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New online discussion starts with focus on restoring equity-led growth and aligning the financial recovery with climate transition
This article is part of the Salzburg Questions for the Future of Finance series by the Salzburg Global Finance Forum
Ensuring the appropriate balance of debt and equity is a necessary ingredient for sustainable and inclusive growth. While this balance may differ across jurisdictions and conditions, clearly excessive debt – sovereign, corporate, household – has had consequences for financial system resilience and growth in recent decades. Therefore, maintaining the right balance of financing needed for new investments to support economic growth and capital expenditures without causing vulnerabilities that may cause downgrades and defaults during less benign market and credit conditions is paramount to stable long-term growth.
As global finance recovered from what was largely a real estate crisis a decade ago, sovereign and corporate debt have gradually increased across OECD countries. More recently, such debt has also grown in emerging markets. As low rates suppressed borrowing costs, issuers were more able to take on higher debt without jeopardizing market views of their sustainability. However, the COVID-19 pandemic quickly tested this fragile condition, as high-yield rates quickly doubled from five to 10 percent, undermining sustainability and choking high yield issuers across many OECD countries to access to credit. COVID-19 crisis policies, including monetary and fiscal stimulus, were very much needed to address the acute market stress and subsequently restored market conditions through low rates and credit costs.
As such, government policies have contributed to conditions that allowed sovereign and corporate issues to take on additional debt in 2020 and 2021. Moreover, this debt has contributed to shortened maturities combined with continued large new borrowing needs, resulting in elevated refinancing risk over the next several years. In the case of corporates, many of the government emergency facilities provided needed debt financing through traditional banking systems, with only modest amounts earmarked for green investments. This suggests that governments' exit from pandemic crisis policies will coincide with issuers' refinancing of debt, a search for greater equity, and heightened investor and societal scrutiny over the environmental sustainability of such investments.
Reversing the rising indebtedness, particularly among corporates, calls for several forms of incentives to help restore the equity balance. First, government programs could provide financing without incentivizing higher leverage. One way is to facilitate government injection of preferred equity, allowing firms greater financial flexibility while ensuring governments are repaid principle if the corporates remain viable. Second, government programs could cap leverage levels, such that issuers can only borrow to replace maturing liabilities at lower borrowing costs but not raise their debt to equity ratios. Third, tax policies could help reduce the incentives toward debt. Other policies, such as strengthening insolvency regimes, offer important considerations, but are beyond the scope of this article.
OECD assessment of government financing programs found a number of innovative practices to support green recoveries, from large corporates to SMEs. Notwithstanding this progress, programs largely refrained from linking disbursements to any sort of sustainability conditionality.
However, distinct from crisis programs, the overall resurgence of financial markets following governments' unprecedented crisis programs has supported a substantial pivot toward ESG and green financing through equity and debt markets. These markets are showing promise to shift behaviors to align corporate behaviors with climate transition better. However, current ESG disclosures and investment practices are not fit for purpose.
The lack of comparability of ESG metrics, ratings, and investing approaches makes it difficult for regulators and investors to differentiate between managing material ESG risks within their investment mandates and pursuing ESG outcomes that might rebalance financial performance and impact. This is particularly important where markets have difficulty connecting the management of short and medium-term risks with long-term material consequences, such as the eventual impacts of today's carbon emissions. In this respect, it is of paramount importance that policy-makers and market participants agree on a set of principles to foster productive investing that addresses risks and harnesses the opportunities from an orderly climate transition so that more resilient and sustainable economic growth prevails.
I propose the following questions for policy-makers and market participants alike:
Robert (Rob) Patalano is acting head of the financial markets division at OECD. He directs a team of economists and financial analysts that develop analytical reports and policy recommendations for the OECD's committee on financial markets, its expert group on finance and digitalization, the working party on public debt management, and the Taskforce on Long-Term Investment. These bodies include delegates from central banks, finance ministries, market regulators, and public debt managers from OECD member countries. Rob oversees structural analyses and policy recommendations related to global financial markets; sovereign debt markets; digitalization of finance; sustainable finance, including ESG, markets and climate transitions; and quality infrastructure. In this capacity, Rob represents the OECD on the Financial Stability Board's working groups on financial stability, climate risks, fintech, the Network for the Greening of the Financial System, and the European Securities and Markets Authority's Financial Innovations Consultative Working Group. Before joining the OECD, Rob spent five years at the Financial Stability Board. He led the assessment of global financial stability risks for the Standing Committee on Assessment of Vulnerabilities and chaired its Analytical Group on Vulnerabilities. Also, he spent a decade at the Federal Reserve Bank of New York in managerial and analytical roles in the Markets Group. He served on the NY Fed's commercial paper and AIG liquidity facilities during the global financial crisis. Also, during the European financial crisis, Rob was a senior economist on the sovereign crisis management team at the European Central Bank, which managed surveillance and adjustment programs for Ireland and Italy. He was a sovereign and investor relations director in New York and several Asian capitals before this. Rob earned an MBA in finance and corporate strategy from the University of Michigan and an MA in international relations and economics from Johns Hopkins SAIS. He is a CFA charterholder and a Salzburg Global Fellow.
The Salzburg Questions for the Future of Finance is an online discussion series introduced and led by Fellows of the Salzburg Global Finance Forum. The articles and comments represent opinions of the authors and commenters and do not necessarily represent the views of their corporations or institutions, nor of Salzburg Global Seminar. Readers are welcome to address any questions about this series to Forum Director, Tatsiana Lintouskaya: tlintouskaya@salzburgglobal.org