In a recent report, the Bank for International Settlements, the bank of the world’s central banks, issued an ominous warning. It drew attention to the growing gap between buoyant world asset and credit market prices and the weak post COVID-19 world economy. It warned that such disconnects should not be expected to continue indefinitely and that when they do end, they generally unsettle the world’s financial markets.
Among the more striking examples of the disconnect between financial market prices and underlying economic fundamentals that does not get the attention it deserves pertains to several Eurozone and emerging market economies. This is all the more surprising considering how heavily indebted those economies are and how troubled they are in the pandemic’s wake.
Much attention is rightly being focused on brewing U.S. debt problems in the real commercial property market and in the highly leveraged debt market. However, as big as these problems might be, they pale in comparison to the debt problems brewing abroad. Indeed, while there might be around $1.5 trillion in debt of both the U.S. real commercial property and the highly leveraged loan markets, Italy alone has a public debt load of close to $3 trillion, and the emerging markets have dollar denominated debt of around $3.5 trillion.
The reason to be very concerned about the highly indebted Eurozone and emerging market economies is that not only did they enter the current economic recession in worse shape than they did during the Great Recession in 2008-2009. They are also now experiencing very much deeper economic recessions. This has to beg the question: If those economies experienced serious debt and currency crises in the wake of the 2008-2009 economic recession, why will they not do so now in the very much worse economic and financial circumstances in which they find themselves?
Italy, the Eurozone’s third-largest economy, provides a good example of the serious challenges that lie ahead for the Eurozone’s economic periphery, although much the same could be said about Spain, the Eurozone’s fourth-largest economy. According to the International Monetary Fund (IMF), even without a second COVID-19 wave, Italy’s tourist dependent economy is forecast to contract by more than 12 percent in 2020. If that occurs, Italy’s COVID-19 induced recession would be around three times as deep as that experienced in 2008-2009.
Compounding Italy’s economic and financial problems is the fact that it entered the current recession with a higher public debt level and a weaker banking system than it entered the last recession. With its budget deficit now expected to exceed 10 percent of GDP in 2020 and its public debt-to-GDP is set to skyrocket to over 150 percent of GDP by year end, it is difficult to see how Italy will avoid another debt crisis. Similarly, with the Italian economy expected to decline by around three times the worst-case scenario of its banks’ stress tests, it is difficult to see how the country will avoid a banking sector crisis sometime down the road.
To be sure, in principle the European Central Bank (ECB) can stave off an Italian sovereign debt and banking sector crisis by continuing to buy very large amounts of Italian government bonds. But considering that the Italian economy is some ten times the size of Greece’s, the ECB might have to buy some 1-2 trillion euros of those bonds to keep Italy afloat. It’s fanciful to think that the ECB could do that without inviting serious pushback from the German Constitutional Court, which already in May questioned whether the ECB’s earlier bond buying program did not exceed its mandate.
Brazil, by far Latin America’s largest economy, offers a good example of how other large emerging market economies such as Turkey and South Africa might be heading for foreign exchange crises that could have spillover effects to the rest of the world economy. Like many other emerging market economies, Brazil seems to have little control over the pandemic, which is ravaging its economy and causing its public finances to spin out of control. Having entered the current recession with weak public finances, it is now officially estimated that Brazil’s budget deficit could exceed 12 percent of GDP in 2020 while its public debt-to-GDP ratio is well on its way to exceed 100 percent.
Despite a still highly favorable global liquidity environment, since the start of the year the Brazilian currency has depreciated by 25 percent against the dollar. As soon as the global liquidity tide recedes, Brazil could be headed for a full-blown foreign-exchange crisis.
Let’s hope U.S. economic policymakers are paying close attention to the economic storm clouds that are gathering abroad. Maybe then they will not be as keen as they appear to be today to dial back on the strong economic stimulus that has been provided thus far to the U.S. economy.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.