Could A US Credit Crunch Bring About A Debt Holiday?

Despite its exceptional size, US policy support could disappoint due to poor targeting. With presidential elections in November, this suggests further support that could give a greater role to debt forbearance this time around.

Table 1: Budget and Fed COVID-19 Relief $bn

The US policy response to COVID-19 so far dwarfs that of most other countries. Yet it may not be enough to engineer a V-shaped recovery, in part due to lack of targeting. Out of $6tn (about 30% of GDP) deployed by the Fed and Congress, only $0.7tn consist of transfers and tax cuts for households (Table 1).

In addition, out of the $2.5tn in corporate tax cuts, subsidies and lending, only $0.8tn is conditional on worker retention, namely $700bn in Paycheck Protection Program, and $67bn in tax credit and payroll tax deferrals. By contrast, in Australia for instance 70% of government spending and tax cuts consist of wage subsidies.

Furthermore, households and employers are also facing tighter credit conditions. Banks have been cutting consumer lending, and the April Fed Senior Loan Officer Survey shows a marked tightening of credit standards on C&I and consumer loans.

And while Congress and a number of states and local governments have enacted some forbearance on student and mortgage debt (Table 2), debt relief has been limited relative to other countries.

Table 2: Debt Relief Under Cares Act

Poorly targeted support and tightening credit conditions add downside risks to the economy as corporates have been leveraging and household finances are not as strong as commonly assumed. Financial distress is rising, with online lenders reporting a sharp increase in impaired payments since mid-March, and with credit managers reporting an April increase in payments arrears larger than in 2009 (Chart 1).

Chart 1: Impaired Payments Are Rising

With a presidential election in November, these trends are likely to elicit a policy response. Because reaching bi-partisan consensus in Congress could be more difficult this time around, the policy response could rely more on debt forbearance and less on further fiscal pump priming. The Fed is unlikely to announce new initiatives since it will probably still be in the process of standing up its announced facilities.

Table 3: COVID-19 Scenarios (Outstanding), $bn

The advantage of a debt holiday relative to budget or central bank support is that it avoids levering the government or adding to money creation. The mechanics of debt forgiveness are displayed on Table 3, which presents a stylized economy where an original equipment manufacturer (OEM) funds an inventory of goods through supplier credit. The supplier in turn funds its loan to the OEM through bank credit. In a normal scenario the OEM is able to sell its inventory and OEM, supplier and commercial bank can extinguish their debts.

With COVID-19, however, the OEM cannot sell its goods and requires a new lender to refinance its debt to the supplier. The nature of the creditor influences leverage and composition of financial assets. When the commercial bank refinances the OEM loan, the increase in nonfinancial private sector debt and in money is lowest since the bank does not issue new debt but simply substitutes credit to the OEM for credit to the supplier. As mentioned, however, banks appear unlikely to extend credit to COVID-19 affected businesses.

This leaves the government or central bank as backup credit suppliers. The main difference between central bank and government funding is that the government funds its loan to the OEM through bond issuance, while the central bank funds itself through reserves issuance (i.e. an increase in the money base). Bond-funded government lending does not change the money base since the proceeds of the bond issuance are on-lent to the private sector.

By comparison with government funding, a debt holiday avoids the leveraging of public sector balance sheet. This could be why Italy, which has public debt above 130% of GDP and does not control money creation, has extended a moratorium on municipalities’ utility bills and on households and SMEs mortgage payments. In the US, based on current policies, the CBO expects an increase in federal government debt of 29% of GDP by end Q3 2021. This could make a debt holiday an attractive option since it would keep leverage in the private sector.

In addition, a debt holiday requires less liquidity (i.e. money base) provision by the central bank than outright lending since it only requires funding lenders affected by the payments holidays.  In the debt holiday scenario (Table 3), the central bank supplies only $10bn in additional reserves. In the US currently, should the Fed find it difficult to lend directly to SMEs, it could focus on the Term Asset-backed Securities Loan Facility (TALF) to provide liquidity to structures impacted by a debt holiday and unable to access their other liquidity facilities.

Debts holidays have a number of drawbacks. For instance, they can weaken the payments culture and, over the longer run, borrowers’ credit worthiness. In addition, a government-mandated holiday on loans extended by private lenders could be viewed as an infringement of property rights. In the US so far, debt relief has involved only federally held or guaranteed debt, and there could be opposition to broadening it to other categories of debt. Nevertheless, given the unprecedented scale of the US economic collapse and policy response, there is a good chance debt holidays could figure prominently in the next round of COVID-19 relief measures.