Corona Warfront: Economic Shocks Transforming into Banking Instability
(Published in the Financial Express in April 2020)
Professor Shah Ahsan Habib
Global economies are fighting coronavirus at a significant economic cost. Though, some policymakers are still searching for right kind of responses for containing the virus, social distancing and reduced mobility came up as the most effective ways till now. And policymakers are also supporting vulnerable households and smaller businesses to mitigate the impact of this severe jolt. The strategies resulted slowing down economic activities and huge costs. Probably this is the only option to minimize long-term economic costs and to address the escalating economic and financial instability. However, upcoming policy responses and market intervention strategies would depend on the development and success of the corona warfront.
Economists are forecasting severe contraction of GDP of the global economy in the coming months. There are predictions that we are proceeding to a much more severe shock compared to the most recent financial Crisis during 2006-08. To fight the infection, several countries enforced strict regulations to avoid unnecessary contact, and there are closure of schools, universities, factories and businesses. There are visible evidences of very weak production and business conditions and decelerating confidences. IMF data show historic fall in production and retail sales in the globe from December 2019. With the stoppage of the production and growing consumption demand, price level might increase dramatically in the coming months, if not intervened rightly. By all indications, slowdowns in China, USA, Italy, Spain, United Kingdom and other European countries in the first quarter of 2020 is going to be significant and will leave a profound mark for the year. In a recent analyses, J.P Morgan economists viewed that global economy would experience an unprecedented contraction during the first half of the year: the US economy is projected to contract by 14 percent in the second quarter, after experiencing a 4 percent contraction in the first quarter; Euro area GDP would suffer an even deeper contraction, with double-digit declines of 15 percent and 22 percent in the first and second quarters. All indications are showing a road towards severe economic shocks and following financial instability.
As the expected outcome of the contraction and interruptions of economic activities, firms of all sizes and banks started facing liquidity problems. With the reduction of cash flows, business firms are struggling to pay their suppliers, their employees, and ultimately their bankers, even though the business models have proven strength and potentials. A significant of these firms have got capabilities to come back as the situations get normal in the coming months. But, at this moment, smaller firms are already facing solvency challenges, and bigger corporates may also face the challenge of insolvency once their inventories and cash reserves are depleted. The changing business conditions are affecting the creditors, i.e. banks and financial institutions. Withdrawal of deposits and fear of banks failures amongst a section of depositors in some countries caused additional liquidity pressures. Ideally, the changes should affect non-performing loans, loan-loss provisions, and capital adequacy positions of banks, very critical indicators of financial stability. As temporary measures, central banks in most global economies have introduced short term options to inject money in their economies through banks and financial institutions and offered some reliefs to the liquidity shortage of firms and financial institutions. But, the transformation chain does not stop at this point, government has already started preparation and some have undertaken steps to address the uncertain financial positions of firms, businesses, unemployed people and also banks and financial institutions. However, sovereign funding capacity of all global economies are not same and have limitations.
Disruption of international value chain and trade transactions started following the spread of coronavirus in China. During last two decades China became the key trading center of global economy not only related to its status as a producer and exporter of consumer products, and also as the main supplier of intermediate inputs for manufacturing companies globally in all economies. Chinese manufacturing is essential to many global value chains, mainly those related to machinery, automotive and communication equipment. Significant disruption in China’s supply in these sectors has already affected producers in the rest of the world. Recent UNCTAD report identified the most impacted economies to be the European Union (machinery, automotive, and chemicals), the United States (machinery, automotive, and precision instruments), Japan (machinery and automotive), the Republic of Korea (machinery and communication equipment), Taiwan Province of China (communication equipment and office machinery) and Viet Nam (communication equipment). Some developing countries have even greater trade dependence. Practically, all the major trading partners are now in the corona warfront and facing international trade contraction and supply chain uncertainty. Banking industries have been extensively involved in facilitating trade transactions and offering trade financing services over the years. Contraction of international trade activities are reflected into shrinkage of trade financing activities, one of the key areas of fee and interest incomes of banks.
Contraction of banking activities are clearly visible. Banks are forced to reduce their opening hours and in many cases can only serve a few customers to enforce social distancing rules. A number of banks are offering free services and allowed waiver of service charges. Banks are forced to allow delay in the repayments of loans. There are clear uncertainty of getting repayment of loans from the group of people who have already lost jobs or are losing. While, there are evidences of increased demand for online and mobile banking and payments, many fin-tech firms are offering their services to consumers and businesses for free while the coronavirus crisis is ongoing. As a whole the situation indicate notable contraction of both interest and non-interest incomes of banks and financial institutions.
Instability in the other segments of the economy and the financial sector have also notable implications for the banking industry. Uncertainty and lack of confidence on equity and bond market are getting visible. Stock markets in major economies, such as the US, the Euro zones, Japan and in several other countries fell sharply and witnessed huge volatility following the spread of the coronavirus. Falling stock markets are causing concerns for the economy and businesses and are clearly hazardous for banks and financial institutions.
The above analyses point to the fact that the economic shock is transforming or will transform into banking instability. We are observing the roles and responses of monetary policy authorities and central banks to address the changing situations and developments in different economies. There is no doubt that it is time of joint action of the fiscal and monetary policy authorities, however, it is the fiscal authorities that have to play due roles to save the economy and the financial sector. Extent of damage and the required policy responses are not yet clear, however, that might be very challenging for the developing countries. It is important that the developing countries identify and estimate the extent of damage in a transparent manner to get itself and its citizen prepared and ready.