Though the US Federal Reserve moved aggressively over the weekend to slash rates, investors around the globe were not comforted. Now the coronavirus threatens to set off financial contagion in a world economy with very different vulnerabilities than on the eve of the global financial crisis, 12 years ago.
In key ways the world is now as or more deeply in debt than it was when the last big crisis hit. But the most risky pools of debt have shifted – from households and banks in the United States, which were restrained by regulators after the crisis, to corporations all over the world.
As businesses deal with the prospect of a sudden stop in their cash flows, the most exposed are a relatively new generation of companies that already struggle to pay their loans. This class includes the “zombies” – companies that earn too little even to make interest payments on their debt, and survive only by issuing new debt.
The longer the pandemic lasts, the greater the risk that the sharp downturn morphs into a financial crisis with zombie companies triggering a chain of defaults, the way subprime mortgages did in 2008.
Over the last century, recessions have almost always been started by a sustained period of higher interest rates. Never a virus: The damage such contagions inflicted on the world economy typically lasted no more than three months. Now this once-in-a-century pandemic is hitting a world saddled with record levels of debt.
Central banks around the world are realising that a cash crunch could beget another financial crisis. As the Fed pushes aggressive easing measures straight out of its 2008 playbook, in an effort to stem market panic, it’s worth examining why the financial system feels so vulnerable again.
Around 1980, the world’s debts started rising fast as interest rates began falling and deregulation made it easier to lend. Debt tripled to a historic peak of more than three times the size of the global economy on the eve of 2008 crisis. Debt fell during the crisis, and central banks around the world subsequently dropped rates to new record lows in hopes of stimulating recovery.
Instead, much of that money went into the financial economy, including stocks, bonds and cheap credit to unprofitable companies. As the economic expansion continued, lenders grew increasingly lax, extending cheap loans to companies with questionable finances. Today the global debt burden is again at an all-time high.
The level of debt in America’s corporate sector amounts to 75% of the country’s gross domestic product, breaking the previous record set in 2008. And hidden within this $16 trillion corporate debt market are a host of potential troublemakers, including the zombies.
Zombies now account for 16% of all the publicly traded companies in the United States, and more than 10% in Europe, according to the Bank for International Settlements, the bank for central banks.
Signs of stress are multiplying in industries from transport and leisure to autos and oil. Slammed by fears of both a supply glut and a virus-driven collapse in demand, oil prices have fallen under $35 a barrel – too low for many oil companies to meet their debt payments.
Though investors always demand higher returns to buy bonds issued by shaky companies, the premium they demand on US junk debt has nearly doubled since mid-February. By last week the premium they demand on the junk debt of oil companies was nearing levels seen in a recession.
The direct economic effects of the pandemic will be magnified not only by its impact on these balky debtors, but also by the impact of failing companies on the bloated financial markets.
When markets fall, investors feel less wealthy and cut back on spending. The economy slows. The bigger markets get, the larger this negative “wealth effect”. And, boosted by endless promises of easy money, markets have never been bigger. Since 1980 the global financial markets (mainly stocks and bonds) have quadrupled to four times the size of the global economy, above the previous record highs set in 2008.
On Wall Street, bulls still point to China for hope that the worst can pass quickly. China reported its first Covid-19 cases on December 31, and the rate of growth in new cases peaked on February 13, just seven weeks later. After early losses, China’s stock market bounced back and the economy seemed to do the same. But the latest data on retail sales and investment suggest the Chinese economy is set to contract this quarter.
As the virus spreads worldwide, there are renewed fears that the crisis could circle back to China by hurting demand for exports. Over the last decade China’s corporate debt swelled fourfold to over $20 trillion – the biggest binge in the world.
The International Monetary Fund estimates that one-tenth of this debt is in zombie firms, which rely on government-directed lending to stay alive.
Calls are growing around the world for governments to offer similar support to fragile corporations. No matter what the policy makers do, however, the outcome now depends on how soon the coronavirus peaks. The longer it spreads at its current pace, the more likely it is that zombies begin to die, further depressing the markets — and increasing the risk of wider financial contagion.