The Coronavirus caused severe damage to the world economy until now – and much more than what we can repair. Developing economies will most likely suffer more from the effects of the pandemic. The worst impact of the health front may be behind us; however, it seems that the full impact 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. A liquidity event refers to the inability of the banking system to supply funds to those in need of it. Whereas, a solvency event refers to the situation where an individual/ household or government do not have access to a cash flow. For example, during this Coronavirus pandemic, millions of people have lost their jobs worldwide. As such, these individuals do not 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, as they still do not earn an income. Thus, the individual in this scenario do not have access to a cash flow.
The same is currently happening to governments around the world – a solvency crisis. Because many economies shutdown with hard lockdowns, they were not able to earn their previous levels of income, thus they do not have access to their normal cash flows, resulting in a solvency crisis. When we look at the U.S., (the dominating currency around the world) the Fed has given trillions worth of stimulus packages, which is just a means of papering over the losses of income. However, the government won’t be able to provide stimulus packages over the long run as the country is experiencing a sharp decline in income levels.
The currency market is currently being dominated by the USD, as such, the USD is not a reserve currency, it is a standard, similar to the Gold Standard in the past. The problem with this is, many economies have millions of debts denominated in USD. If everyone needs USD, and no one can repay their USD denominated debt – we are looking at a solvency crisis, as there will not be enough USDs available.
The problem we are faced with is balance sheet impairment at the household level, corporate and government levels. Households will be of the opinion that their future earnings will be impaired, thus for every dollar they receive by means of a stimulus package, that dollar will not go back to consumption. The focus would rather be towards saving as much of their income as possible. As such, consumption declines and corporates will experience decreased revenues. Thus, they will look at cutting wages or jobs, ultimately continuing a negative cycle. The main effect of this is the impairment on government’s balance sheets – as they have already provided stimulus packages. Globally, central banks can help to shield shocks to the flow of credit, with interest rates near or at zero. However, the ability to meaningfully stimulate demand is severely limited. Consequently, massive fiscal interventions will likely be required to prevent a broader economic collapse.
The graph below shows the projected US Federal Debt until 2025. It is evident that their debt increases tremendously. It is suggested that the US’s debt will equal their economy’s size this year. Furthermore, it is also projected that their debt will reach $4 trillion during 2020. However, with the economy operating within tight limits, their GDP cannot, or is rather slow to increase. Thus, once again adding 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. Although, the economy still remains mostly closed – with dire effects. As such it is safe to say that South Africa is looking at a solvency crisis. In the event of a global solvency crisis, which is not too far over the horizon, economies would have to be rebuilt, nations would have to be rebuilt and that will amount to tens of trillions of dollars. As the virus has been diagnosed, it is important that we too diagnose the economic challenges that lie ahead.