Hadas: Virus debt will leave toxic residue

Covid-19 is hitting United Airlines very hard. The Chicago-based carrier says it is burning through $40 million a day. Fortunately, it can borrow enough money to keep on flying some of its planes. On Monday, United announced that it had raised $5 billion, backed by the value of its frequent-flier programme.

As a corporate survival strategy, such borrowing makes sense. But United’s need to put up one of its most reliable assets as collateral shows that anti-virus travel restrictions are durably weakening the company’s financial health. The interest bill on the new loans will suck up cash flow, discouraging ambitious investment even if passenger numbers return to the pre-pandemic normal.

The virus has been especially tough for airlines, but the basic borrow-to-survive pattern is widespread. In the United States, new issuance of corporate debt in April was 181% higher than a year earlier, according to data from the Securities Industry and Financial Markets Association. In an economy shrinking at a double-digit percentage rate, only a small portion of that newly raised money will be spent on revenue-increasing investment.

When the total global corporate borrowing numbers come in, they are likely to follow the American pattern: less revenue supporting more debt. The increased financial burden will be laid on an already highly leveraged world. The ratio of private sector debt to global gross domestic product was 243% at the end of 2019, up from 191% when the Bank for International Settlements first collected the data in 2001.

Even if pre-Covid leverage levels had been more moderate, borrowing to make up for sales destroyed by the lockdown would have been a problem.  When companies borrow to make investments, the idea is that the extra revenue generated covers the interest expense on the loan. There is no such self-balancing for debts incurred to meet regular corporate expenses.

Such desperation-borrowing was fairly common in pre-modern economies. It was also frequently disastrous. Farmers who borrowed to buy seed for next year’s crop or food to tide them over to the next harvest often ended up in some sort of indentured servitude.

Crippling debts became rarer as people got richer and governments were more willing to help out in tough times. For companies, the need to raise debt because large chunks of economic activity have suddenly disappeared is unhappily reminiscent of a more primitive financial era.

Not that today’s governments are standing idly by. In every affected country, the state is helping companies out with numerous plans, from salary-replacement schemes and guaranteed loans to equity investments and outright monetary grants.

Central banks are acting in tandem with the governments from which they are theoretically independent. Policy interest rates are hovering around zero in the developed world, reducing interest bills. The monetary authorities are also buying or backing corporate loans. On Monday the U.S. Federal Reserve promised to buy bonds issued by companies that did not even ask for support.

These policies will help reduce the quantity and burden of extra debts, but they come with major adverse side effects. Many people worry about rising fiscal deficits. Even those who don’t recognise that generous government funding can end up subsidising inefficient businesses. Meanwhile, ultra-low policy interest rates encourage unnecessary borrowing and propel yield-hungry investors to take on more risk than is good for them or the overall financial system.

Unfortunately, all possible cures to the excess-debt disorder have deep flaws. Higher policy interest rates or a smaller tax shield for debt might reduce corporate reliance on leverage, but at the risk of triggering an avalanche of defaults. Any attempt to encourage companies to add more equity to their balance sheets will be overpowered by financial incentives to increase borrowing.

Historically, policymakers have used higher inflation rates to erode the real value of outstanding debts. Even if that approach is politically and economically sensible, it is unlikely to work. The price-wage system has become largely unresponsive to monetary policy.

The other way to ease an excessive debt burden is through rapid economic expansion. But nobody knows how to push up growth rates sustainably in developed economies. It’s technically much easier to lower leverage by rewriting debt contracts. However, while some very poor countries will get some slack, a global balance sheet restructuring remains a political non-starter.

In sum, by far the most likely financial legacy of Covid-19 is more of the problems that have been bedevilling the financial system for several decades: too much debt, too-low rates, too much risk, and no easy way out. – Reuters