BBK Bd Member Buch: Debt Sustainability Hinges on Growth and Interest Rates

20 April 2021

By David Barwick – FRANKFURT (Econostream) – How sustainable the additional debt incurred during the pandemic will be depends on economic developments and the evolution of interest rates, German Bundesbank Vice President Claudia Buch said Tuesday.

In a speech for a virtual ESM seminar on debt sustainability, Buch noted that while in the global financial crisis excessive leverage in the banking sector had caused a financial crisis, the pandemic was a threat to the liquidity and solvency of the corporate sector.

‘So far, the financial system has weathered the storm and continued to function – because policy coordination has worked well during this crisis’, she said, citing monetary and fiscal policy reactions. Moreover, she said, reforms after the global financial crisis had led to a better capitalised banking sector along with regulatory flexibility limiting pro-cyclicality.

‘However, key challenges for debt sustainability and financial stability may still lie ahead’, she said. ‘Dealing with increasing insolvencies, maintaining crisis-related policy support only as long as necessary, and ensuring financial sector resilience will be among the policy priorities going forward.’

‘There is still a high degree of uncertainty concerning the future evolution of the pandemic and the damage that has been done to the real economy’, she continued. ‘One cannot rule out an adverse scenario with feedback loops to the real economy if banks deleverage to meet capital requirements imposed by regulators or markets.’

For this reason, she said, it is essential to watch closely how public debt sustainability, the corporate sector and banks interact.

Although especially fiscal measures had bolstered corporate debt sustainability and thus indirectly protected banks, public and private sector debt had increased and debt sustainability ‘hinges on the evolution of future economic activity and interest rates’, she said.

It will be important to counter solvency problems as they emerge, in particular addressing increasing non-performing loans, she said. How big these solvency problems could be is very uncertain, she said.

‘Elevated debt levels for households and firms might become unsustainable if the economic crisis lasts longer than expected’, she said. ‘This could lead to an accumulation of losses in the financial sector. Maintaining and addressing the sustainability of corporate debt will be of utmost importance.’

Buch urged that fiscal support become more targeted over time to those sectors and companies in need, which she said could include an emphasis on solvency rather than liquidity, thus mitigating issues of debt sustainability.

As standard indicators of insolvency are often ‘misleading’, she said, transparency must be enhanced.

The removal of support must be done so as to avoid cliff effect, she said. ‘While withdrawing support too early can lead to cliff effects, maintaining it for too long can be fiscally costly and delay structural change’, she said.

‘Even though crisis-related policy support needs to be maintained for some time, preparations for an eventual withdrawal should resume sufficiently early on’, she said.

Buch urged policy coordination, ‘ideally also across borders’.