The battle to contain Covid-19 has impacted most economies by putting a lid on the amount of economic activity that can transpire, which in turn spawns economic output declines, followed by recessions. The nature of the pandemic inhibits retailing the most, and particularly services such as hair salons, health spas, movie theaters, lodging, food, and beverage. The entire travel sector has been hammered to the extent that it could take years for airlines, cruise lines, hotels and resorts to get back to even. But is the worst over with or just around the corner?
Historically, financial crises follow an expansion: Long, steady economic expansions are often fueled by low interest rates provided by central banks, and correspondingly, major amounts of debt taken on by businesses. When the expansion hits full tilt, central banks typically raise interest rates to prevent bubble busts thereby driving up the cost of capital for most of these over-leveraged businesses. Marginal companies with loads of debt start to default, causing banks and other lenders to engender losses. As these losses mount, the financial companies’ capital comes under pressure often reducing loans to other marginal businesses which in turn might also default.
High debt levels in many places: Even before the pandemic struck last March, high levels of debt have permeated businesses in the world’s two largest economies – United States and China. These high debt levels have provided headwinds for financial institutions as the debt is disproportionately distributed among high-risk borrowers. High debt levels have reached into other developed economies such as Canada and Australia where household debt has reached record proportions. In emerging economies microfinancing has long been a mainstay of support for many small businesses. However, these financial institutions are showing major debt load increases to their balance sheets. This is placing their loan portfolios under stress with much of the capital being loaned to households or small businesses that have volatile sources of income and few or no assets for collateral.
Government assistance to locked down businesses: The governments of many economies throughout the world have provided various security nets for businesses that have suffered owing to lockdowns or travel bans. Policies such as grace periods for repayment of existing loans and re-contracting loans with longer maturity dates and/or lower interest rates have provided much needed help for struggling businesses. But these policies cannot go on forever as the fallout can reach deep into the financial sector. The health crisis is temporary and these support schemes will end up going away when it’s over. But no matter how temporary the health crisis turns out to be, numerous financial institutions already have significant financial damage done to their balance sheets. Further, how many businesses are being saved by government aid that cannot survive without it.
Conclusions: The coming Covid-19 credit crunch does not fit the normal pattern as there was no major boom that led to asset bubbles forming. Further, the maturing U.S.
economic cycle had not been managed by increases in interest rates before the pandemic began. The pullback that began with the first lockdowns is disproportionately hitting low-income households, and smaller businesses that have fewer asset reserves to withstand a prolonged downturn. Government aid programs are helping, but they cannot go on forever as the fallout could reach deep into the financial sector already laded with massive amounts of debt. What will turn it around, of course, is the widespread distribution of the vaccine that fights Covid-19. This activity is underway, but might take several months before health officials can see that the virus is on the wane. In the meantime, the government help will also retreat, and the debts at all levels will mount, pressuring financial institutions everywhere.
Sources: The Coming Covid-19 Credit Crunch, Carmen Reinhart, The World in 2021, The Economist, November 13, 2020.
Thanks David. As someone who fears the degradation of the global environment caused by human activity, I continue to worry that our economy and much of the world’s economy is based on growth generated by population growth and the demands for goods created by that growing population. More people want and need more stuff. Creating more stuff with today’s technologies destroys resources that can not be replaced.
granted , the problem facing the large economies discussed in this weeks blog portend large long term negative effects for the major countries mentioned above. but i worry about the effects on the small business owners more than i do for the large corporations in these countries. small family owned business often don’t have the resiliency of large businesses to bounce back when things improve. anyway, good blog, david.