Could COVID-19 spark a sovereign-debt crisis?

May 20, 2020

The global nature of the COVID-19 pandemic means that nearly every country will need to borrow money for relief and aid packages. That may lead some investors to shift their portfolios away from riskier countries. Chicago Booth’s Chang-Tai Hsieh says that could force some countries to choose between caring for their people and servicing their debt.

Video Transcript

There’s been a lot of focus in the US on the two big rescue packages. The first rescue package was $1 trillion. The second rescue package was $2 trillion. That is already 15 percent of US GDP. And now there are talks about yet a third rescue package for the US.

What’s happened in other countries? All the European countries have put in place, or are going to put in place, their own rescue packages. I’ll just give you two examples. The Danish government, about a month ago, put in place its rescue package, where it’s going to subsidize 70 percent of the payroll of every single one of the small and medium-sized companies in Denmark. The UK is going to do something similar. Canada has done something similar. 

The details of these rescue packages differ between countries, but they fundamentally involve borrowing huge sums of money, and China is already starting to do exactly the same thing. And it is likely to spend even more money, although that decision has not been made.

There are two questions to think about. One is, where exactly is that money going to come from? That is, when you think about a country borrowing money, you have to borrow money from somebody. Somebody else has to be giving you the money. So let’s put that question on the side for now.

The second thing to think about is, think about who is affected by this crisis. It’s not just China, it’s not just Europe, Canada, and the US, but every single country in the world. And then the question is: If you think the US needs to put in place a rescue package, well, every other country needs to do the same thing.

So India needs to increase their spending by—you know, the US is increasing the spending by 15 percent of GDP—you know, just to be on the very low side, they really should be spending at least 5 percent of their GDP. Or Mexico should be spending another 5 percent of their GDP, and if they don’t, then the people die. There’s just no other way around it.

This ties into my very first question. Well, what happens when everybody tries to borrow money at the same time? That is just an impossibility. We cannot all borrow money at the same time. We can only borrow money from each other.

This is why what’s going on now is very different from what’s happened before. In 2008, only some countries needed to borrow. The US needed to borrow. China did not need to borrow in 2008. So what happened then, in 2008, was that China lent a lot of money to the US. But that’s not possible now.

Then the question is: What is going to happen when everybody tries to borrow money at the same time? You have to ask yourself, well, the people with the resources to take on that debt, what are they going to invest their money in?

What is going to happen, and we’ve already started to see it happen, is that they’re going to put their money into what I’m going to call the countries that are the safe havens, the countries that are able to issue debt that is relatively risk-free. What’s going to happen is that they’re going to buy up debt that’s issued by the US Treasury, by the Danish Treasury, by the German Treasury, by the Canadian Treasury, by the People’s Bank of China.

Where is that money going to come from? Well, it’s going to come out of, say, US investors deciding, well, I no longer want to keep Mexican debt in my portfolio. I’m no longer going to want to keep Argentinian debt in my portfolio. I’m going to put my money somewhere else. So they are going to liquidate their holdings of Mexican debt. They’re going to liquidate their holdings of Indonesian debt. And they’re going to shift their portfolios toward US Treasuries. It’s going to come from wealthy Mexicans, or wealthy Colombians, or wealthy Indians that are going to basically take their money, and they’re going to invest it in assets that are safer. As a consequence of every country needing money at the same time, the market is going to choose. It’s going to choose to invest in places that offer these safe assets.

So two things are going to happen to a country like Mexico. One is that it’s not going to be able to raise the money that they need. They may need to borrow 5 percent of their GDP, just to be on the low side. I’m going to come back to just remind you that the US, just in the last few weeks, has borrowed 15 percent of its GDP. If Mexico wants to borrow 5 percent of GDP, which I think is really on the low side, they are not going to be able to do so, because nobody is going to buy that debt.

Second, on top of that, because of what the US and Europe are doing, their money—regardless of whether they try to borrow money—their money is leaving the country. We’ve already seen that happen in the last three weeks. The best estimate that we have is that there has been a flight of about $100 billion coming out of the middle-income countries in the world just in the last three or four weeks.

So now, look forward. What is going to happen? Well, you’re going to have a situation where they can’t spend money. They can’t raise more money. Money is leaving. Millions of people are dying. Millions of people are losing their jobs.

What do you do as a government? You either let your people die on the streets, you let your people starve to death, or you grab whatever resource you have. And for a lot of countries, one of the biggest things that they spend on is debt service.

You’re essentially faced with the situation, do I not pay my landlord, or do I not buy food? And what I think is going to happen is that many countries, not all, but many countries are just going to choose, “Well you know, if I don’t pay my landlord, I can still live in the house for another few more months. But if I don’t eat now, I’m going to starve.” So they’re going to choose to just not pay. 

It’s sort of like a large version of what you are seeing many people and businesses take in the US, that you’re going to try and go and buy those ventilators. You’re going to go and try to buy the personal protection equipment. You’re going to go and try to buy that testing equipment. You’re going to try to do something to provide your millions of workers that have lost their jobs with something so that they don’t starve.

What is that? That’s a default. 

And then the question is, if that’s coming, can we do that in an orderly way, or are we just going to have this be a chaotic massive sovereign default.

Unless we do something, I fear that’s what’s going to happen. Many governments are just going to make the decision that they’re just going to take the money, the billions of dollars that they would otherwise pay servicing their debt, and just take that money and spend it on these urgent social needs.