The end of cheap money reveals global debt problem

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A U.S. dollar banknote is seen in this picture illustration taken May 3, 2018. REUTERS/Dado Ruvic/Illustration

LONDON, Oct 3 (Reuters Breakingviews) - The global financial crisis of 2008 was supposed to have taught the world the dangers of excessive debt. But borrowing has shot up since then. The debt of governments, companies and households was 195% of global GDP in 2007, according to the International Monetary Fund. By the end of 2020 it had reached 256%.

These debt mountains are harder to bear because interest rates are rising to stamp out inflation, the Covid-19 pandemic and the energy crisis have clobbered growth, and investors are more averse to risk. This will cause economic stress especially in Europe, China and the Global South, poisoning domestic politics and geopolitics.

Debt has risen for three main reasons. First, governments bailed out the financial system. Then they supported households and companies during the pandemic. Now they are cushioning the blow of eye-popping gas and electricity prices.

Debt and GDP

QE DEBT SPLURGE

Cheap money enabled these splurges. In the West, this came in the form of quantitative easing (QE), where central banks bought government bonds and other assets. While they were right to use QE to prevent an economic slump, cheap money has been a painkiller. Many governments stopped worrying about balancing their books. Companies and emerging markets also leveraged up.

If the borrowers had used the money to fund productive investment, that might not have mattered. But instead, they spent much of it on unproductive investment or consumption.

China’s excess property construction is the prime example of unproductive investment. The country’s debt as a proportion of GDP has doubled since 2007, according to the IMF. This is suffocating its economy and is one of the reasons the World Bank has just slashed its growth forecast for China this year from 5% to just 2.8%.

Meanwhile, European governments’ massive support operations during the pandemic and the energy crisis are a classic example of borrowing to fund consumption. Politicians have made little attempt to target subsidies at the most vulnerable.

The poor productivity of this borrowing can be seen in the data. In the past decade, global debt has risen by $90 trillion, whereas GDP has grown by only $20 trillion, according to Sonja Gibbs, who leads the Institute of International Finance’s (IIF) debt policy work.

Artificially cheap money has also encouraged risky behaviour. Investors have used leverage to help them chase higher returns, while funding long-term assets with short-term borrowing. The UK pension fund industry, which effectively received a bailout from the Bank of England last week, is a good example of the former. The British habit of funding house purchases with mortgages whose interest rate is floating or fixed for short periods is an example of the latter. Other problems are bound to emerge now the era of cheap money is ending.

ROADRUNNER POLITICS

It’s not just central banks that are pushing up interest rates in a belated attempt to restrain inflation. So-called “bond vigilantes” – debt investors who impose discipline on profligate borrowers – are waking up from their long slumber.

The sharp fall in British sovereign bonds last week before the BoE stepped in is the first big sign of this in rich countries. Investors lost confidence in Liz Truss, the new British prime minister, because she is borrowing to cut taxes as well as to cushion consumers from high energy prices; and because Brexit had already harmed the country’s economic prospects.

But Truss’ willingness to take the risk is evidence of a generation of politicians which has grown up thinking there are few consequences for rising debt. They are scared that voters will throw them out of office if they balance their budgets. Central banks are worried about deepening recessions and provoking financial crises if they tighten monetary policy too much. But if central banks become government stooges, investors will lash out.

It’s not just the United Kingdom which is at risk. Italy and Greece are especially vulnerable because of their high ratios of debt to GDP. If investors conclude these are unsustainable, the euro itself may suffer renewed strains.

OUR CURRENCY, YOUR PROBLEM

Compared with others, the United States has some protection from this problem. Reserves of shale gas make it a relative winner from the energy crisis. And the rising dollar will help it stop inflation faster than other countries.

But the strong greenback makes life harder for almost everybody else. It is pushing up inflation in the rest of the world and adding to the distress of those that have borrowed in dollars. It’s more than 50 years since the then-U.S. Treasury Secretary told his counterparts that the “dollar is our currency but it’s your problem”. The adage is relevant again today.

We are in the early stages of a new debt crisis in the Global South. Poor countries are especially vulnerable to high food and energy prices. Investors’ increased risk aversion is also hitting them hard. The spread on high-yield sovereign dollar debt over U.S. Treasury bonds is now more than 10 percentage points – around double what it has been for most of the last decade, according to the IIF.

Sri Lanka, Ghana, Egypt and Pakistan have already called on the IMF for help with their debts. About 60% of low-income countries are in debt distress or at risk of it, according to an IMF article. So far, this isn’t as serious as the Latin American debt disaster of the 1980s, which also infected Africa, or the East Asian crisis of the late 1990s, which dragged in Russia and Brazil. What’s more, the large western banks have less exposure to emerging markets than in the 1980s. But the flipside is that the debt is spread among many bond investors and that China is a massive lender. This fragmented creditor base makes it harder to restructure countries’ borrowings: no lender wants to take a hit unless they are confident that others will share the pain.

Poor countries could explode with anger, as they feel they are the victims of richer countries’ actions. They didn’t flood the world with cheap money, they didn’t get many vaccines to help with the pandemic, they didn’t cause the food or energy crises – and they are not to blame for the climate crisis which is hitting their countries particularly badly. Nevertheless, as in Europe and China, the problems caused by more than a decade of seemingly free money are now coming home to roost.

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(The author is a Reuters Breakingviews columnist. The opinions expressed are his own.)

Editing by Peter Thal Larsen and Oliver Taslic

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