The global economy starts 2021 with record amounts of debt that will slow the recovery and could destabilise some countries, the Institute of International Finance (IIF) warned in a note on January 7.
“The surge in global debt levels has been unprecedented since the onset of the pandemic, increasing by over $17 trillion to $275 trillion last year. IIF economists Emre Tiftik, Paul Della Guardia and Khadija Mahmood said in a paper.
The jump in debt was driven by emergency borrowing by governments around the world in an effort to stave off the worst damage caused by the coronacrisis. As the vaccines are rolled out that should end the pandemic begin the task ahead is to start paying down this debt.
The sharp increase in debt has brought the global government debt-to-GDP ratio to nearly 105% in 2020 up from 90% in 2019, IIF reports.
“The aggressive, synchronized fiscal and monetary policy responses to date have been successful in curtailing financial stress and have played a big role in reviving appetite for risk assets, including EM securities,” the IIF team said. “However, this much-needed policy support has often come at the cost of a sharp rise in financial and budgetary imbalances.”
The flood of new debt has sent a record amount of bonds into negative yield territory to a new record high of $18 trillion, up from $11 trillion in 2019. With so many bonds paying a negative yield bond traders have been scouring the world in the hunt for yield. At the same time central banks have been pumping cash into their system, which means too much money is chasing too few profitable assets that have driven down yields on bonds further while pumping up equities everywhere.
“The S&P 500 forward 12-month P/E ratio is now at levels last seen during the peak of the dot-com bubble in the early 2000s. And despite credit concerns and uncertain earnings prospects, fund flows into high-yield US corporate bonds in 2020 have turned positive for the first time since 2016,” according to IIF.
Will EM borrowers step up FX borrowing?
Another factor driving markets is the widely anticipated weakening of the dollar in the coming years. IIF points out that in the wake of the 2013 taper tantrum, markets anticipated US monetary policy normalization and higher rates, which lead EM sovereigns and corporates to avoid dollar debt.
This time round the weakness of the dollar and the fact that the frist hike to US interest rates is not expected to happen until 2025 at the earliest borrowers will be much more willing to take on dollar denominated debt. The ongoing need to raise funds to pay for coronavirus counter measures only acts as a tailwind to this trend.
“At present, some 10% of EM debt is denominated in dollar. Greater use of external financing could well appeal to many EM sovereigns, especially given the pandemic-related decline in government revenues,” the IIF team report.
IIF worry that a build up of EM FX debt will only exacerbate debt-related vulnerabilities. EM external borrowing costs have already fallen to record lows making FX borrowing increasingly appealing but that will also leave EM borrowers more exposed to sudden shifts in global risk sentiment, warns IIF.
“Indeed, following the temporary market shutdown in March 2020, Eurobond issuance in many emerging and frontier markets is running at a record pace—well above pre-pandemic trends,” IIF said. “A number of sovereigns are planning to tap international bond markets in the coming months, including those eligible to benefit from G20 Debt Service Suspension Initiative (DSSI). Keeping debt on a sustainable trajectory may become a challenge for many in the current low interest rate environment.”
One of the countries already reacting to the new conditions is China which has pared back its overseas lending dramatically in the last years.
“The expansion of China’s overseas lending after the 2008 crisis was unprecedented: outstanding debt claims on the rest of the world rose from some $1.6 trillion in 2006 to over $5.6 trillion by mid-2020,” IIF said. “Many emerging market economies have benefited from project financing related to the Belt and Road Initiative over the past decade, with China’s overseas lending to EMs outpacing financing from the World Bank. However, China’s two largest policy banks (China Development Bank and Export-Import Bank) have significantly reduced new credit provision to emerging markets and developing countries in recent years.”
China has pulling in it head after an increasing number of countries worried about “debt enslavement” thanks to unsustainable levels of borrowing from China, especially in low-income countries such as those in Central Asia, where anti-China sentiment was growing.
At the same time growing US-China conflicts added to the concerns under the Trump administration as China slowly started to replace Russia as Washington’s bête noire.
“Although lack of transparency in Chinese cross-border lending makes it difficult to quantify the full scope of the retrenchment in 2020, anecdotal evidence suggests that new lending commitments by Chinese policy banks were significantly lower than those made by the World Bank,” IIF said.
Debt stress in DSSI-eligible countries
Although economic activity in DSSI-eligible countries is expected to pick up by nearly 5% in 2021, gross financing needs are set to remain very high at over $260bn in 2021, reports IIF.
“With public sector external debt service representing over 20% of gross financing needs this year, even a full suspension of sovereign debt-service repayments would not be large enough to cover sizeable structural funding gaps, which stem primarily from persistently large current account deficits,” the IIF team said.
Ukraine is a typical example. Although the country ended 2021 with reserves at an eight-year high of over $29bn and enough money to cover well over four months of imports, it faces a heavy debt repayment schedule in 2021 of some $14bn of which $11bn is due in the third quarter. Ukraine has been running a small current account surplus – largely due to some $10bn of remittances by expat workers – but without a working Stand By Agreement (SBA) with the IMF worth $5bn it will not be able to service its debt obligations. Kyiv has already said it intends to tap the international capital market and has issued more debt in December, but IIF estimates it can only raise another $3bn-$4bn in 2021 which will still leave it short.
“This highlights the importance of good policies and reforms to support market access—private finance is crucial for sustainable economic growth for low-income countries. Such policies can be encouraged and reinforced in the context of bilateral and multilateral development bank projects,” IIF said.