The growth in government debt to fund the fight against the Covid-19 pandemic and to shore up domestic economies has been substantial. Total government debt, estimated at US$66 trillion pre-crisis, is now expected to surpass US$92 trillion this year. Total global debt as a percentage of GDP has surged some 35% since the pandemic to more than 360% of GDP currently.
While many would argue that this build-up in government debt was unavoidable given the unprecedented crisis, the fact remains that governments have been addicted to easy money and debt-funded growth for many years now. All the major economies — the US, Japan, China and the eurozone countries — have debt exceeding their total output as measured by GDP. In the case of Japan and China, it is several folds.
With interest rates across the world at or near historic lows, the cost of these debts to governments has thus far been manageable. However, going forth, in a less sedate interest rate environment, managing this massive debt overhang is likely to throw up numerous challenges, with the potential for a banking doom loop a key challenge.
The doom loop refers to the mutually beneficial, symbiotic relationship that exists between governments and domestic banks. Governments that seek to meet budget shortfalls through the issuance of sovereign papers have domestic financial institutions as ever eager investors. Since banking regulations everywhere deem government debt instruments to be “risk-free”, they impose zero capital adequacy requirements on banks and would be counted as part of a bank’s reserves. That these government-issued papers bring regulatory benefits while also providing a “riskless” return, makes it a much more attractive risk-return proposition for banks, relative to other funding.
Governments indeed cannot possibly default on their home currency denominated debt, for they have the ability to print the currency needed to pay off the loan. So, yes, credit/default risk may be zero, but other risks — such as inflation risk, liquidity risk, rating risk and political risk — remain. So the “risk-free” label for government debt, as shown by the eurozone crisis involving PIIGS (Portugal, Italy, Ireland, Greece and Spain), is a serious case of mislabelling. What happened in Europe was a straightforward case of the banking doom loop. Domestic banks lent money to their governments by purchasing the bonds issued. But as government debt kept rising and the quality deteriorated, the banks that had accumulated huge holdings of government debt began to wobble. They were affected by the need to write down the value of their assets in order to meet mark-to-market regulations.
The immediate impact would be a freezing of the banks’ lending activities. But, worse, the hit on the asset side of the banks’ balance sheet would cause an equal offset on equity capital, which, if large enough, would require the banks to be bailed out. The result is the need for a government that itself is overstretched to bail out its banks. The banks now need the government as much as the government needs the banks as a source of continued debt financing. Both the government and its banks become hostage to excessive debt. What once appeared to be a mutually beneficial relationship now becomes a death embrace — thus the doom loop.
The eurozone doom loop required all the firepower of the troika — the European Commission, the European Central Bank and the International Monetary Fund — and a lot of human suffering to put things in order. Unfortunately, the lessons may have been forgotten. Today, given that much of the world is sitting on a tinder box of debt, the situation may be ripe for a repeat of this doom loop in other parts of the world.
There are two distinct possibilities through which a tipping point can be reached. The first is inflationary pressures, and the second is a forced rerating of government debt. Both will lead to an increase in the required yield for government bonds, causing bond prices to fall, which, if substantial, can set off the chain of events leading to the doom loop. That inflation has returned is obvious, and the massive recent build-up in debt becomes problematic now that the way out of this pandemic appears less straightforward.
The banking doom loop is just one of the numerous problems that come with debt financing. Imagine how much the moral hazard problem gets accentuated when governments are forced to bail out banks, because the banks got into trouble from holding government bonds. The clearest way out of all these would be to move away from debt-reliant systems.
The risk-sharing contracts of Islamic finance offer a viable non-debt alternative for government financing, especially the funding of development infrastructure. But the current debt-based system, no matter how disruptive it has been, is symbiotic, with each player providing the conditions necessary for the other to exist.
As Andrew Haldane of the Bank of England said of the Federal Reserve’s action during the 2008 US sub-prime crisis: “If the government (Fed) has been so swift and purposive in rescuing big finance, it is because it is deeply enmeshed with big finance. But each bailout promotes further speculation and larger bets. The scale and scope of each rescue keeps ratcheting up. Hence the doom loop.”
With home currency debt, governments indeed have the tools to delay, if not forestall, the doom loop and keep the banks intact, but as always, society would bear the costs.
Dr Obiyathulla Ismath Bacha is professor of finance at the International Centre for Education in Islamic Finance (INCEIF)