COVID-19 - Who pays?
11th May, 2020
Who is going to foot the bill and what are the investment implications?
The IMF has predicted that the COVID-19 crisis will see the Eurozone economy contract by 7.5% this year, while ECB President Christine Lagarde has warned it could be much worse – potentially falling by a staggering 15%. Governments are trying desperately to offset the impact by borrowing unprecedented amounts of money to backstop businesses and support employees who have been laid off or furloughed. Public debt is surging. With countries already highly-leveraged in the wake of the Global Financial and European Debt Crises, it is worth considering how all this debt is going to be paid back and what, if any, are the implications for investors?
We believe looking back at previous episodes in history when governments have been highly indebted can help to answer both questions. Several methods have been used in the past to reduce debt. These include what I would categorise as The Good, The Bad and the Ugly:
- The Good – strong economic growth: Outgrowing debt is the preferred method. However, as we saw in the years following the Global Financial Crisis, when economic growth in the developed world was lacklustre, this can be difficult to achieve.
- The Bad - austerity and higher taxation: Cutting one’s cloth to suit one’s means sounds prudent in theory. However, government cutbacks and increased income taxation can hinder growth and therefore be counterproductive. Politicians also receive a lot of pushback and therefore find this strategy difficult to implement.
- The Ugly – Default or hyperinflation: Thankfully, we foresee no imminent default of an advanced economy as a result of the current crisis. Although many countries are highly indebted, the average service cost of their borrowings is generally low. In addition, since the Global Financial Crisis, banking systems have been strengthened and central banks have significantly better toolkits to help fight financial instability. Regarding inflation, this has not been an issue in recent years, and we view a hyperinflation scenario as highly unlikely.
Reduce debt by stealth
There is another option to reduce public debt and that is Financial Repression. Despite its rather complex sounding name, Financial Repression is quite simple. It basically means that conditions are engineered which allow governments to borrow at extremely low interest rates. Furthermore, if governments can borrow at an interest rate even lower than the prevailing rate of inflation, then over time the ‘real’ burden of government debt can be reduced, even if a country’s economy is struggling to grow. This is much more palatable politically than government cutbacks and raising taxes. Therefore, Financial Repression is likely to be a large part of the solution to help reduce the current debt mountain.
Financial Repression is nothing new. It was a deliberate strategy used by countries to help pay for World War II. One academic study estimates that between 1945 and the 1980s the US and UK were able to use this method to reduce their debt by on average 3-4% of GDP per annum.1 In fact, Financial Repression was already being deployed across the world to pay for the Global Financial Crisis before the current COVID-19 crisis began. Central banks cut interest rates to record lows and ‘printed money’ to purchase government bonds and push down their yields (effectively pushing down government borrowing costs) in a process known as Quantitative Easing.
Good for borrowers, but bad for savers!
All this has been good news for governments trying to borrow and service increased levels of debt. Thanks to these policies Ireland can currently borrow at a rate of just 0.09% per annum over 10 years.2 Even if one assumes no economic growth, if Ireland can borrow at such low rates, even moderate levels of inflation will reduce the ‘real’ value of debt over time.
Indeed, artificially low interest rates are a boon for almost all borrowers, if they can get credit, whether they are businesses or those looking to take out a mortgage. However, good news for borrowers is bad news for certain categories of savers. Artificially low interest rates hit those with cash on deposit the hardest, with retail clients receiving practically zero interest, while institutions are typically charged to hold money at banks. This is effectively a “stealth tax” on savers to help borrowers pay back debt.
Given the massive debt burden governments have taken on to fight successive crises (the Global Financial and European Debt Crises and now COVID-19), central bank policies which keep government borrowing costs exceptionally low are likely to be with us for a long time. For investors this means that the rates available on deposits and government bonds are likely to continue to remain low also - too low to meet the income requirements of many investors.
Portfolio diversification can play a key role generating a higher income, by combining the defensive qualities of high-quality government bonds with riskier assets classes such as equities which can provide higher returns.
Corporate bonds also warrant consideration, particularly by any institutional investors who are restricted to only investing in Fixed Income. The yields on corporate bonds are significantly higher than those on cash or government bonds, particularly after the recent COVID-19 sell-off. However, because of their higher risk profile, inclusion of corporate bonds may require more active and informed management to avoid their potential pitfalls.
Of course all investment decisions bring risks and such risks need to be weighed against the costs of doing nothing. Financial repression is a form of imposed decision making, one that cuts debt on the one side and wealth, by stealth, on the other.
1Reinhart & Sbrancia (2011) ”The Liquidation of Government Debt”
2As at time of writing 05/05/20
This article appeared in the Irish Independent newspaper on 7th May 2020
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