Can the Debt Market be the Cause of the Next Financial Crisis?

Updated: Sep 23

Written by: Saumil Mehta


Introduction


The debt market has seen better days in the past. Lately, it has been in the news for all the wrong reasons, being losses, write-offs, downgrades and defaults on payments. Leading market experts believe that this is not an industry-wide issue and that capital firms see it as an investment opportunity in the credit risk category due to its attractive valuations (Roy, 2019).


Debt Domination and Financial Instability in Emerging Countries


Central bankers in emerging economies need to make a decision of whether to channel external pressure into higher interest rates or into a weaker Forex rate either of which is expected to make a dent in the balance sheet. In the case of emerging markets, policy makers are subject to tighter constraints when expansion policies are warranted. In these scenarios, organizations such as the IMF may help countries to reach a sound financial position but a temporary financial constraint less crisis prone.


Countries such as the U.S., U.K., Australia and South Africa have had stable financial markets that have been developed to withstand heavy debt deals, and are able to issue bonds or loans in their own currency due to the stability created over the years in the economy rather than having to borrow in other currencies and then lend it out.


Emerging markets have achieved redemption from original sin, overcoming challenges set by the structure of international lending systems as well as multinational private lending corporations that due to their own self-interests prefer to lend or borrow in the currencies of the countries they operate in (Eichengreen and Hausmann, 2019).


Debt Markets in the Low-Income Countries


The IMF has warned countries with low GDP about the borrowing spree that they have been on lately, stating that it may cause the economy to never recover and send it on a downhill slope. Median ratio of Public Debt to GDP has increased by 13% since 2017 according to the IMF. 2013-2017 saw the rise of fiscal deficient along with reduction in FDI indicating that the money borrowed initially was never used for the purpose it was intended for.


The IMF further stated that if the lending spree continued, institutions such as the Paris Club Forum that was established for the purpose of helping countries come out of debt crises will not be able to resolve issues as private institutions part of the forum would be unwilling to bring numerous countries out of debt at such a large and increasing scale.

Debt payments have increased more than 60% for developing countries. The scale at which low-income countries are increasing their liability cannot even be compared in this regard (Allen, 2018).


Debt Markets have Given Rise to Higher Market Discipline


Market discipline has been enforced upon by central and commercial banks after major experiences post the financial crisis in the last decade. The most common proposal set out by banks for reducing the cost of safety nets has been to issue a minimal amount of subordinated, uninsured debt to the general population.


Subordinate debt holders are the first to suffer any credible losses due to their high-risk investments in the debt instrument markets. However, they do not participate in upward gains from risky activities such as the shareholders. The banks have a direct influence on the risk on subordinate debt hence the debt holders are given preference by these banks to low-risk investments and the option to monitor the behavior of the bank.


There are certain advantages to being a subordinate debt holder. The holder is entitled access to data that influences market behavior. The holder has access to rate spreads as they are part of the debt and is able to improve their assessment of the riskiness of the banks. Therefore, the market data is more readily available and is able to make corrective decisions instantly when the debt spreads exceed the threshold level. Banks cannot commit to a level of risk; subordinated debt may lead to greater risk if there is no compliance over them as under a complete deposit insurance scheme.


However, I believe that when data is more accessible it also causes massive disruption in financial balance in the economy. The users of the data may be subject to greater risk given the lucrative market they are in and the high premiums they have paid to be in it.


However, it also allows the user to cheat the market by open market rules of knowing what decision is going to be made by the banks regarding their investments.


The mortgage crisis was caused the same way due to lack of data to the general population and the banks knowing all about it and did not intend to share it with their stakeholders despite their fiduciary responsibilities. With debts not being monitored by proper authorities that are independent and part of the government, it leaves room for a lot of dealings under the table and may look at severe compliance issues with the banks (Blum, 2002).


Student Loans in the US


U.S. Secretary of Education Betsy DeVos and the education department were termed as “Fundamentally Broken” by a former student-loan officer that was fired by the Trump Administration for collecting loan payments from countless students defrauded by for-profit colleges and universities.


Student loans have tripled since 2006 taking the grand total to $1.5 trillion till today’s date. Education may have been one of the pillars of the Trump administration coming into power, however, it seems to be that college and general education costs have still increased. This will have an effect by shortage of professionals in key public roles that pay less than most private sector jobs. The cost of achieving a Bachelor’s degree is approximately $20,000 and Master’s degree is $50,000.


At the same time, teaching salaries have not seen any rise in the past few years. If the cost of education rises but the colleges refuse to increase the teaching compensation, then the teachers may feel some uncertainty in job security. Student numbers in classrooms will keep rising regardless of the burden of student-loans.


Hence the fatigue level of teachers increases due to longer hours and no change in salary. If the student debts affect the availability of teachers in the US it will result in teachers applying for loans as well since they will not be able to survive on the regular teaching salary and help sustain a family on the same dime. If the students or teachers fail to pay the premiums on these loans, it can result in the possible collapse of the education system of the U.S (Hammond, 2019).

Credit Card Defaults


The Bank of England stated that the default rate on credit cards has been at its highest in the last two years. The default rate was at 12.7% in the last quarter of 2018 and was at 22.9% in Q1 2019. Due to this, a statistic showed that low-income households faced serious financial difficulties and revealed a sharp increase in council tax arrears. In 2018, banks were expected to face numerous restrictions on unsecured lending, however, that has had no effect since the default rate continues to rise.


Peter Briffett, Chief Executive of Payments Firm Wagestream, stated: “A surge in defaults in credit card borrowings show that rising wages in the UK mask the financial stress that is still a reality for many”. “This is a big red flag for household finances” (Inman, 2019).

Britain’s overall unsecured consumer debt pile which is at £200 billion is expected to grow annually by 6.5% (Bloomberg.com, 2019).


Geo-Political Issues Impacts on the Debt Market


Brexit has been the subject of discussion across the UK for the past few years. Multiple referendums and delays in the decision to leave the EU had a massive impact on not just the debt market but the entire financial sector of the UK.


The Institute for Fiscal Studies (IFS) had issued a warning to Boris Johnson and the UK government that they were set to double their borrowings in the next year regardless of the outcome of negotiations with Brussels. It also stated that the national debt would reach 90% of the GDP if the British super-power left the EU without a deal which would be the highest since the 1960’s. A “No-deal Brexit” would result in the economic growth to flatline in 2020-21 even if the Bank of England cut interest rates and introduced emergency tax cuts and spending, according to an analysis conducted by the IFS (Partington, 2019).

Hong-Kong protests have been another great influencer on the debt market in Asia as well as the world economy. The impact is caused as in past history, Hong-Kong has been considered as a financial capital in the eastern part of the world. Stocks on all the indices have been declining by 2% taking the indices to a four week low.


The Hang Seng index fell by 2.6% (Aljazeera.com, 2019). The economy is also built on tourism and retail and both sectors have seen major decline in the past few months. Shops have reported more than 30% decline in sales and tourism has already been impacted with flights being cancelled and hence traders not being able to deal with the nationals to maintain international relations (Shao, 2019).


Indian economic slowdown has been caused since the Modi Government was formed earlier this year. The election was in the favour of Narendra Modi with his ideas of economic reform and national defence, however, it has only resulted in the slowdown of the economic growth. The economy has been at a standstill with less than 5% growth and claims were made by the Prime Minister and the Finance Minister of the economy reaching a value of $5 trillion by 2024-25.


The Reserve Bank of India has already slashed 135 basis points off its key lending rate due to the slowdown in the economy. Annual retail inflation rose to 4.62% in October which breached the RBI’s medium term target of 4%. Furthermore, the lending situation has taken a hit due to the closure of India’s largest private airline Jet Airways after it failed to payback the loans and had to shut down due to non-payment of its international fees as well as labour costs.


Private and public banks were involved in multiple scams involving the massive Nirav Modi scam where loans were sanctioned without any collateral due to influence of political pressures, leading to millions of Rupees worth of tax money of the general public lost without any option of repayment (The Economic Times, 2019).

Conclusion


Based on the data I have provided here I believe that the debt market can definitely be the cause of the next financial crisis. It will have to be based on the fact that only if the banks, whether they are private or publicly owned, will need to cut down on the lending regardless of their motives if they want to remain in business for the long-term. Banks cannot be greedy like they were in 2007-08 during the mortgage crisis.


Compliance is still being avoided just so that companies can make higher profits and with money being funneled into the government from these banks to avoid being investigated. Unsecured loans such as credit cards need to be capped to a limit where the customer cannot make transactions higher than 70% of their monthly income limit so as to avoid heavy penalties and closing down of bank accounts.


Student loan companies need to create a system where the student should be able to devise their own payment structure to not be burdened with the pressure of paying back. This will help them focus on their education and would help them land a decent job to pay-off loans eventually. Students should not be made to work over and above the time they spend in class and harm their health just by focusing on ways to pay off their debt.


Unfortunately, geo-political issues are out of the hands of the general population in most cases. However, the think tanks, research institutes and academics should focus on maintaining the economic standards or at least bringing it back to the same level after any kind of crisis so as to not go back to square one. Crisis’s need to be solved as quickly as possible to avoid economic disasters and help maintain international relations.


The UN needs to step into situations regarding economic disruptions between two countries to avoid economic wars. The governments at the point of economic wars only focus on themselves and their benefits from it. Very little focus is given on the lives of the common men and women. It also needs to be agreed upon that no changes in the policy created after the recession will take place for at least a year to help the economy grow by 2-4% needed to create jobs (The Balance, 2019).


References


Allen, K. (2018). IMF warns of mounting debt crisis risk in poor countries | Financial Times. [online] Ft.com. Available at: https://www.ft.com/content/0b875b52-2d26-11e8-9b4b-bc4b9f08f381 [Accessed 10 Nov. 2019].

Aljazeera.com. (2019). Stocks have become latest casualty of Hong Kong’s protests. [online] Available at: https://www.aljazeera.com/ajimpact/stocks-latest-casualty-hong-kong-protests-191113081735707.html [Accessed 19 Nov. 2019].

Bloomberg.com. (2019). Bloomberg U.K. Credit Card Default Rate Jumps at Start of 2019, BOE Says. [online] Available at: https://www.bloomberg.com/news/articles/2019-04-18/u-k-credit-card-default-rate-jumps-at-start-of-2019-boe-says [Accessed 19 Nov. 2019].

Blum, J. (2002). Subordinated debt, market discipline, and banks’ risk taking.

Ft.com. (2019). Indian economy: problems pile up for Narendra Modi | Financial Times. [online] Available at: https://www.ft.com/content/798795ce-f4f6-11e9-b018-3ef8794b17c6 [Accessed 19 Nov. 2019].

Eichengreen, B. and Hausmann, R. (2019). other people’s money:Debt denomination and financial instability of emerging markets.

Hammond, L. (2019). Burdensome Student Loan Debt Is Contributing To The Country’s Teacher Shortage Crisis. [online] Forbes.com. Available at: https://www.forbes.com/sites/lindadarlinghammond/2019/11/17/burdensome-student-loan-debt-is-contributing-to-the-countrys-teacher-shortage-crisis/#375af3055fc9 [Accessed 18 Nov. 2019].

Inman, P. (2019). Default rate on UK credit card debt at highest for two years. [online] the Guardian. Available at: https://www.theguardian.com/money/2019/apr/18/default-rate-uk-credit-card-high-banks [Accessed 19 Nov. 2019].

Partington, R. (2019). No-deal Brexit would ‘push national debt to levels last seen in 60s’. [online] the Guardian. Available at: https://www.theguardian.com/politics/2019/oct/08/no-deal-brexit-would-push-national-debt-to-levels-last-seen-in-60s [Accessed 19 Nov. 2019].

Roy, K. (2019). `Current Situation In Debt Market Is A Huge Investment Opportunity’. [online] The Finapolis. Available at: https://www.thefinapolis.com/news/artmid/677/articleid/5029/%60current-situation-in-debt-market-is-a-huge-investment-opportunity [Accessed 10 Nov. 2019].

Shao, G. (2019). Hong Kong just entered a recession. Experts say economy will ‘remain weak’ amid protests, trade war. [online] CNBC. Available at: https://www.cnbc.com/2019/11/01/hong-kong-recession-economy-will-remain-weak-amid-protests-trade-war.html [Accessed 19 Nov. 2019].

Statista Infographics. (2019). Infographic: U.S. Student Debt Is a National Problem. [online] Available at: https://www.statista.com/chart/17777/student-loan-debt-united-states/ [Accessed 18 Nov. 2019].

The Balance. (2019). The Surprising Truth About the US Debt Crisis. [online] Available at: https://www.thebalance.com/us-debt-crisis-summary-timeline-and-solutions-3306288 [Accessed 19 Nov. 2019].

The Economic Times. (2019). Fiscal stimulus needed to revive India’s stuttering economy: Analysts. [online] Available at: https://economictimes.indiatimes.com/news/economy/finance/fiscal-stimulus-needed-to-revive-indias-stuttering-economy-analysts/articleshow/72109050.cms [Accessed 19 Nov. 2019].

© 2020 Westminster Business Consultants. Proudly created with Wix.com