Debts, deficits and stimulus

We have just witnessed the Japanification of world finance as central bank attempt to counteract measures to stop Covid-19. How will this all end?

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  1. Charles Stanley

Never before in human history has so much extra money been created by central banks and thrown at a deep recession. Never have governments pledged to borrow so much as they try to offset some of the damage done by policies designed to stop the spread of the pandemic.

Since March this year, the Federal Reserve Board has created an additional $3 trillion. The European Central Bank has chipped in an extra $ 2.3 trillion, the Bank of Japan $900bn and the Bank of England $380bn. These central banks have swollen their balance sheets by these amounts, creating cash and buying-up government bonds. Their aim has been to keep markets liquid, to allow easy financing of big budget deficits, and to drive interest rates low and keep them there. So far, they have succeeded.

The Fed has provided a huge monetary stimulus, lending direct to banks and companies – as well as acquiring government paper. M3 money growth is up by almost a fifth since March. UK and Euro-area money growth have both accelerated to around 10% over the same time period, whilst Japan has managed 7%.

The Japanese say they will keep ten-year government bonds at a zero rate, buying as much as it takes to do so. The Fed has said there is no upper limit to how many bonds it would buy, as it is determined to keep rates low and markets liquid. The Bank of England has expanded its total bond-buying to £745bn so far – and is widely expected to announce some more soon. The ECB has promised to buy €1.35 trillion of bonds by June 2021.

Governments have taken advantage of this central bank enthusiasm to keep their borrowing rates at – or near – zero to allow or to create by policy action much higher state deficits this year. The International Monetary Fund (IMF) has come forward with forecasts of what we might experience as a proportion of GDP in each country. It places Canada at the top at 19.9%, the US at 18.7%, and Brazil at 17%.

The UK is at the high end of the Europeans, at 16.4%, with Spain at 14%, Italy at 13% and France at 11%. Even Germany is at 8%, showing the EU has put on hold its 3% deficit ceiling for the crisis. China is estimated at 12% and India at 13%. These are huge figures and will mean a sharp rise in total state debt around the world. Whilst Japan will remain an outlier with state debt near 250% of GDP, there will be more countries with state debt higher than GDP. Italy is at 160%, France at 116%, Belgium at 114% on these figures.

The case for money printing

This based on the collapse of demand, income and tax revenues brought on by the aggressive policies to curb the virus. With around a quarter of the world economy shut down or badly impaired by the rules on tourism, leisure, travel and shop retailing – there needs to be a big offset.

The corporate sector plunges into deficit, short of revenues. The government sector falls into bigger deficit with the loss of tax income, whilst families and individuals on average see an increase in their surplus as their ability to consume is curtailed whilst most keep their jobs and full pay. In these conditions, governments seek not only to borrow to fill the hole left by lost tax revenues and to pay increased bills for unemployment, but they also wish to spend more and tax less to provide an additional boost to badly hit economies.

There are two main issues about this account of what is happening that matter to investors. Can this continue? What does it mean for share values?

So far, the massive injections of cash from official sources have sustained a strong recovery in share prices, but it has been a skewed one – with more progress for the sectors and companies that can survive and thrive and less for the ones that are in troubled areas. The US and China have experienced the best share-price recoveries, though China is still way below 2015 whilst the US Nasdaq has powered on to new all-time highs. Markets rally on news and rumours of more government or central bank stimulus to come and fall back when they think the easing is ending.

Governments and central banks have created a circular economy, where the governments overspend, the public lends their surplus savings to cover the gap, then the central banks buy in much of the debt from the private sector to sustain its price and keep interest rates at very uninviting levels.

Japan welcomes the world

We have just witnessed the Japanification of world finance, as Japan has been doing this ever since its own spectacular banking and share crash 30 years ago. Japan has shown that if an economy relies on its own domestic savings, has a strong external position – and very low inflation – it can carry on lending and borrowing to itself at zero interest rates for as long as it likes.

All that policy is doing is redistributing wealth and income between savers and borrowers, and between the state and citizens at artificial rates that the authorities themselves control. The US and UK have a balance of payments deficits and are more prone to inflation, but these constraints on this print and borrow model are not yet effective as there is no immediate inflationary pressure and the external deficits are also readily financed. We should expect more public sector printing and borrowing before this phase is over. It will be the main reason shares are sustained at expensive levels.

People worry about how the debt will be repaid. The answer is most of this state debt will not be repaid anytime soon. The short-term borrowings will be rolled over, as the years pass. The aggressive bond-buying programmes mean the effective debt levels are much lower than the gross debt figures quoted by the IMF for countries that are not part of the Euro.

In the UK's case, the 100% of GDP figure for state debt is actually 63% when adjusted for the amount of the UK debt which the state owes itself, as the Bank of England is 100% state-owned. The Euro area is different as the ECB owns the state debt, not the individual country central banks of the issuers.

This model is one for trying to prevent a worst-case economic disaster from anti-virus measures. It will best be replaced by a return to normal working in economies, with a big reduction in deficits as incomes and tax revenues return to 2019 levels and above. Meanwhile, as we wait for that, the plentiful supply of deficit cash and central bank money is crucial to sustaining equity market valuations. It looks as if inflation and external trade accounts will allow further stimulus, which is now doubly necessary as we see the anti-virus restrictions being increased in many countries.

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