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Pandemic impact on global sovereign bonds

May 2020

Sovereign debt risk after the virus

How governments were placed on the eve of the coronavirus pandemic will play a significant role in how they emerge from the crisis.

The global health crisis triggered by the coronavirus pandemic has firmly put the spotlight on how well countries will be able to handle the burden of rescuing their economies from an unprecedented meltdown. The question fixed income investors face is which countries will weather the storm and will sovereign debt crises follow?

Government deficits are ballooning everywhere, driven by two forces. First, huge fiscal programmes have been instituted to support households and companies at a time when many have seen incomes and revenues plummet due to the global lockdown. And, second, governments’ tax revenues have been hit hard by the dearth of economic activity, both domestic and cross-border.

So far governments have announced fiscal stimulus programmes in response to the coronavirus crisis worth 4.1 per cent of potential global GDP, nearly half of which will come from the US alone. Across the euro zone, the stimulus programmes are worth 3 per cent of GDP, while in Japan it’s 10 per cent. This spending necessitates huge volumes of government debt issuance. Central banks in the best-placed countries like the US, which benefits from reserve currency status, can absorb most, if not all, of this new debt through their asset purchase programmes. The US Federal Reserve’s balance sheet has expanded from USD4 trillion to USD6.5 trillion over the past couple of months alone and we expect it to peak at around USD8 trillion by the end of the year. In the UK, the Bank of England is pursuing an even more aggressive form of asset purchases by buying bonds directly from the Treasury in a form of debt monetisation – a policy that for long has been taboo.

But if the lockdowns last more than two quarters, a new set of fiscal measures will have to be adopted, which could mean solvency problems for some already highly indebted countries. We estimate US debt will have risen from 108 per cent of GDP to between 133 per cent and 145 per cent following its massive stimulus programme, worth some 7 per cent of GDP,  depending on how sharply the economy bounces back. In the worst case, it could hit 165 per cent of GDP by the end of 2022. Elsewhere, higher debt levels are likely to ring alarm bells – it’s worth remembering that during the euro zone’s sovereign debt crisis, Greece flirted with ejection from the single currency as its debt breached 150 per cent of GDP.

Who's at greatest risk?

Pictet Asset Management’s sovereign risk scores show which countries were most vulnerable to dangerous debt dynamics coming into the coronavirus crisis. The metric is based on how countries stand relative to each other and to their own historic trend on three dimensions – how affordable their existing debt is, how well they’re able to finance it and the degree to which the debt will fall naturally as their economies grow.
Fig. 1 Developed sovereign debt dynamics
Pictet Asset Management short-term sovereign debt risk metric vs debt sustainability score (2019)
debt sustainability scores

Debt dynamic scores are generated by Pictet Asset Management from a number of official indicators, comparing countries relative to each other and to their own trends. Source: Pictet Asset Management, CEIC, Refinitiv. Data are for 2019 for the structural sovereign scores and Q4 2019 for the short-term debt score. 

Our analysis shows that Greece had by far the poorest state of debt sustainability at the end of 2019 among developed countries, followed by Italy, Japan, Belgium and the UK. At the other end of the scale, Switzerland, the Netherlands and Ireland were in the most enviable positions.
Mapping countries’ short-term debt situations against their structural scores confirms that Greece, Italy and Japan exhibit the worst debt dynamics, though France is also a worry. By contrast, other northern European and Scandinavian countries are in a good position.
Fig. 2 Emerging sovereign debt dynamics
Pictet Asset Management short-term sovereign debt risk metric vs debt sustainability score (2019).
Emerging Markets debt sustainability scores

Source: Pictet Asset Management, CEIC, Refinitiv. Data are for 2019 for the structural sovereign scores and Q4 2019 for the short-term debt score, excluding China for which structural sovereign score is for 2018 and short-term debt score is for Q4 2018, Bulgaria for which short term debt score is Q4 2018, and Egypt for which short-term debt score is Q3 2019.

Among emerging economies, the countries that faced the biggest risks to their sovereign debt at the start of the crisis were Brazil, South Africa, Egypt and Argentina. In terms of debt dynamics relative to short-term debt situations, South Africa, Egypt and Ukraine are of greatest concern. Those likely to be most resilient were Russia and Korea.

Flashpoint

Italy was a flashpoint during the euro zone crisis and it could prove to be one again. Italian government debt could potentially hit 150 per cent of GDP by the end of this year. The European Central Bank already owns Italian bonds worth some 22 per cent of Italy’s GDP and, as such, it has a big role in the sustainability of the country’s debt. The ECB has already said it would take a flexible approach to purchases of member states’ bonds and will be absorbing some 90 per cent of net new issuance by the single currency region’s governments this year.

Those purchases by the ECB come against the backdrop of northern European concerns about creeping debt mutualisation. But ultimately, if the euro zone is to be kept together, some sort of debt pooling will be necessary – extend and pretend can only be supported for so long before the market tests the region’s political resolve. We expect that there will be moves in the direction of mutualisation, which ensure that yields on Italian bonds stay contained.

The ECB faces a fine balancing act in how it navigates the coming months.

The ECB, however, faces a fine balancing act in how it navigates the coming months and will have to be deft in how it applies game theory. It wants to prevent another sovereign debt crisis. But it also doesn’t want to entirely remove pressure on euro zone politicians to reach agreement on some sort of debt mutualisation. If the central bank is too accommodative and compresses southern European government bond spreads too much, this would lessen the need for euro zone governments to agree on how to move forward.

An even more immediate concern is that some emerging market economies have already run out of monetary headroom. Inflation won’t be an issue for some time in developed economies as depressed demand and weak oil prices drag down consumer prices overall, notwithstanding aggressive central bank action. In some emerging economies, however, central bank policies are already acting to drag down their currencies in what could turn out to be another devaluation/inflation cycle. Worryingly some large developing economies – Turkey, Brazil, South Africa – are heading in this direction. 

The global pandemic is likely to expose strains that already exist in the global economy as well as throwing up new problems. How governments came into the crisis will play a big role in how they emerge.