Outlook for the global financial system in the wake of the pandemic

Op-ed by Mr Hyun Song Shin, Economic Adviser and Head of Research at the BIS, published in Nikkei, 18 September 2020.

The Covid-19 crisis is three shocks rolled into one. Above all, it is a health crisis that has brought untold human suffering. Second, by disrupting everyday life so severely, it brought an economic sudden stop, especially in those countries that imposed widespread lockdowns to contain the virus. However, even countries with no lockdowns have suffered sharp declines in economic activity, suggesting that the virus must be contained to sustain economic activity. And third, the pandemic unleashed a financial sudden stop when significant segments of the global financial system experienced acute stress.

The financial sudden stop bears some resemblance to the stresses seen during the Great Financial Crisis, but there are important differences. The crisis of 2007-09 was essentially a global banking crisis, with overextended banks at its epicentre. The real economy became the collateral damage as these banks stumbled and fought for survival.

This time round, the direction of the shock has been reversed. Banks have been at the receiving end of the financial stress and economic sudden stop that resulted from the exogenous shock of Covid-19. The banking sector has proved resilient so far. Post-crisis regulation has had a hand in strengthening the capital and liquidity positions of banks. Plus, they are now a smaller part of the financial system than they were before the Great Financial Crisis, following a long period of slower lending growth.   

For all these reasons, banks were not in the eye of the storm. Instead, the strains were felt most by market-based financial intermediaries and in bond and money markets. As the stresses reverberated within the system, key short-term funding markets came under severe stress, including the crucially important dollar funding markets that underpin the global financial system.

Although banks were not the origin of the crisis, they cannot expect to remain unscathed. As the economic downturn starts to bite, the immediate liquidity phase of the crisis is giving way to the solvency phase, and banks will undoubtedly bear the brunt of the wave of bad loans and insolvencies affecting weaker businesses, especially in those sectors the pandemic has hit the hardest. A sign of banks' apprehension is the soaring provisioning levels for loan losses. At the same time, surveys show a significant tightening of lending standards.

The triple shock and its likely impact on the banking sector largely explain why fiscal policy has taken centre stage in the economic policy response to the pandemic. Fiscal authorities globally moved swiftly to implement very large direct budgetary packages amounting to 6% of GDP, augmented with another 10% of GDP in loans and guarantees. At the outset, actions by many authorities across the world to enable direct transfers to households helped to alleviate immediate hardship resulting from the lockdowns. Meanwhile grants and loans to businesses allowed them to meet essential outlays. Such prompt actions prevented the wholesale unravelling of the intricate web of economic relationships between firms and their workers, suppliers and customers, all of which are crucial for maintaining the fabric of a modern economy.

Credit guarantees and funding for lending schemes have been instrumental in mitigating the tightening of credit availability to businesses. Some tightening of credit standards will be unavoidable as the economic downturn and restructuring of businesses run their course, but the objective is to lean against a sharp and abrupt tightening to keep credit flowing to support the recovery when the worst of the virus passes. One of the challenges now facing authorities is to ensure that unviable businesses can be restructured in an orderly way rather than indiscriminately under financial stress.

In step with the fiscal response, central banks have intervened in financial markets on a massive scale, through both collateralised lending and direct asset purchases. These liquidity injections and asset purchases have restored the orderly functioning of financial markets and alleviated stresses in short-term funding markets. Particularly important were the Federal Reserve's central bank dollar swap facilities, which it extended to a larger number of counterparty central banks. The Fed also expanded its dollar liquidity toolkit to allow lending against treasury collateral. These actions quelled the funding stresses in the critically important dollar funding market.

Partly as a result, emerging market economy (EME) central banks were able to depart from their usual playbook for financial crisis monetary policy, which calls for raising interest rates sharply in the face of currency depreciation and portfolio outflows. Instead, they eased monetary policy and managed to cut interest rates. Indeed, many EME central banks rolled out bond purchase programmes for domestic currency sovereign bonds. The bond purchases were small and were aimed at restoring market functioning rather than engaging in quantitative easing. Loosening monetary policy in the face of a financial crisis was highly unusual, and signalled a coming of age of EME central banks, reaping the greater monetary policy credibility built up over recent years. However, the more benign environment of a weaker dollar and the more accommodative global liquidity conditions engineered by the major central banks have been key enabling elements.

Revealingly, whereas EMEs were able to loosen monetary policy aggressively, their fiscal policy response was more modest. Compared with advanced economy packages that amounted to around 22% of GDP, fiscal packages in EMEs were much smaller, at around 6% of GDP, even though EMEs arguably need a still larger fiscal response to the pandemic. One reason for their greater caution may be the assessment that they have less fiscal space, given domestic investors' limited capacity to absorb government debt sales, and foreign investors' limited appetite to do so. The alternative would be monetary financing by the central bank, but on this score memories are still fresh from the financial crises of the 1980s, when monetary financing in some EMEs led to collapsing currencies, monetary instability and sharply higher inflation.

EMEs have so far largely avoided the pitfalls of monetary financing. Financial conditions have remained accommodative on the back of a weaker dollar, which tends to coincide with greater risk-taking capacity of market participants through the financial channel of exchange rates. However, it would be foolhardy to be swayed too much by prevailing market conditions and expect the trend to continue indefinitely. Indeed, the longer the dollar's weakness persists, the larger will be the risk-taking exposures that will come under stress when the dollar cycle eventually turns.

Ultimately, the prospects for the global economy will depend on the pandemic's trajectory. If the virus lingers in large parts of the world, or if there is a resurgence, more of the fiscal and monetary interventions seen so far will be needed. The challenge facing authorities is that fiscal space varies widely across countries. For EMEs with a history of monetary instability, it is more limited. Even advanced economies whose currencies enjoy reserve currency status face theoretical limits to their fiscal firepower, even if prevailing market conditions obscure the exact boundaries of available fiscal space. As central banks come under pressure to accommodate additional fiscal expenditure through asset purchases, the risk of fiscal dominance will pose new challenges to central banks' policy frameworks. To chart the course ahead, joined-up thinking from a global perspective and an emphasis on long-term monetary stability will be more important than ever.