Central banks’ anti-inflation missiles make a global debt crisis seem inevitable

The roots of the crisis go deeper than the financial shocks produced by Covid-19, the Ukraine war, inflation and rising interest rates
Advanced economies, whose banks are significantly exposed to emerging markets, cannot shrug off the impending distress

Anthony Rowley

Published: 3:30am, 22 Aug, 2022

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Picture a situation in which one country is firing missiles at another in rapid succession and then lowers its firing rate a little, whereupon the attacked country feels relief that the situation is easing even though missiles already in-flight are about to rain down destruction.

This is one way of analogising what is happening now in the global economy as what economists refer to as the “lagged effects” of tighter monetary policy threaten to produce not only a global economic recession but also a new international debt crisis.

This is a clear danger as anti-inflation missiles launched by the US Federal Reserve, the Bank of England, the European Central Bank and others in the form of interest rate rises cruise toward their targets. Yet, financial markets do not appear to have an eye on the sky.

Even if they did, there is little they could do. There is an awful sense of inevitability about the advancing debt crisis, and its roots go deeper than the series of financial shocks produced by Covid-19, the Ukraine war, inflation and rising interest rates.

The new shock is likely to be sudden and painful, and it is by no means impossible that a series of systemic crises could appear as lenders (chiefly, but not exclusively, banks) and borrowers (governments, corporations and households) all run into serious debt distress.

Interest rates are set to continue rising this year and probably beyond, whatever happens to inflation. So, debt service costs will bite even harder. The lagged impact of monetary tightening will become a whiplash effect with a sting in the tail.

So, what happens when a rise in the cost – and reduction in the quantity – of money meets a situation of historically high debt? Something has to give.

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In its most recent Global Debt Monitor published in May, the Institute of International Finance (IIF) in Washington observed that total global debt rose by US$3.3 trillion in the first quarter to a record of over US$305 trillion – mostly due to rising debt in China and the US.

The report revealed that debt accumulation is accelerating across all principal economic sectors – government, corporate and household – and that the situation is becoming especially acute in emerging markets and low-income countries.

It also noted evidence of rising debt service costs, caused by scheduled or implied interest rate hikes, even as governments continue to borrow to meet fiscal demands, companies (smaller ones, especially) borrow to ward off bankruptcy, and households do so to cope with surges in food and fuel costs.

Accumulation of debt mountains is not new. There are plenty of precedents. What is new is the size of this particular mountain, created by a tectonic shock to financial orthodoxy, liquidity creation and historically low real interest rates that produced a massive surge in loan demand.

Perversely, while inflation is driving the interest rate rises that are poised to burst the global debt bubble, it also increases the money value of national output and thus reduces the size of debt to GDP ratios. But this benefit is illusory against the damage of soaring absolute debt.

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Asia is among those at risk. Corporate debt reached 140 per cent of gross domestic product in Vietnam and 116 per cent in South Korea, while household debt has climbed to 104 per cent of GDP in South Korea, 89 per cent in Thailand and 72 per cent in Malaysia in the first quarter of the year, according to the IIF.

Risk is by no means confined to Asia or emerging markets. As the International Monetary Fund noted in April, “the number of advanced economies with debt ratios larger than the size of their economy has increased significantly”.

And, as Hung Tran, a senior fellow at the Atlantic Council and a former senior IMF official and IIF managing director, suggested to me, emerging markets and low income countries face a “perfect storm” caused by Covid-19 and the war in Ukraine, leading to cascades of sovereign debt distress and default.

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Advanced economies cannot shrug this off. Their banks are significantly exposed to emerging markets, in the case of the euro zone and the US, while Japanese banks have also stepped up emerging market lending. Emerging market banks themselves are overexposed to domestic government debt.

It does not take much imagination to understand the potential for “cascading” debt impacts among banks and “shadow banks”, just as other leading financial institutions are nursing serious wounds from stock losses.

Sovereign, and to some extent bank, debt can always be “restructured”. But such restructuring is not so well established (or likely) in the case of corporate and household debt.

Debt distress is likely to be widespread. Who is to blame? A finger can be pointed at former US Fed chair Alan Greenspan for bailing out markets when the dotcom bubble burst 20 years ago with monetary expansion that subsequently went wild, until inflation exploded. The lesson may be that it’s best to take pain from excess right away and not try to stave off the day of reckoning.

Anthony Rowley is a veteran journalist specialising in Asian economic and financial affairs