COVID-19, Cryptocurrency, Economy

The Magical Money Tree and Where to Find It

Shamel Azmeh, Lecturer in International Development, Global Development InstituteUniversity of Manchester.

COVID continues to ravage societies worldwide, and a key issue is how governments can afford to fight it. As economies are disrupted, governments are stepping in to increase their spending to bail out companies, pay the cost of health measures, and subsidize workers’ wages.


Before COVID, when people argued that the state should offer free healthcare and free education, among other services and welfare measures, a standard political response was that state resources were limited. Asked by a nurse in 2017 why her wages hadn’t increased from 2009 levels, then British prime minister, Theresa May, said:

“There is no magic money tree that we can shake that suddenly provides for everything that people want.”

Except, a few years later, the government has not only been able to pay the wages of millions, but it has also created rescue packages for thousands of firms and offered people vouchers to eat out in restaurants. Several European countries have also taken the unprecedented step of underwriting millions of workers’ wages in response to the pandemic.

How are the British state and others capable of this radical increase in spending at a time when revenues from taxes are collapsing?

‘Magic money tree.’

The answer to this lies in the debt market. Over the past few months, world governments have drastically increased their borrowing to cover the pandemic costs. It might appear logical that the cost of credit will go up during uncertain economic times. However, the reality is that capital often goes to safer sovereign debt during economic downturns, particularly as the equity markets become unstable and volatile.

Over recent months, rather than struggling to find lenders or having to pay more for debt, the governments of the major economies have been awash with credit at historically low rates. In October, the EU, until now a small player in the debt market (as borrowing mostly is by national governments of member states), began a significant borrowing campaign as part of the efforts to fight COVID through the SURE program (Support to mitigate Unemployment Risks in an Emergency) which was created in May.

The first sale of bonds worth EUR 17bn was met with some described as “outrageous demand”, with investors bidding a total of USD 233bn to buy them. This intense competition was for bonds that offered a return of -0.26% over ten years, meaning that an investor who holds the bond to maturity will receive less than they paid today.

The EU is not the only borrower that is effectively being paid to borrow money. Many of the advanced economies have been in recent years and months selling debt at negative rates. For some countries, the shift has been dramatic. Even countries such as Spain, Italy, and Greece that were previously seen as relatively risky borrowers, with Greece going through a major debt crisis, are now enjoying borrowing money at low rates.

The reason for this phenomenon is that while “traditional” market actors initially buy these bonds, central banks are purchasing vast quantities of these bonds once they are circulated in the market. For a few years now, the European Central Bank (ECB) has been an active buyer of European government bonds – not directly from governments but from the secondary market (from investors who bought these bonds earlier). This ECB asset purchase program was expanded to help weather the COVID crisis, with the ECB spending EUR 676bn on government bonds from the start of 2020 until September.

Other central banks in the major advanced economies are following the same strategy. Through these programs, those central banks encourage investors to keep buying government bonds to know that the demand for those bonds in the secondary market will remain strong.

Poorer countries

Not everybody, however, enjoys a similar position in the debt market. While the prosperous economies are being chased by investors to take their money, the situation is radically different for poorer countries. Many developing countries have limited access to the credit market and rely on public lenders, such as the World Bank.

In recent years, this pattern began to change, with many developing countries increasing their foreign borrowing from private lenders. Developing countries, however, are in a structurally weaker position than more affluent peers. The smaller scale of their capital markets means that they are more reliant on external financing. This reliance means that developing countries rely on raising money in foreign currency, which increases the risk to their economies.

As many developing countries have less diversified exports with a higher percentage of commodities, the price decline in recent months has increased those risks. As a result, developing countries face a significantly higher borrowing cost than the more prosperous economies.

A few large developing countries, such as Indonesia, Colombia, India, and the Philippines, have begun to follow the policy adopted by the advanced economies of buying government bonds to fund an expanding deficit. However, the risks of doing this are higher than the more prosperous economies, including a decline in capital inflows, capital flight, and currency crises. A report by the rating agency S&P Global Ratings illustrated the differences between those two economies:

Advanced countries typically have deep domestic capital markets, strong public institutions (including independent central banks), low and stable inflation, transparency, and predictability in economic policies. These attributes allow their central banks to maintain extensive government bond holdings without losing investor confidence, creating fear of higher inflation, or triggering capital outflow. Conversely, sovereigns with less credible public institutions and less monetary, exchange rate, and fiscal flexibility have less capacity to monetize budgetary deficits without running the risk of higher inflation. This may trigger large capital outflows, devaluing the currency and prompting domestic interest rates to rise, as seen in Argentina over parts of the past decade.

While the market’s reaction to this approach by developing countries has been muted so far, the report argued, this situation might change. Developing countries that do this could “weaken monetary flexibility and economic stability, which could increase the likelihood of sovereign rating downgrades.”

Rating downgrades

Over recent months, downgrading by rating agencies has been a significant risk facing developing countries, with many economies facing higher borrowing costs due to such downgrades. These downgrades were often linked to a decline in prices and exports of commodities, as was the case for diamonds for Botswana and oil for Nigeria.

In July, following the participation of Ethiopia, Pakistan, Cameroon, Senegal, and the Ivory Coast in a World Bank-endorsed G20 debt suspension initiative, the rating agency Moody’s took action against those countries, arguing that participation in this scheme increased the risk for investors in bonds issued by these countries, leading to some developing economies avoiding the initiative in order not to send a “negative signal to the market.” Zambia is on the verge of being the first “COVID default,” and other developing countries could face a similar situation in the coming months.

As a result of these dynamics, many developing countries face the tough choice of giving up any economically costly health measures or facing severe fiscal and economic crises. Access to credit has become a defining factor in the ability of governments to respond to the pandemic. As a result of access to cheap credit, developed economies are so far able to take such health measures while limiting the pandemic’s social and economic impact. Many developing countries do not have this luxury. Not everyone gets to shake the branches of the magical money tree.

This article is republished from The Conversation under a Creative Commons license. Read the original article.

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