the more disastrous.

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Since the situation is health related and doesn’t have an economic cause, fiscal measures will be truly helpful only once the pandemic has sufficiently receded. Until then, breaks in the supply chain and the fallen demand cannot be adequately revived and hence, recovery for several affected sectors will not be possible. However, once the worst is over, it is hoped that dynamism and revenue will return with the aid of these measures.

With regard to the debt, we are presented with two scenarios which are determined by when the pandemic shall end;

Should corona virus lose its threatening position in the coming few months or if cures and vaccines are successfully developed, the lockdowns and restrictions will be rapidly lifted while consumer demand and labour supply shall see boosts that would raise income levels and allow for the honouring of debt payments.

However, in several emerging markets, the post-crisis expenditure for re-establishment of supply chains shall be significant and in countries like India, there will be a need for sustaining consumption in the badly hit informal sector via greater spending. It is unlikely that the high debt to GDP rations for emerging markets shall fall substantially.

In Europe and the developed world, there is a greater concern over the ability to honour debts.

These are countries that have ageing populations and increasing social security burdens; their fiscal requirements shall continue post the crisis and may cause worries over sovereign debt.

It is without a doubt that the debt situation shall rely heavily on the administrative performance of governments and specific risk factors. Sovereign Debt performance is unlikely even post the crisis for the given reasons and sector specific performances depend on the successful and timely supply chain recovery.

A debt crisis can arise in this situation if fears over the riskiness of bonds and debt instruments cause their prices to fall and interest rates to rise in response. This will create a lack of funding which, like in 2019, might generate a consumption slump.

Such a situation is more probable if governments and corporates fail to act efficiently post Covid-19.

In the case that the virus continues to the end of the year or, in the worst case, into 2021, the governments’ fiscal measures and low interest rates will have to continue for much longer and debt payments will have to be further deferred.

This can be done with effective collaboration and decisions by the IMF, international institutions and creditors as well as governments.

However, even if monetary and fiscal measures across the globe are well managed, the probability of a debt crisis is still significantly high;

COLLAPSE OF THE DEBT ACCUMULATION WAVE

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Since the 1970s, there have been three global waves of debt accumulation and they all ended in financial crises;

The first wave, which spanned the 1970s and 1980s, resulted from borrowing by governments in Latin America and in low-income countries of sub-Saharan Africa This wave saw a series of financial crises in the early 1980s.

The second wave originated in 1990 and rose till the early 2000s, being fed by banks and corporations in East Asia and the Pacific and by governments in Europe and Central Asia who borrowed heavily in this period. It ended with a series of crises in these regions in 1997-2001.

The third wave was a runup in private sector borrowing in Europe and Central Asia which lead to the financial crisis of 2007-08 that resulted in heavy recessions for several economies.

We are currently witnessing the fourth wave of global debt accumulation which is larger and more rapidly moving than the previous ones, generating worry of a fourth financial crisis.

This is an important background for the current crisis that the world economy is facing, as it worsens the situation created by the pandemic.

CONCLUSION

The increased rate of defaults and high uncertainty towards the collapse of a debt wave larger than ever before could end in humongous disaster for the world as we know it. Given the circumstances, a financial crisis seems probable. The most crucial question is how well governments and the international community can deal with it.

One of the reasons the World Bank believes to be why we may avoid a crisis is stable debt in advanced countries and better policy frameworks. These have been threatened by the pandemic which has shaken governments and sent them into war time planning and action.

The future is expectedly bleak but there are chances of avoiding the same.

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