(Bloomberg Opinion) -- The novel coronavirus has already had a significant impact on the global economy, which will worsen if the outbreak and the shutdowns designed to contain it continue for very long. But it’s only an accelerant: If not Covid-19, as the disease caused by the virus is known, something else would have started the conflagration. Shortfalls in revenue and cash flows, caused by the shutdowns, have simply exposed the vulnerabilities of a structurally unsound economic and financial system.
A fall in revenue is problematic but manageable without debt. Unfortunately, in the aftermath of the 2008 crash, debt levels were increased rather than reduced, encouraged in part by low policy rates and the abundant liquidity engineered by central banks globally. Global debt as a percentage of GDP rose from around 250% in 2007 to 325% in 2019. Current debt levels are triple what they were in 1999. Businesses and households, with declining or no income and high levels of borrowing, now face an existential struggle to meet large financial commitments.
A second problem is that, in the “everything bubble,” asset prices were priced for perfection. Policymakers boosted the values of financial assets to increase economic activity via the wealth effect, and to support borrowing to protect financial institutions.
High asset prices reflected high leverage, in the form of leveraged loans for private equity or structured investments such as collateralized loan obligations. Debt-financed share buybacks and distributions to shareholders inflated equity values by increasing earnings per share, but simultaneously raised corporate leverage. Toxic layers of debt were heavily exposed to significant revenue downturns.
Third, the weaknesses of the banking system were ignored. Regulatory rollbacks and tolerance for large dividends and capital buybacks undermined steps to strengthen bank capital and liquidity. In Europe and many emerging markets, non-performing loans were not appropriately recognized. The growth of the shadow banking sector was not checked. The current problems in the inter-bank market, reflecting increased counterparty risk concerns, are testament to these missteps.
Fourth, declines in trading liquidity were disregarded. In the search for returns, investors assumed liquidity risk, sometimes unwittingly. Redemption terms offered by investment funds to investors were inconsistent with their illiquid holdings. As traditional market makers reduced activity, market-following structures, such as ETFs, and algorithmic traders were relied on for liquidity. In a crisis, these entities are users rather than providers of liquidity—as the current inability to trade even modest parcels of many securities shows.