Debt Service Suspensions: The Hidden Threat to the Global Economy — A Financial Crisis?
Disclaimer: Opinion Piece
“The purpose of this is to open discussion upon the impact of DSS and Credit Moratorium with the reactionary increase of Interest Rates to tackle inflation.”
Debt service suspensions (DSS) and Credit Moratoriums (CMs) have been implemented globally to prevent defaults and avoid economic collapse amid the COVID-19 pandemic. During COVID-19, Credit Moratorium(CM) and Debt Service Suspensions were used on all levels, from IMF to personal debt, corporate bonds, and even rent repayments. However, the long-term consequences of this practice have yet to be well researched, and there are significant unexplored risks to the global financial system. When DSS and CMs’ deferred impact is realized, it may trigger a liquidity squeeze that could lead to a “shock” shortage of cash supply, higher borrowing costs, cause supply & demand shock and lower asset prices. Even though the benefits of widespread DSS during COVID-19 were evident, the impact, though mitigated, is still yet to be realized.
DSS and CMs are tools that can be used to prevent defaults on debt obligations, such as loans or bonds, to stabilize markets and avoid economic collapse while also providing lenders with a recovery mechanism. DSS and CMs can potentially defer the impact of default on liquidity by allowing borrowers to suspend their debt payments temporarily. However, DSS and CMs are not necessarily the direct cause of a liquidity crisis as per standard practice, but the application and usage of this globally deflected circulation, thus why many quantitative macro models are not accounting them comprehensively.
As credit practices normalize, the elasticity of market cash flow could be impacted. While a mild recession is currently anticipated, there is also a risk of a negative cycle triggered by DSS and CMs impact on liquidity, causing a full-blown financial crisis.
This could lead to higher default rates and increased borrowing costs than forecasted. Currently, Fitch and similar studies are anticipating rates of 2.5%-3.5% for high-yield bonds and 2.0%-3.0% for lower-quality bonds in 2023. These estimates do not adequately account for the potential impact of DSS/CMs, which was deflected with “False Liquidity”, which could push rates even higher. In a scenario where credit liquidity is tight and the circular economy is disrupted, it is possible that we could see a “superposition” of default and liquidity shortage, leading to further destabilization of the global financial system.
Policymakers and financial institutions must address this risk and ensure that we are prepared for the potential impact of DSS/CMs on credit cycles in the future. This may require a more cautious approach to injecting liquidity and a greater focus on understanding the micro and macro dynamics of credit.
Recommendations:
- Conduct further research on the long-term consequences of DSS/CMs and its potential impact on credit cycles and the global financial system, including the effects of global deflection of cash flow.
- Develop contingency plans to address the potential risks of a liquidity squeeze or other negative consequences resulting from DSS/CMs, using framework criteria reflective of quantitative models.
- Consider alternative policy tools or approaches that may be more effective in preventing defaults and stabilizing markets during economic crises, such as a more spread approach to dealing with default at an institutional level with a potential for long-term deferment of failed securities.
- Take a cautious approach to inject liquidity or increasing interest rates, considering the potential impact of DSS/CMs on credit and cash flow in the future.
- Improve understanding of the micro and macro dynamics of credit and how they interact with quantitative models to inform policy decisions better.
What do you, the reader, think? Is this something to be alarmed over?
“The purpose of this is to open discussion upon the impact of Credit Moratorium and reactionary increase of Interest Rates to tackle inflation; this is based upon a heuristical understanding of economics and is an opinion piece, not scientific literature. I would appreciate any opinions regarding this. Please consider multiple perspectives before deciding and forming an opinion on this topic.”
— Abhishek Sehgal
