1. In initial lessons of corporate finance, debt is considered to carry the lesser cost of capital than equity and hence becomes an interesting leverage aspect of designing the capital structure. The calculations demonstrate a gradual increase in the value of a firm when debt is added as part of the capital as against equity. This notion, as a concept in finance, helps corporates to reduce the overall cost of capital to maximize its value by creating an optimum mix of equity and debt. In public finance, on the other hand, debt is a means of financing the deficit to bridge the shortfall of income to incur the required public expenditure. Most governments resort to deficit financing as a fiscal tool to further the growth prospects of the economy. Economists have theorized that enhancing public expenditure, even if it is non-productive, is positive for the economy due to its multiplier effect and support to the demand curve of the economic equilibrium. The debt, therefore, is an inseparable part of the finance and is an important factor that circulates the money and helps to expand the size of the economic cycle with each rotation.
2. Due to this reason, central banks across the world tend to take an accommodative stance to facilitate easier credit creation by bringing down interest rates and infusion of liquidity. This infusion becomes more prominent during a crisis like COVID-19, as everyone runs to keep firms/businesses viable and employment at acceptable levels. In normal times, however, central banks keep balancing between liquidity and inflation, keeping both within reasonable limits.
3. The cost of debt, though less than the equity, is an unavoidable liability for the borrower, which compounds and rises exponentially, in case not paid on the due date(s). The borrowers that do not generate enough returns to service their debts, face prospects of losing management control or, at worst, liquidation. Public debt, however, has a different character due to sovereign backing, a guarantee that can not fail (except foreign debts). For a government, that runs short of revenues, debt can be repaid with additional debt (about 70% of sovereign borrowings refinance maturing loans. Source: Reuters), which amounts to shifting liabilities of the present to future generations, an otherwise unsustainable cycle, moving purely on the sovereign backing. In case markets are not adequately deep to facilitate borrowing, governments may resort to even printing of fiat currency (it has its own implications for the economy).
4. In our attempts to relentlessly push the economic cycle towards higher growth, the debt levels around the world have been rising sharply. As per the World Bank, the world's total debt (public and private) stood at USD 188 trillion, 227% of the world's collective economic output in 2018. It has grown from 114.6% of GDP in 1970 to its present levels (Figure 1). As per an estimate by the International Institute of Finance, this burden would have surpassed USD 255 trillion in 2019, nearly three times of world GDP and amounts to USD 32,500 debt (INR 24.37 Lakh) for each human on this planet. This sharp rise in the debt levels is due to public borrowings, mainly by the USA, Japan and China that constitute about 68% of world public borrowings. Source: Reuters).
Figure 1: World Debt as % of GDP (Source: World Bank)
5. The share of both public and private debt has increased constantly as indicated in Figure 2. However, the public debt has witnessed a sharper increase since the 1970s as compared to private debt. In the last 48 years, while the private debt has increased its share 1.89 times (from 76.6% to 144.8%), the share of public debt has more than doubled (2.15 times, from 38.1% to 82.2%) during the same period.
Figure 2: Share of Public and Prive Debt (Data Source: World Bank)
6. With this size of the debt, the liability of debt servicing becomes extremely critical. Though the long term interest rates have declined over the past two decades (Figure 3), they constitute a substantial part of the expenditure. If the world weighted average interest rates are taken at 4%, the annual debt servicing liability comes to around USD 10.2 Trillion, with emerging and low-income economies bearing the substantial part of this liability due to higher interest rates.
Figure 3: Long Term Interest Rates (Source: World Bank)
7. Due to this massive increase in debt and debt serving burden, many private entities become unviable and face eventual closure/bankruptcy. The non-performing debts (Non-Performing Assets or NPA for the lenders)) have become a major problem across the world and threaten the stability of the financial system itself. This led to the introduction of debt reforms including debt restructuring and bankruptcy codes in most economies. The banks, the primary credit creators for an economy, face an existential threat due to mounting NPAs, many having succumbed and failed. When the lender or the borrower involved were systemically significant, the government had to even bail them out at the expense of taxpayers. This led central banks to prescribe NPA provisioning, capital adequacy and lending norms for banks. The result is that banks and borrowers, both are fearful and do not want to engage, leading to a decline in credit growth in most economies of the world. In India, the bank credit growth has declined to a five-decade low to 6.14% in FY 19-20 (Source: Business Standard). With the disruption of business cycles due to COVID-19, the situation is likely to further worsen despite RBI taking exceptional measures to ease the liquidity.
8. The situation of public debt is no better, but for the sovereign backing, it carries. The public borrowing of some of the governments, as a % of GDP, has crossed their GDP with Japan at the top of list with 236%, followed by Greece at second spot with 182%, Singapore at 13th place with 110%, Bhutan at 17th place with 103%. Some others are inching closer to this mark with UK at 29th place with 87%, USA at 34th position with 83%, Sri Lanka at 36th place with 75%, India at 50th place with 70% and Pakistan at 55th place with 67%. (Source: CIA World Fact Book). With the COVID-19 outbreak, the governments across the world are taking steps to stimulate their economies and have announced packages up to 20% of their GDPs (total commitment of about USD 9 Trillion, Source: IMF), which will eventually push the public debt envelop and fiscal deficits further.
9. Over the last century or so, the world has clearly overindulged in debt and has enjoyed easy availability of money for both public and private borrowers. Higher and faster economic growth being the sole objective, the interest rates have been driven down with easy access to money. Credit creation targets have eroded the process of due diligence leading to a substantial increase in default risk. The problem has gradually reached a tipping point beyond which the fine balance between credit creation, business risk and economic growth, shall reverse its benefits threatening the very functioning to the financial system leading to yet another financial crisis.
10. Indications, accelerated by COVID-19 pandemic, are already appearing including the slowing down of economies, rising unemployment levels, declining business sentiments and risk aversion, rising bond yields, rising market capitalization without strong fundamentals (rising PE levels) and above all, debts reaching unsustainable levels. Are we heading for challenging times in the short to medium term?
