Should the world fear a post-pandemic debt crisis?

The short-term economic outlook remains worrying worldwide, particularly for small and medium-sized companies fighting to survive. But a large-scale debt crisis may not be nearly as likely as many fear

Terry ChanandAlexandra Dimitrijevic

Published: 5:15pm, 1 Nov 2020

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As countries, companies, and households confront the Covid-19 pandemic’s economic fallout, many market watchers are sounding the alarm about rapidly rising leverage worldwide. And for good reason: in an acceleration of a years-long trend, the debt-to-GDP ratio among these three sets of borrowers is set to swell by 14 per cent this year, to a record 265 per cent.

But while this has raised the risk of insolvencies and defaults, particularly among corporations, a near-term debt crisis looks unlikely.

Given the higher leverage and a challenging operating environment, S&P has downgraded the credit ratings of roughly one-fifth of corporate and sovereign debt issuers globally, especially speculative-grade borrowers and those suffering the most from Covid-19’s economic effects.

For corporate borrowers, insolvency risks are likely to increase if cash flows and earnings do not return to pre-pandemic trend levels before extraordinary fiscal stimulus is withdrawn.

The world is likely to experience a gradual, albeit choppy, economic recovery, assuming that accommodative financing conditions are maintained, in a lower-for-longer environment, and adjustments to spending and borrowing behaviour are made.

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Add to that a widely available vaccine by mid-2021, and global leverage should flatten out around 2023, with governments scaling back stimulus, firms slowly repairing their balance sheets, and households spending more conservatively.

But absolute debt levels are only part of the story. We must also – and more importantly – consider borrowers’ ability to repay. Today, unprecedented fiscal and monetary stimulus is keeping the liquidity tap open for firms through bond markets and bank loans.

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Borrowing costs are very favourable, and appear likely to remain so for a long time. Meanwhile, credit spreads have tightened from their March peak.

For the most part, the increased debt is intended to help create conditions for an economic recovery that improves borrowers’ future ability to repay. This is especially true for sovereigns, whose fiscal stimulus measures aim to reduce the pandemic’s economic impact.

All sovereigns will emerge from the pandemic with a larger stock of debt. The most developed economies are likely to bear the largest share of increases. However, they are largely wealthy, with strong financial markets and substantial monetary flexibility.

We assume governments will reverse the trajectory of fiscal deficits as economies recover, stabilising debt dynamics. So far, S&P has not lowered the ratings of any G7 country.

Speculative-grade sovereigns are more vulnerable to downgrades, given their inherently weaker finances and higher susceptibility to shocks.

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For all sovereigns, much will depend over the next year on how the new debt is used. If it finances productive activity, boosts national income and increases government revenues, it will ultimately be supportive of debt sustainability.

As for business, many large companies have so far used the proceeds from their newly acquired debt to add cash to their balance sheets as precautionary reserves or to refinance their existing liabilities.

This is not the case for firms at the lower end of the ratings scale or for many small and medium-sized companies. Fighting to survive, they are borrowing to cover income shortfalls and working capital needs.

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For households, the increase in the debt ratio has been driven in part by the decline in GDP. Households often take on more debt soon after facing income loss. But, in past downturns, households have soon adjusted to more conservative spending patterns, slowing debt growth.

Based on those experiences, we forecast that the global household debt-to-GDP ratio will stabilise at around 66 per cent at the end of 2023.

Of course, the shape of the post-pandemic recovery will affect how much and how quickly these three groups of borrowers can trim debt. And several factors – including additional waves of Covid-19, a delayed vaccine, and increased interest rates – could turn the recession into a W-shaped one.

Even if the recovery unfolds as expected, there will be no shortage of economic pain. As a result, the short-term outlook remains worrying. Nonetheless, we can take some comfort from the analysis that a large-scale debt crisis may not be nearly as likely as many fear.

Terry Chan is senior research fellow of credit research for the Asia-Pacific at S&P Global Ratings. Alexandra Dimitrijevic is global head of research at S&P Global Ratings. Copyright: Project Syndicate

This article appeared in the South China Morning Post print edition as: Should we fear a post-pandemic debt crisis?

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