Though the Federal Reserve moved over the weekend to slash rates and buy treasuries, markets around the world fell on Monday anyway. The coronavirus threatens to set off financial contagion in a world economy with very different vulnerabilities than on the eve of the global financial crisis, 12 years ago.
In key ways the world is now as or more deeply in debt as it was when the last big crisis hit. But the largest and most risky pools of debt have shifted — from households and banks in the United States, which were restrained by regulators after the crisis, to corporations all over the world.
As businesses deal with the prospect of a sudden stop in their cash flows, the most exposed are a relatively new generation of companies that already struggle to pay their loans. This class includes the “zombies”— companies that earn too little even to make interest payments on their debt, and survive only by issuing new debt.
The dystopian reality of deserted airports, empty trains and thinly occupied restaurants is already badly hurting economic activity. The longer the pandemic lasts, the greater the risk that the sharp downturn morphs into a financial crisis with zombie companies starting a chain of defaults just like subprime mortgages did in 2008.
Over the last century, recessions have almost always been started by a sustained period of higher interest rates. Never a virus: The damage such contagions inflicted on the world economy typically lasted no more than three months. Now this once-in-a-century pandemic is hitting a world economy saddled with record levels of debt.
Central banks around the world are waking up to the prospect that the cash crunch can beget a financial crisis, as in 2008. That’s why the Federal Reserve took aggressive easing measures on Sunday that were straight out of the 2008 crisis playbook. While it is unclear whether the actions of the Fed will be enough to prevent the markets from panicking further, it’s worth asking: Why does the financial system feel so vulnerable again?
Around 1980, the world’s debts started rising fast as interest rates began falling and financial deregulation made it easier to lend. Debt tripled to a historic peak of more than three times the size of the global economy on the eve of 2008 crisis. Debt fell that year, but record low interest rates soon fueled a new run of borrowing.
The easy money policies pursued by the Federal Reserve, and matched by central banks around the world, were designed to keep economies growing and to stimulate recovery from the crisis. Instead, much of that money went into the financial economy, including stocks, bonds and cheap credit to unprofitable companies.
As the economic expansion continued, year after year, lenders grew increasingly lax, extending cheap loans to companies with questionable finances. Today the global debt burden is again at an all-time high.
The level of debt in America’s corporate sector amounts to 75 percent of the country’s gross domestic product, breaking the previous record set in 2008. Among large American companies, debt burdens are precariously high in the auto, hospitality and transportation sectors — industries taking a direct hit from the coronavirus.
Hidden within the $16 trillion corporate debt market are many potential troublemakers, including the zombies. They are the natural spawn of a long period of record low interest rates, which has sent investors on a restless hunt for debt products that offer higher reward, with higher risk. Zombies now account for 16 percent of all the publicly traded companies in the United States, and more than 10 percent in Europe, according to the Bank for International Settlements, the bank for central banks. A look at the data reveals that zombies are especially prevalent in commodity industries like mining, coal and oil, which may spell upheavals to come for the shale oil industry, now a critical driver of the American economy.
Zombies are not the only potential source of trouble. To avoid regulations imposed on public companies since 2008, many have gone private in deals that typically saddle the company with huge debts. The average American company owned by a private equity firm has debts equal to six times its annual earnings, a level twice what ratings agencies consider “junk.”
Signs of debt stress are now multiplying in industries impacted by the coronavirus, including transportation and leisure, auto and, perhaps worst of all, oil. Slammed on one side by fear that the coronavirus will collapse demand, and on the other by fears of a supply glut, oil prices have fallen to below $35 a barrel — far too low for many oil companies to meet their debt and interest payments.
Though investors always demand higher returns to buy bonds issued by financially shaky companies, the premium they demand on U.S. junk debt has nearly doubled since mid-February. By last week the premium they demand on the junk debt of oil companies was nearing levels seen in a recession.
Though the world has yet to see a virus-induced recession, this is now a rare pandemic. The direct effect on economic activity will be magnified not only by its impact on balky debtors, but also by the impact of failing companies on the bloated financial markets.
When markets fall, millions of investors feel less wealthy and cut back on spending. The economy slows. The bigger markets get, relative to the economy, the larger this negative “wealth effect.” And thanks again to seemingly endless promises of easy money, markets have never been bigger. Since 1980 the global financial markets (mainly stocks and bonds) have quadrupled to four times the size of the global economy, above the previous record highs set in 2008.
On Wall Street, bulls still hold out hope that the worst can pass quickly and point to the encouraging developments in China. The first cases were reported there on Dec. 31, and the rate of growth in new cases peaked on Feb. 13, just seven weeks later. After early losses, China’s stock market bounced back and the economy seemed to do the same. But the latest data, released today on retail sales and fixed investment, suggest the Chinese economy is set to contract this quarter.
While China is no longer center stage, as the virus spreads worldwide there are renewed fears that the crisis could circle back to its shores by hurting demand for exports. Over the last decade China’s corporate debt swelled fourfold to over $20 trillion — the biggest binge in the world. The International Monetary Fund estimates that one-tenth of this debt is in zombie firms, which rely on government-directed lending to stay alive.
In other parts of the world, including the United States, calls are growing for policymakers to offer similar state support to the fragile corporate sector. No matter what the policymakers do, the outcome is now up to the coronavirus, and how soon its spread starts to slow.
The longer the coronavirus continues to spread at its current pace, the more likely it is that zombies begin to die, further depressing the markets — and increasing the risk of wider financial contagion.
Ruchir Sharma is the chief global strategist at Morgan Stanley Investment Management, author of the forthcoming book, “The Ten Rules of Successful Nations,” and a contributing New York Times opinion writer. This essay reflects his opinions alone.
