How Can Asia Avoid Fallout If Covid-19 Triggers A Debt Crunch?

Asia’s economies have generally maintained sound macroeconomic policies that can help the region withstand this latest challenge and emerge even stronger.

- Cyn-young Park

The coronavirus (COVID-19) pandemic raises the spectre of another global debt crisis. The global economy is deep in debt—to the tune of an estimated $ 250 trillion in 2019—after a decade of historically low interest rates. Global debt-to-GDP hit a record high of over 320%, according to the Institute of International Finance.

A pandemic-induced economic slowdown implies lower corporate earnings and greater debt servicing burdens on companies. This would lead to increasing defaults, plunging investor confidence, and potentially a widespread credit crunch.

How policy makers respond now will be crucial in avoiding this worst-case scenario, and deciding whether the recovery path will be V, U, or L-shaped.

Economists have warned for years of the risks posed by massive debt accumulation. While the corporate sector ratcheted up its borrowing, financial engineering also played a role in expanding and leveraging loans. Leveraged loans are a type of loan extended to companies with below investment grade credit ratings (i.e. subprime corporate borrowers). Ten years of very low interest rates enticed investors to buy them, as they typically pay higher interest rates.

The bank for international Settlements has estimated that outstanding leveraged loans worldwide reached $ 1.4 trillion at the end of 2018, more than double the amount a decade ago. Yet the Bank of England has estimated this figure at around $ 2.2 trillion. For comparison, the stock of US mortgages at the time of the US subprime mortgage crisis was estimated at about $ 2.3 trillion, of which subprime mortgages were $ 1.3 trillion.

About half of US leveraged loans are repackaged into collateralised loan obligations, which were estimated by the US Federal Reserve at $ 617 billion at the end of 2018. Collateralised loan obligations are similar to collateralised debt obligations and mortgage-backed securities—touted as the root causes of the global financial crisis.