Debt Sustainability in the World of Debt-Driven Growth
The global debt at the end of the year 2020 stood at $281 trillion, which is ~335% of the global GDP, according to the Institute of International Finance, a global association of the finance industry with ~450 members from 70 countries. Historically the global debt has been piling up since the Oil Shock in 1973 and has shot up in a higher proportion since the 2008 financial crisis. 2020, the COVID year witnessed tremendous expansion in debt, thanks to the low interest rate, larger moratoriums and ease of obtaining funds from the government. It is proven according to the Keynesian theory that during a standstill / crisis in an economy, a bit of government push sets the economy running again and growing returns start getting generated. However, the question is, to what extent must the government stretch itself to feasibly run the economy and reverse the downward trend? Another question is that can the current global debt level sustain stability in the global financial system? Lastly, is there a way we can cap or diminish the rate at which we pile up the global debt?
According to S&P Global, non-financial corporate debt1 has grown at a faster rate in the past decade than the nominal GDP. Though a major chunk of such debt is skewed towards larger economies, other emerging economies have also seen a rise in such non-financial corporate debt. For example, the corporate bond market in emerging economies has risen by ~20-25%. But the problem with emerging economies is the high risk of default. Also, emerging economies are more vulnerable to externalities and crises, especially for a few years after a major crisis like the 2008 financial crisis or the current COVID-19 pandemic.
Debt sustainability ideally states that a country must be able to pay off the debt in full through their resources. Emerging economies before the pandemic also were not in the state to pay off their debts completely. With the pandemic, their debts have widened further. Although they have high return generating potential, it is theoretically logical to slowly diminish the debt while generating the return. Options of restructuring, easy availability of credit and rising LBOs may mean that the global debt will probably never fall but keep rising. However, will the returns also be generated in the same or higher proportion? If yes, then the current global debt can definitely sustain and would not cause a problem. If not, then what other options we have apart from debt to raise funds, and how are we going to increase the returns? Since, on a global level, the focus is shifting towards sustainability, climate-impact and resiliency in all regards, the fund allocation in the future has a high chance of generating more returns. But what about the debt that has already been piled? For example, debt stuck in the oil industry which may not see a positive momentum probably in two decades’ time.
In the 2008 financial crisis, we observed how subprime loans2 led to a bubble that burst to devastate the world. Similarly, the Indian NBFC crisis unfolded how straining Working Capital to cover defaults can bring an entire economy to a bottleneck. The very recent Greensill Capital downfall surfaced the fundamental problem in supply chain finance. All these events raise the following questions:
- Is technology incompetent to alert when the leverage is stretched too much to a level that one small glitch (like in the case of the Indian NBFC crisis) or a temporary downfall (like the pandemic) leads to massive job loss and losses to multiple companies and economies?
- Is technology easing the way for fraudulent activities instead of just providing convenience? Cybersecurity is one thing and easing way for frauds is another. Cybersecurity is required even when the technology is providing 100% convenience to the end-user and is complete in itself without any loopholes. Easing the way for frauds (in the sense of routing money and causing a serious problem to an entire economy like in the 1MDB case) means that there are loopholes that are not monitored or guarded enough (till a solution is found to close the loophole) which results in fraud.
- Have we not learnt from the 2008 financial crisis that an instrument made out of bundling a set of underlying debt obligations is highly risky and requires rigorous and regular due diligence? We saw a similar mistake by Credit Suisse in the case of Greensill where Greensill’s securities were a bundle of the unpaid invoices. Whether it was a fraudulent activity by a member of Credit Suisse or a genuine mistake, the point is, that due diligence should’ve been stricter and more rigorous.
- Why do investors fall for such instruments in the first place when it was sufficiently clear that supply chain is the most vulnerable to externalities? Well, the answer here may be the confidence given out by Credit Suisse.
While borrowing is an essential part of keeping an economy running, the level at which it is sustainable to keep borrowing must be thought through. The current 335% global debt to GDP ratio may or may not be sustainable, only an expert can answer that for us. Now that we already have such high amount of debt, the focus is definitely on generating returns that add to the overall global GDP. While doing that, it may also be interesting to consider a scenario where an alternative to debt exists and where the global Debt is growing at a diminishing rate than the global GDP. It may be a theoretical concept but why not give it a thought and discuss it further to get to the roots?
1Non-financial debt includes debt instruments issued by non-financial institutions. Examples include: treasury bills, credit cards, commercial loans, etc.
2Subprime loans are loans offered at a higher than market rate to individuals / institutions who are not qualified to obtain loans otherwise from a bank for some reason – amount of the funds required or credibility, etc.
This was more of an opinion and thought provoking article than informative article. If anyone of you have any thoughts, suggestions, questions or pieces of information to answer any question above or discuss the topic further, please do so in the comment section here or on the blog's social media pages.
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