A Covid-19 debt shock in Asia?

Even before the outbreak of Covid-19, the level of global debt was high by historic standards. According to the Institute of International Finance, by late 2019 global debt (including private and public debt) was more than US$250 trillion. Public debt, in particular, has increased everywhere since the global financial crisis of 2008.

International Monetary Fund calculations show that public debt ratios in almost 90% of advanced economies are higher than before 2008. On average, such ratios in emerging markets have increased to levels similar to those seen during the crises of the 1980s and 1990s. Public debt has also built up in low-income countries, two-fifths of which are at high risk of debt distress.

How much global debt has been added on the back of the Covid-19 health emergency? Focusing only on low-income and emerging economies, IMF managing director Kristalina Georgieva reckoned that US$2.5 trillion was a ‘very conservative, low-end estimate’ of their financing needs.

Where does Asia stand in all this? The two largest Asian economies, China and Japan, have some of the highest levels of debt in the world—at the end of 2017, Japan’s total debt stood at 395% of GDP and China’s at 254%. But there are some significant differences in their debt composition.

In Japan, debt is mainly public—approximately 237% of GDP in 2019—and is mostly held domestically. Around 70% of this debt is held by the Bank of Japan. Under normal conditions the combination of domestic–public debt holdings and very low interest rates considerably reduces the risk of default.

But will things change now? Japan’s emergency stimulus package announced in April 2020—a mix of cash handouts to households and firms, concessional loans and deferrals on tax and social security premiums—will widen the budget deficit to approximately 7.1% of GDP from 2.8% in 2019. This will bring the debt to around 252% of GDP. Japan’s already limited fiscal space has significantly narrowed as a result of the pandemic, pointing to some fiscal tightening and debt stabilisation when the economy gets onto a firm recovery path. This is especially necessary given Japan’s ageing population.

In China, on the other hand, debt is mainly corporate, with ramifications in the banking and shadow banking sectors. The rate at which it has grown in recent years is a cause of concern domestically as well as internationally. Capital controls, which were tightened in 2017 on the back of the renminbi’s weakening, are ensuring that individual and family savings remain in the country and continue to feed into the banking and the shadow banking sectors, keeping China’s debt sustainable.

The Covid-19 crisis and its impact on China’s economic activity—real GDP is expected to grow by 1–1.2% this year—created significant bottlenecks and increased the risk of financial instability. There are a number of areas of potential stress.

Small and medium-sized banks are exposed to the potential insolvency of small private firms and private borrowers. Larger banks face credit and liquidity risks due to their exposure to the heavily indebted real estate sector. The shadow banking sector, in which there are significant liquidity and maturity mismatches, is vulnerable to outflows that could be driven by savers withdrawing their money—either because they need their savings to face the economic crisis or because they panic amid falling equities prices and rising bond defaults.

China has responded to the crisis with an increase in welfare spending—such as unemployment insurance payments to support households—and temporary tax relief and deferral of tax payments for businesses in affected sectors and regions. Having significant fiscal space, China can extend its safety net to effectively mitigate the risk of personal and corporate bankruptcies, creating a buffer between banks and insolvent debtors.

Asia’s emerging economies show remarkable differences in levels of total debt. Some have entered the Covid-19 crisis with significant overall debt. Among the most indebted countries are Vietnam, India and Cambodia—with 189%, 126% and 116% of GDP, respectively—followed by the Philippines (99%), Pakistan (89%), Bangladesh (75%), Malaysia (73%) and Indonesia (69%).

The sharp decline in economic activity coupled with the risk of capital outflows—and a sudden increase in borrowing costs—could be particularly unsettling for countries with limited scope for fiscal policy measures, such as, for example, India, where state-owned banks are saddled with a significant stock of bad loans.

Other countries, like Indonesia and Thailand, have resorted to foreign currency interventions to mitigate the impact of capital outflows on their currencies. During the few weeks until the end of April, portfolio outflows from emerging markets amounted to approximately US$100 billion. Both Indonesia and Malaysia also implemented exceptional fiscal measures amounting to 1.8% and 2.8% of GDP, respectively.

Despite being at the epicentre of the Covid-19 outbreak, Asia (and East Asia in particular) has been more successful than Europe and the United States in containing the health emergency. Asian economies are due to recover earlier and faster. There has already been a rebound in Chinese exports (up 8.2% in April after a negative first quarter) due to stronger demand in Southeast Asia.

The international financial safety net has been extended in response to Covid-19, offering enough support for small and medium-sized economies to avoid them falling into liquidity or, worse, a solvency crisis on the back of the currency emergency. The IMF’s lending capacity has been stretched to US$1 trillion through the new arrangements to borrow and the bilateral borrowing arrangements. This is four times the amount that was deployed during the global financial crisis.

Concessional lending has tripled while the G20 agreed to suspend government loan repayments for developing countries. This makes the IMF the most significant provider of emergency funding in Asia while regional arrangements, such as the Chiang Mai Initiative Multilateralization, can provide further contributions. Of course, any IMF intervention needs to be set against the bigger global debt problem, while this is not the case for the CMIM. But the CMIM remains too small and untested.

Strong growth should eventually help Asia reduce its debt—at least the portion added as a result of the current crisis. Strengthening the CMIM and other regional financial arrangements, however, remains the best way to underpin financial stability.