For professional investors only

2020, a global debt tidal wave

April 2020

Every country in the world is currently unveiling its plans to fight Covid-19 in
an effort to mitigate the severe impact that the disease is causing. A fiscal
expansion of enormous magnitude has started, but the question is: who will
finance this?
Pushed by pure necessity, our knowledge of the virus increases at a rate that mankind has
never seen, with most of the global scientific efforts concentrated on a single point. It is a
race against time to save as many lives as possible that is testing our preparedness, our
Jesús Martinez
Investment manager willingness to cooperate, and challenges the very way we understand society. Limiting the
disease's contagion before a viable treatment or a vaccine are widely available means
reducing human contact as much as possible. In the future, massive and repeated testing
could prove to be the most effective tool for restarting the economy. For the moment,
however, this confinement necessarily implies reduced economic activity which starts with a
reduction of leisure all the way to the most critical activities.

In a system based on debt and leverage, stopping all non-essential activity for an unknown
period of time triggers the need for cash in all fronts of the economy: to pay salaries, to pay
rent, to pay for groceries, or to pay taxes. In order to comply with existing contractual
obligations, it is necessary to use cash buffers, liquidate assets, use extra funding or ask for
deferrals. Governments are mitigating the effects of an economic slowdown by providing a
safety net strong enough to support their economies for as much time as needed.
Additionally, the asynchronous way in which the virus spreads across countries will cause a
delay in the return to normality, increasing the load on government shoulders.

Central banks: Pulling themselves out of the mire

Since the start of the coronavirus crisis, both governments and central banks have
announced extraordinary plans in an effort to reduce the increasing amount of risk in the
financial markets and to mitigate its impact where possible. In the case of central banks,
flexibility has been the key phrase. Both the FED and the ECB have established open ended
market purchases that guarantee current and future market support for government bonds.
The latter is key, as through these policies, central banks are enabling governments to
finance their soon-to-be-increased deficits. Just like Raspe's 1785 fictional character Baron
Munchausen, both Europe and the US plan to pull themselves out of the mire by their own
hair, that is: governments will issue massive amounts of debt and their central banks will
print money to buy it.

What governments can do

In the case of governments, so far the efforts have been proportional to the rate in which
the virus has spread internally and the expected amount of time that social distancing will
be needed. Most countries in Europe are still at the initial stages of the disease, and plans
are announced with caution as there are still many details that remain to be worked out.

Thus far, we have observed the following actions, targeted to get the economy going:

• Redirect the existing budget's allocations to fight the disease: as a large percentage of
normal economic activity stops, governments can transfer those budget lines to higher
priority activities. We expect a large majority of countries to do this - the acquisition of
medical equipment being the most relevant example.

• Allow for deferrals: some tax schemes and social security contributions can be deferred
in time so that they can be charged whenever economic activity allows for it. The
intention is that these contributions are paid in the future and, as such, countries might
 2020, a global debt tidal wave
April 2020
For professional investors only

Figure 1: Balance sheet assets held by the ECB and the FED as of 3rd April 2020. Source: Aegon Asset Management

not consider them part of the deficit. Germany, Austria and France have thus far announced deferrals.

• Implement guarantee schemes: the intention is to provide state-based guarantees for loans that act as collateral
and thus support liquidity for businesses (usually, SME's). These guarantees typically are not consolidated when
calculating the total debt of the countries, and this was a common measure in the prior crisis. Finland, France,
Germany, Greece, the Netherlands, Portugal and Spain have so far announced such measures.

This effort could be funded via:

• Shorter term issuance in primary markets: a trend that we saw after the 2008 crisis, where countries chose to issue
shorter maturities at wholesale markets, as it increases investor appetite. This reaction was confirmed in March
and the first days of April in countries like Austria, Belgium, Portugal or Spain.

• Issuance at retail level: like Italy did during the European sovereign crisis in 2012 with BTP Italia bonds targeted to
retail markets, this is a last resort measure to be considered if market access at wholesale level becomes
restricted, something we interpret as unlikely given the strong stance of the ECB and expected support from EU
mechanisms.

Per country, the volume of measures announced varies enormously, and accounts for between 5% up to +20% relative
to the countries' GDP. Not all of it will translate immediately into new issuance or higher deficits, but it is safe to assume
that a considerable fraction of it will. The questions are: how much of that can the market absorb? And can countries
remain solvent afterwards?

A problem of solvency...
In the eurozone, a large majority of countries have seen their debt levels increase since the financial crisis started in
2008, with some of them surpassing the frontier of a 100% in relation to their annual GDP. The coronavirus crisis is
hitting them at a moment where deficit reduction protocols practiced in the last decade have not lead to much

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 2020, a global debt tidal wave
April 2020
For professional investors only

improvement, with only a few exceptions. Needless to say, a drop in the overall GDP figure would increase even further
the relative weight of their debt, even if the expected extra spending is not yet taken into account, which worsens the
problem.

Figure 2 shows the gross yield versus the SCR for spread risk for a range of fixed income asset classes on 31 March 2020,
compared to 31 January 2020 when the WHO declared coronavirus a global emergency and the first cases outside China
were reported.

Figure 2: Total debt and budget balance as a percentages of GDP by country. Sources: Eurostat, Central Intelligence
Agency, OMB, Department of Finance Canada.

As of the first week of April, and in parallel with the health challenge we are facing, there is much that is unknown to
the market, except for the fact that European countries will need to finance larger amounts of debt in the primary
market as compared to 2019. These amounts will vary depending on the design of the plans that will be announced in
the coming weeks. Thus far, Austria has indicated an expected deficit figure of 5.4% for 2020, and Villeroy, Governor of
the Bank of France, has estimated that two weeks of confinement raises France's budget deficit by 1% of GDP. This
figure assumes that deferrals would be fully paid back to the government later during the year, which makes it a non-
conservative assumption. For many other countries, like Belgium, the market is still expecting a comprehensive and
more detailed announcement of measures. In the meantime, it is expected that the ECB frontloads both PSPP (public
sector purchase program) and PEPP (pandemic emergency purchase program) will bring stability to European debt
markets.

...solved with coronabonds?

Despite the overwhelmingly strong presence of the ECB in the European fixed income markets, investors need to be
convinced further of the financial viability of countries. Otherwise, their doubt can translate into periods of distress just
like we experienced in 2012. For such moments, mechanisms to contain risk remain in place, namely the European
Stability Mechanism (ESM) and Outright Monetary Transactions (OMT) by the ECB. ESM can be activated if a member
country requests it when market access is limited, and until now it has required strict conditionality on how public

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 2020, a global debt tidal wave
April 2020
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finances must be managed in future years, something currently under discussion. On the other hand, OMT is the
ultimate ECB weapon to control spreads in a single country.

As the estimated impact of the virus rises, so does the need to finance larger deficits. Due to the universal nature of the
problem, Italy and Spain are proposing to move forward with the issuance of Eurobonds. France supports the initiative
as well in the form of temporary funding. This proposal would target funding for medical help and to compensate the
economic fallout directly related to the disease. The fact that this step would have future implications on how the
different countries apply their own fiscal policy has gained the opposition of Germany and the Netherlands. As an
alternative, the Dutch government has proposed a two-way system. First, a fund based on transfers and not loans,
which countries could use unconditionally and as needed to combat the consequences of the disease related to the
health system. Second, to make use of the existing mechanisms of ESM, subject to strict conditionality. These
discussions are still ongoing and a solution does not seem immediate. Despite this, solidarity amongst European
countries has been and most likely will still be close to the core of the beliefs that built the Union as we know it today.

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April 2020
For professional investors only

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