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Just as control of COVID-19 requires slowing transmission of the disease, policymakers want to interrupt the pernicious financial feedback loops that the pandemic has caused. But unlike in the Great Financial Crisis of 2008-09, the world economy is affected directly by the measures aimed at containing the spread of the coronavirus. As a result, businesses now are experiencing precipitous declines in revenue, earnings and cash flows.
The services sector, including travel, tourism and entertainment, has been hit hardest. Non-essential construction work is also adversely affected by the lockdown, reductions in investment or lack of funding. Manufacturing, such automobiles and aerospace, is beset by a lack of sales and difficulties in obtaining necessary products from suppliers in other countries. Ultimately, movement restrictions, diversion of resources to fight the coronavirus and demand constrained by falling income will affect even sectors now considered insulated, such as supermarkets, consumer staples, utilities, technology, telecommunications, online media and the health sector.
This global business slowdown feeds unemployment. The loss of household income sets off a dire feedback loop as reduced consumption drives business revenues lower, forcing companies to downsize or shutdown creating more unemployment.
Vicious spiral
Given that the world’s advanced economies are structured around consumption, which frequently makes up around 50%-70% of activity, output declines of 50%-100% translate into an economic contraction of around 25% or more. For every week the lockdown continues, global GDP may be decreasing by between 0.25 and 0.50%. Prices must adjust accordingly to lower corporate earnings, reduced rental income from properties, and reductions in dividends and buybacks, driven by falling earnings and regulatory prohibitions.
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Leveraged investors, including hedge funds, private investors and entrepreneurs who borrowed against shareholdings, face margin calls. The inability to liquidate certain investments limit investors’ access to cash. Attempts to hedge against further falls pressure share values and investment liquidity, transmitting the stresses across asset classes and financial markets. Such a decline in investment income and difficulties in realizing investments in turn decreases household cash resources and constrains spending.
Banks, initially, benefit from higher trading income and emergency corporate capital raisings. Yet as the coronavirus-induced crisis continues, households, businesses and investors initially breach loan conditions and eventually default or restructure debt. Forced sales of collateral weigh on asset prices. Reduced savings pressure bank funding.
Rising bad debts reduce banks’ willingness to lend. Where funds are available, borrowing costs are higher. The credit-dependent real economy and investment markets will be increasingly affected. Recapitalization needs necessitate converting hybrid instruments into equity or writing-down capital values of bail-in bonds, adding to pressure on investors.
To counteract these stresses on households, government in the U.S. and around the world have introduced or scaled-up unemployment benefit coverage, income support and helicopter money drops. But the demand effect is muted by lockdowns, necessitating separate support for business — grants, rent and debt payment suspensions, loans and government guarantees. Central banks are supporting the prices of financial assets and trading. They have increased financial institution access to funding as well as relaxed bank capital and accounting rules for impaired assets.
Herculean or Sisyphean task?
It is uncertain whether these measures will slow and ultimately arrest the progress of the crisis. Eligibility criteria and details are ambiguous. Agencies and banks are struggling to administer the programs, which have wasteful overlaps and redundancies.
The one-time direct payments and unemployment relief are modest relative to living expenses for newly unemployed workers and their families, and they all have time limits. With around two-thirds of assistance being concessional loans, it is unclear how increasing borrowing will help already indebted businesses and individuals. It may merely defer insolvency. Measures to suspend rents and loan repayments are reminiscent of the 2009 U.S. mortgage modification program to avoid foreclosures, which failed.
“ Loss of tax revenues, rising health costs and the cost of supporting the economy will necessitate large increases in government debt. ”
In seeking to arrest the crisis, heavily indebted governments are assuming massive liabilities, currently between 10%-20% of GDP and likely to increase, setting the public finance feedback loop in motion. Loss of tax revenues, rising health costs and the cost of supporting the economy will necessitate large increases in government debt. Additional issuance may offset efforts to reduce rates. It will place pressure on currencies, making it difficult for capital-importing countries to attract external investors, especially with low- or negative rates. Alternative financing, through quantitative easing (QE) or more explicit debt monetization risks debasing the currency.
It is also uncertain whether lowering already low rates and additional liquidity infusions can support asset prices or offset declines in economic activity in an environment of falling income and unsustainable debt levels. Further QE may be ineffective — having just about reached its limits. Complicating matters is that the crisis is global, and trade is shrinking.
With half the world’s population now under some form of stay-at-home order, it remains unclear whether policy makers, despite their “whatever-it-takes” promises, can halt the pandemic and prevent a financial crisis — especially if it continues for any length of time.
Satyajit Das is a former banker. His latest book is A Banquet of Consequences (published in North America as The Age of Stagnation). He is also the author of Extreme Money and Traders, Guns & Money.
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