Covid-19 creates a perfect storm for debt crises
The coronavirus epidemic means that the global economy will experience a severe shock this year. In addition to the human and social impact of the epidemic, output is stalling around the world.
Quarantine measures, illness, and negative consumer and business sentiment suppress demand. At the same time, the closure of some factories and disruption to supply chains create
supply bottlenecks.
There is hope that once the epidemic is contained (if this is possible), the global economy will recover quickly as quarantine measures are lifted and sentiment recovers. There is a high chance, however, that things will become much worse precisely at that time for the global economy, in the form of another debt crisis.
All at once
Debt crises happen when governments prove unable to pay back the debt that years of fiscal deficits have produced. By lowering fiscal revenues, while at the same time increasing fiscal expenses, the coronavirus epidemic will put many governments in a tricky position. Given that all countries will face the same fiscal challenges at the same time, this looks like a perfect storm.
Fiscal revenues drop as growth slows. This is because tax revenues work in sync with economic output. When the economy grows, successful companies pay more taxes, and so do citizens as they increase their consumption (and, hence, pay more VAT).
Conversely, when growth slows, as will be the case around the world, state coffers receive less money. The measures that several European governments have recently announced to help businesses that struggle to survive because of coronavirus, such as deferred tax payments, will also weigh on fiscal revenues.
Meanwhile, fiscal spending will rise because of the coronavirus outbreak. In the short term, governments are buying medical equipment, and will spend much more than planned on healthcare this year. In the medium term, ambitious stimulus packages aimed at fostering growth once the epidemic is over mean that public expenses look set to rise sharply.
This is also a consequence of the recently ultra-accommodative monetary policy of the ECB: with interest rates already at zero, monetary loosening is not an option to boost growth, and fiscal packages are the only lifeline.
On the brink
The combination of lower fiscal revenues, and higher public spending, will put many countries on the brink of a debt crisis.
This is compounded by the fact that many of the European countries that are among the worst-affected by the outbreak already had weak fiscal positions before the epidemic started.
Italy, which has recorded thousands of cases, is a prime example. The country has been battling with the European Commission over its budget deficit for several years; Italy’s public debt represents around 130 per cent of its GDP, far above the EU-mandated threshold of 60 per cent.
To make things worse, the usual buyers of Western debt may have lost their appetite for it. Financial markets are turning to safe havens, such as gold, while they feel that the situation is volatile. Their willingness to buy sovereign debt is called into doubt as they question how governments will be able to repay it.
China, another keen buyer of Western debt, will prioritise reviving its economy in the coming months.
Oil-rich Gulf countries usually place their excess of cash in highly-rated sovereign debt. As the epidemic has sent oil prices to record-lows, Gulf countries will want to think of their own deficits first.
Just like coronavirus, a debt crisis in, say, Italy, would quickly spread to other European countries and, in turn, emerging markets. Southern European states, which are still recovering from years of austerity, may be the first in line: they combine high levels of public debt, an ageing population (who will have placed a heavy burden on healthcare systems, as older people are more affected by severe forms of coronavirus), and persistent fiscal deficits. For the global economy, the worst may very well come only after we’re done with coronavirus.
Agathe Demarais is the global forecasting director at the Economist Intelligence Unit