SA will not be spared a global solvency crisis
The problem is that balance sheets have been impaired for households, businesses and governments
The novel coronavirus has caused severe damage to the world economy — far more than we can repair. Developing economies will most likely suffer most from the effects of the pandemic. The worst impact, on the health front, may be behind us but it seems the full effect on the economy is only starting to show. If the effect of the virus continues, it may permanently impair the world economy as we once knew it. As such, the question is: are we looking at a global solvency crisis?
Worldwide, speculation is rising over whether we are looking at a liquidity or solvency crisis. It is important to note that a liquidity event differs from a solvency event. The former refers to the inability of the banking system to supply funds to those in need of them. The latter refers to a situation where an individual, household or government does not have access to a cash flow. For example, during this coronavirus pandemic millions of people have lost their jobs worldwide. These individuals no longer have an income and cannot repay their debts. Even if they were to borrow more funds, they would still not be able to repay their debt because they will still not earn an income. The individuals in this scenario do not have access to a cash flow.
The same is now happening to governments around the world — a solvency crisis. Because many economies shut down with hard lockdowns, they were not able to earn their previous levels of revenues. They thus do not have access to their normal cash flows, resulting in a solvency crisis. When we look at the US (the dominating currency around the world), the Federal Reserve has provided trillions of dollars in stimulus packages, which is just a means of papering over the losses of income. However, it won’t be able to provide stimulus packages indefinitely as the country is experiencing a sharp decline in income levels.
The currency market is being dominated by the dollar, and as such the dollar is not a reserve currency but a standard, similar to the gold standard of the past. The problem with this is that many economies have millions in debt denominated in dollars. If everyone needs dollars and no-one is able to repay their dollar-denominated debt, we are looking at a solvency crisis as there will not be enough dollars available.
The problem we are faced with is essentially balance sheet impairment at the household, corporate and government levels. Households will be of the opinion that their future earnings will be impaired, so for every dollar they receive by means of a stimulus package, only part will go back into the system through consumption. The focus will rather be on saving as much of the household income as possible. Consumption will decline and corporates will experience decreased revenues. They too will look at cutting wages or jobs, ultimately continuing a negative cycle.
The main effect of this is the impairment of the government’s balance sheet, as it has already provided stimulus packages. Globally, central banks can help reduce shocks to the flow of credit by cutting interest rates to near or at zero. However, the ability to meaningfully stimulate demand is severely limited. Consequently, huge fiscal interventions will likely be required to prevent a broader economic collapse.
The graph of projected US federal debt up to 2025 shows a tremendous increase, suggesting that US debt would have equalled the size of the economy by this year. Furthermore, it is also projected that debt would reach $4-trillion during 2020. However, with the economy now operating within tight limits, the US GDP cannot increase easily, certainly not rapidly. This too adds to the solvency crisis.
Locally, the government has implemented several stimulus packages at both the household (in the form of grants) and corporate level (in the form of relief packages). The most notable, however, is the cut of the repo rate to 3.75% in an effort to provide relief. However, much of the economy remains closed, with dire effects. As such, it is safe to say that SA is also looking at a solvency crisis.
In the event of a global solvency crisis, which is not too far over the horizon, economies and nations would have to be rebuilt at a cost of tens of trillions of dollars. Just as the spread of Covid-19 has been diagnosed as a pandemic, it is important that we correctly diagnose the economic challenge that lies ahead.
• Cilliers is director and chief of dealing at TreasuryONE.