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Affordable debt burdens?

Recovery is much easier if the lockdown is short lived and the debt burden limited. Companies with too much debt and too little income will eventually go bust.

Recovery is much easier if the lockdown is short lived and the debt burden limited. Companies with too much debt and too little income will eventually go bust.

John Redwood

in Features


The US government announced it will be borrowing $3 trillion in the second quarter of this year. Taken together with the large programme of money creation and bond-buying by the Fed, this represents a huge fiscal and monetary offset to the shutdown of a large section of the US economy.

All knew there was going to be a huge surge in borrowing to get us through the Covid-19 recession. Governments will borrow much more to pay unemployment benefits, to offer grants and cheap loans to restricted businesses, to pay for extra health care and to deal with the shortfall in tax revenues as the downturn bites. Many companies too will borrow much more to pay the fixed costs whilst they are unable to earn any revenue, and then to make up lost revenue as the controls are gradually relaxed.

The scale of it in the US had been sketched in part by the independent Congressional Budget Office. They forecast that the US government will need to borrow $3.7 trillion to cover a greatly expanded budget deficit this year, and $2.1 trillion next. This compares with a still-large $1 trillion each year anticipated before the crisis. It looks as if it will be higher than this, as the government has said it will need to borrow an additional $677 billion in the third quarter following the $3 trillion this quarter.

US national debt soaring

The Office of the Budget saw the US national debt rising to more than 100% of GDP this year. National output will fall at a 40% annualised rate this quarter, before starting a recovery later in 2020. GDP will still be 6.7% lower than planned by the end of next year. Unemployment will run at 14%, an increase from 3.8% earlier this year. On these figures, the US needs to boost its outstanding stock of debt by around one quarter in just two years. These figures now look moderate given the latest statement.

In the UK, the OBR has forecast a surge in the deficit from £48bn in 2019-20 to £273bn this year. This would be higher than during the banking crash of 2008-9. The Japanese state has been accustomed to running large deficits and creating a mountain of debt and will add more to it this year as it too takes massive action to try to offset some of the damage brought on by the state of emergency the government has declared to fight the virus.

Judging private sector demands for credit is more difficult. Too many companies have had a month or more with little or no revenue. This means they have to rely on bank facilities and bond issues to pay the bills once their cash runs out. We should expect more financial reconstructions. Norwegian Air has just agreed one, where the existing shareholders only kept 5% of the company they owned. New shares were created on a big scale for providers of new capital, and for bondholders, whose claims on the company were converted into shares to cut the interest bills. Companies that need the money are beginning to tap the bond market, as are companies in a strong financial position like Apple, who are borrowing at very low rates to improve shareholder returns.

Central bank reassures

In the last couple of weeks, credit markets have been reassured somewhat by the wall of money coming from the authorities. The knowledge that central banks will create a lot of money and buy a lot of bonds has reassured them that the government deficits can be met, whilst support for higher grade corporate credit has also helped. There are people asking how sustainable this model is. Will markets remain philosophical when bad numbers remind them that states are finding it difficult to collect tax revenue, and companies have lost a lot of customer payments?

The Japanese experience since the late 1980s shows that a country can sustain big government deficits and borrow very cheaply to finance them if it creates money and buys bonds on a big enough scale. We need to remember that Japan has avoided inflationary tendencies thanks to engrained savings habits by an elderly population, and by limits on the capacity of banks to lend too much to companies and individuals for purposes that could trigger price rises.

Inflation to rear its head?

If too many countries think they can keep a large portion of their economy closed for too long they may find their situation different to Japan. If monetary generosity by a central bank leads to inflationary lending it will require a change of policy. To sustain government borrowing there needs to be tax revenue to pay the interest, and to sustain company borrowing customer receipts. These huge deficits are only affordable if their duration is short-lived and there is a decent recovery in employment and economic activity to improve the financial picture.

For the future, we will get used to working with companies and governments that have more leverage than before. That, in turn, is only stable if interest rates remain low. Were governments and companies to wish to make a habit of growing their borrowings there is more danger of inflation picking up, which would require higher interest rates. This would be a dangerous development, creating new instability. As always, it all comes down to a question of timing. Recovery is much easier if the lockdown is short-lived and the debt burden limited. Some companies with too much debt and too little income will become casualties of the recession.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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