Does global finance have an exit strategy?
Policymakers have responded with impressive speed and purpose to ensure that a global health crisis does not turn into a global financial crisis. But what happens now that their cards have been played, and is there a plan for what to do once the great lockdown is lifted?
On March 3, the US Federal Reserve stunned financial markets by announcing an emergency rate cut for the first time since the 2008 financial crisis. Fed chair Jerome Powell had a clear logic: “We saw a risk to the outlook for the economy and we chose to act.” The coronavirus that causes Covid-19 was still nine days away from being officially recognised as a pandemic, but the situation was already critical.
In the weeks ahead, as the Western world went into lockdown, central banks, finance ministries and bank supervisory authorities pulled out all the stops to make sure the global economy had the support it required. They could see that investors were afraid. Every measure of market volatility was skyrocketing.
“There was a real need for central banks to step into what was a difficult market in March,” says Michael Grady, head of investment strategy and chief economist at Aviva Investors in London. “They were facing liquidity problems in markets where you wouldn’t expect to see such issues — for example, US Treasuries, which is supposed to be the biggest and most liquid market in the world. Their quick action provided a backstop when it was most needed. It avoided a downward spiral.”
It is easy to monitor the success of the central banks on this front.
After surging from 17.1 to 82.7 in the first two weeks of March, the Vix — the world’s main gauge of equity volatility — has swiftly returned to figures in the 20s. At the same time, a key risk indicator in the banking system, the Libor-OIS spread, has climbed down from 140bp to 30bp, more or less where it started the year.
But large-scale intervention from central banks will not come without consequences.
Can the world economy afford to go any lower on interest rates, as the Bank of England and the Fed now talk about following the Bank of Japan and the European Central Bank into negative territory?
And how big can central bank balance sheets get, if there is going to be another surge in the volume of bond purchases under quantitative easing programmes?
A little more conversation…
These are by no means new questions. But the financial policy response to Covid-19 has made answering them all the more urgent.
Richard Barwell, head of macro research at BNP Paribas Asset Management in London, finds it frustrating that more progress has not already made.
“It was well known to everybody that the central banks were approaching the limit of what they could do with their traditional ammunition,” he says. “They should have been preparing for how to act in the next crisis before it engulfed them. You could legitimately ask why they are only writing the playbook now, which is diverting their attention from understanding the macroeconomic implications of this virus.”
The biggest discussion is likely to revolve around what the central banks say they want to do, as much as what they actually end up doing.
Though this may sound a little bit like hair-splitting, the point of the debate will be to revisit the role and function of central banks within the financial markets and the economy.
“The central banks need to be really clear about the point of QE,” argues Grady. “Are they a market maker of last resort, which is prepared to step in with unlimited resources to combat dislocation in the funding markets? Or are they looking to purchase debt over a longer timeframe to ensure that bonds are efficiently priced. Those are two very different objectives.”
Many economists now argue that central banks in the West should be targeting a clear policy of yield curve control.
Yield curve control involves setting a cap on government bond yields and committing to buying as much debt as is necessary to achieve that target. This is different from the style of QE employed by the ECB, which has placed limits on how much bond issuance they can buy each month.
An explicit commitment to unlimited QE could prove especially useful at a time when governments are starting out on huge fiscal stimulus measures to meet the cost of Covid‑19, given the likely impact that the surge in issuance could end up having on sovereign borrowing costs.
“If you care about influencing long‑term rates, you should publish your yield targets and stand ready to buy enough debt to meet them,” says Barwell. “The bond market might even work with you in achieving those yields.
“A massive benefit of yield curve control is that it will force the policy debate on to where rates should be, rather than having a hazy conversation about how many bonds the central banks should buy.”
On the other side of the conversation about policy is the global banking system, the health of which is key to making sure that fiscal and monetary measures can work effectively.
Banks amplified the impact of the global financial crisis just over a decade ago, leading to huge public bailouts. But this time around they appear determined to play an active role in bringing the global economy back to health.
The sector certainly comes up against Covid-19 in a much stronger position, thanks to the widespread adoption of the international capital and liquidity rules known as Basel III.
A recent IMF estimate suggests that banks in the G12 economies have increased their tier one capital levels by two-thirds in the years since the crisis, when expressed as a percentage of their risk-weighted assets.
Nicolas Véron, a senior fellow at economic policy think tank Bruegel and at the Peterson Institute for International Economics in Washington DC, says that the Basel III rules have therefore been “spectacularly vindicated”.
“The previous crisis showed that Basel II was wrong,” he says. “The initial phase of the Covid-19 crisis has shown that Basel III was right.”
Banking supervisors in Europe, the US and the UK have all been encouraging banks to use their excess capital and liquidity buffers to lend to households and businesses. Authorities have also lowered some parts of their requirements, including the countercyclical capital buffer and institution-specific Pillar 2 targets.
Véron praises the Single Supervisory Mechanism of the ECB for having led the way in obliging lenders to postpone their dividend payments during the pandemic.
“The ECB was first and then it was followed by the Bank of England,” he says. “It demonstrated the power of the Banking Union, even though it remains unfinished. If we had gone into this crisis with a fragmented system of European banking supervision, then nobody would have wanted to look weak and nobody would have acted quickly enough.”
But it is still far too early to say whether the banking system has passed its test with flying colours.
Many bank credit exposures are being treated more leniently than they would have been in normal times. This is partly because supervisors do not yet want lenders to recognise all the possible risks that could be implied by payment holidays, which have been rolled out fairly widely during the great lockdown.
It is also because governments have been willing to extend guarantees over some forms of bank lending, particularly when it relates to small businesses suffering what are presumed to be temporary squeezes on their cashflows.
“Some firms will have to be let go because they are not viable,” says Thorsten Beck, professor of banking and finance at Cass Business School in London. “But at the moment governments are absorbing a lot of the risks taken by the banks.
“In the long run, we have to get back to a system where banks are taking the risks themselves and allocating capital to the economy without the need for credit guarantees. That could be some time.”
Towards an exit strategy
Ultimately, it will be difficult to disentangle the success of monetary and prudential policy from the success of fiscal policy.
National governments have pledged trillions of dollars of combined support for the economy to try and stave off a downturn. But the scale of their responses has varied wildly.
Countries with lower fiscal headroom, such as Italy and Greece, have so far committed about 1% of their 2019 GDP to tackling the financial impact of the pandemic, according to an analysis carried out by Bruegel in late May. In the US and Germany, the figure is closer to 10%.
There are reasons to be optimistic in the EU, as the European Commission works on building political support behind an ambitious proposal to fund the region’s recovery by pooling fiscal resources between member states.
“This isn’t a question of whether interest rates are 25bp higher or lower,” says Grady. “It is much more about fiscal responses. An important part of the job of central banks is to make sure that the monetary environ-ment allows governments to carry out their fiscal measures.”
In any event, there is no getting away from the fact that the great lockdown will have a colossal impact on the global economy.
The IMF is now forecasting a 3% contraction in world GDP for 2020. At the start of the year, it had been expecting 3.3% of GDP growth.
Policymakers have been successful in the short term in preventing a global health crisis from becoming a global financial crisis. But that may well turn out to have been the easy part.
With the economy still feeling the strains of lockdown, global finance will now have to come up with an effective exit strategy.