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    China is the winner in an austerity policy shift

    December 2020

    There has been a stark shift in global economic thinking on austerity. That was strikingly evident at the annual meetings of the IMF and World Bank in October.

    In sharp contrast to what the IMF and others urged after the 2008 global financial crisis, senior figures at the meeting encouraged governments “to spend their way out of the pandemic”.

    The world is now set to experience another surge in debt and deficits from levels that only 11 months ago would have been deemed unthinkable by most economists and market participants.

    A critical issue policymakers need to address urgently in my opinion is the amount of debt plaguing Europe, the US and the global economy (except China), and the impact the growing status of China as creditor to both the west and the developing world will have on that.

    The IMF and World Bank have urged economies to access financial markets to borrow high during the pandemic. Kristalina Georgieva, head of the IMF, has said: “Only one thing matters – to be able to dare.” But the debt picture is precarious. The global debt to gross domestic product ratio is unsustainable, at over 320%. Perhaps more worrying is that China’s role as a creditor now means debt concerns are not just economic, but also geopolitical. China is one of the top lenders to the US – which in my opinion gives the country’s political class enormous leverage – and also now the largest lender to emerging economies.

    Strained US-China relations, and the fact that China is also the largest trading partner and foreign direct investor for many advanced and developing countries, will limit the scope for negotiations to restructure or even a call for debt moratoriums. This strengthens Beijing’s position in setting trade terms. A debt stand-off between the US and China would have considerable contagion effects around the world, as US government treasuries (so far) remain the risk-free reference rate for most debt issuers.

    Even before the pandemic hit in earnest, economists and policymakers had expressed concern over unsustainable debt. For example, in March 2019 the UK office for Budget Responsibility warned that the ageing population and Brexit would put increasing upward pressure on spending and reduce the chances the government could reach its aim of balancing the budget by 2025-2026.

    Meanwhile, the Congressional Budget office has cautioned that in 2030 the US fiscal position will be extremely challenged, with the projected federal deficit reaching 5.4%, against an average of 1.5% over much of the past 50 years, largely due to healthcare and social security obligations.

    Many in markets may be tempted to see low interest rates and central bank politics as unambiguous good news, heralding a period in which fiscal policy would reliably and repeatedly join monetary policy in flooding the system with liquidity and pushing asset prices higher around the world.

    The impact, however, is likely to be a lot more nuanced – dominated by pronounced dispersion in risk – return outlooks for companies and countries as opposed to another significant “melt up” of stocks, emerging markets and corporate bonds.

    The change in thinking on austerity reflects a revisit of what’s both desirable and feasible. It is almost universally acknowledged that governments should go out of their way to avoid “scarring”, where short-term problems become structurally embedded in the economy.

    A fiscal bridge over a damaged economic landscape owing to Covid-19 is seen as critical to avoid viable companies experiencing a cash crunch becoming bankruptcies and furloughs turning into long-term joblessness. This approach is more feasible now that interest rates are extremely low and central banks readily buy what was, not long ago, an inconceivable amount of government and corporate bonds.

    It is tempting to see this as unambiguously good for financial asset prices that have been long supported by loose monetary policy. Indeed, it may seem even better as large deficits not only flood the system with funds financed by central banks but also involve outright grants and other forms of highly concessional income support to households.

    The notion of generalized support for the markets needs to be heavily qualified, however. As we continue to live with Covid-19, we should expect government support gradually to shift from a universal approach to one that is more selective – people over companies, viable sectors over permanently damaged ones and more partial income replacement for households.

    The result will be a growing distinction between favoured stocks and bonds over orphaned ones. The former includes several healthcare, technology and green economy names. The latter is heavy on hospitality and other elements of the services sector; these faces are significantly higher risk in bankruptcies and weakening of contractual debt terms.

    Countries will also differ in their ability to sustain large deficit spending. What is not a problem for the US will in my opinion be a headache for many developing countries that, as their debt and debt service obligations rise, find it harder to fund themselves through capital markets.

    With their growth models and foreign exchange also challenged, they will turn more to the IMF and other sources of official funding. The real question is whether the rescheduling that follow for some are pre-emptive and orderly – or involve a prior payments default.

    This greater dispersion in market winners and losers will come at a time when investors face difficulties in finding what they believe are reliable risk mitigators.

    In the wake of Covid-19 health and economic concerns, the debt-to-GDP ration in Europe and US has surged to over 100%, which in my opinion is set to drag on future economic growth. In the UK for example, at the beginning of 2020 UK households had borrowed roughly 1.7 trillion pound – almost as much as the government. And every class of debt in the US – government, household, credit card, auto loans and student loans – has surged to over 1 trillion dollar each, and almost 20% of US companies are already seen as zombies.

    The UK does have some space to manoeuvre. It retains the confidence of the debt markets, with 10-year gifts trading at just 0.25% compared with 0.75% in January. And, with an average maturity of almost 20 years, there is no immediate repayment pressure. Also, expectations are that interest rates in UK will remain low for some time, so servicing debt will be cheaper.

    Globally, many conventional ways to manage excess debt – including GDP growth, fiscal spending cuts, bailouts or printing money – are out of reach. With IMF global growth projections at minus 4.4% in 2020, simply growing out of debt quandary seems unlikely. Meanwhile, with historically low interest rates in many developed economies, and central bank balance sheets still stretched by the 2008 financial crisis, there is in my opinion little scope to use further monetary policy tools to tackle debt.

    At a time when governments do not have much room to reduce public spending, policymakers will need to act quickly and in my opinion deftly to avoid future debt crises, and outright default scenarios. They may be pushed to consider aggressive options, such as threats of default that would force lenders to the negotiating table. Their ability to address urgent concerns such as climate change will be limited. This would be devastating to the global economy, and to the prospects for human progress.