With markets already in turmoil, a dollar credit crunch now threatens the world economy. Companies dependent on international trade have seen their earnings collapse, and many will be unable to service their dollar-denominated debts. International banks are facing severe pressure.
The world has learned about the costs of delaying measures to fight a contagious virus. Likewise, the many instruments governments and central banks have to tackle the economic consequences of this health crisis. The measures will also become less effective the longer policymakers dither.
A looming credit crunch was evident even before the COVID-19 pandemic. In December 2019, a report from Robert Triffin International noted that every metric of dollar exposure outside the United States was flashing red. "The dollar debt of non-banks outside the United States is at a new record," the authors warned, and "currency mismatches and leverage in the private sector have increased. The dollar funding of non-US banks looks fragile."
Indeed, the dollar-denominated debt held by non-banks outside the US now exceeds $12 trillion, or 14 per cent of global GDP (gross domestic product), up from 10 per cent in 2007 just before the global financial crisis. Moreover, dollar bonds issued by non-US entities other than banks are almost $7.0 trillion, which is triple the 2007 level. Numerous corporations outside the US (including in China and other emerging markets) will struggle to service their dollar debts.
Three months into the COVID-19 crisis, international trade in goods and services remains disrupted. How long will it be before companies with zero earnings fail to make payments on their bonds? Many corporations will pursue defensive financial strategies which could hit banks hard. For example, stressed companies will withdraw their deposits (regarded as stable funding for banks) or activate their credit lines. A global corporate scramble for dollar liquidity will erode banks' liquidity buffers. Banks could be forced to cut lending and credit lines. And they can do so more quickly than before the global financial crisis, because the new Basel III liquidity rules have made it easier for banks to revoke credit lines. Banks will engage in fire sales of risk assets and, given skyrocketing volatility in markets, will demand more collateral from leveraged customers. Institutions hit by a cross-border string of contagious bankruptcies are thus likely to add further deflationary pressure to the global economy.
Slashing interest rates is not enough. The build-up in corporate dollar debts is too large, and the impending hit to earnings too severe. As in 2007 and 2008, private liquidity is fast draining away from markets. Central banks should quickly inject liquidity with renewed quantitative easing (QE) on a large scale, signaling once again that they will do "whatever it takes."
Only the US Federal Reserve can provide the necessary dollar liquidity on a sufficient scale. Although it has suffered undeserved political criticism at home, the Fed did its duty in the last crisis. In addition to stabilising US bond markets (the epicentre of that crisis), it provided other major central banks with unlimited access to dollar swaps, partly in recognition of the fact that European banks' dollar exposure was primarily related to investments in US mortgage-related securities.
But this time is different. The Fed's lender-of-last-resort powers have been curtailed since the last crisis. Moreover, the epicentre of the coming dollar-liquidity crisis will probably not be in the US, but rather in markets for dollar-denominated bonds issued by non-US companies. The Fed will be reluctant to come to the aid of foreign companies with too much dollar debt.
Still, as in 2007 and 2008, the problem of dollar liquidity will be at the heart of the crisis. Solving it will require concerted action by many official entities - central banks, regulators, and above all governments.
The Fed deserves credit for the measures taken on March 15, and for leading action by other central banks. All central banks need to step up QE substantially. Dollar swap lines with the Fed should be used to ensure central banks lend freely in dollars. Given the huge overall dollar exposure of non-US banks before the coronavirus shock, it is entirely possible that some large banks would face default on their dollar debts in the absence of official assistance. Regulators should ease capital and liquidity rules applying to banks. The European Central Bank was right last week to lower capital and liquidity requirements for the largest eurozone banks.
Yet only governments can deal with the flight from risk during a once-in-a-century pandemic. They can avoid a global economic collapse only if they act quickly. A global cascade of corporate defaults would cripple the financial system. Providing direct and immediate aid to the companies hit by the pandemic is essential. As such, fiscal rules and restrictions on state aid should be relaxed, and governments should offer partial guarantees to banks that extend loans quickly to distressed companies. Nowhere is this more necessary than in the eurozone, which faces a unique test of its ability to help the hardest-hit member states.
Governments should not shrink from supporting equity markets, perhaps through the agency of central banks. Steep declines in equity prices create opportunities for profit, and volatile markets mean that prices are likely to rise more strongly in response to official purchases.
Policymakers around the world delayed too long in taking measures to contain the virus. They should not repeat this mistake with economic policy. They must now agree to act boldly, immediately, and together. We can worry later about the downsides of drastic emergency measures, most of which will be temporary anyway.
Philip Turner is a visiting lecturer at the University of Basel and a visitor at the National Institute of Economic and Social Research in London. He was previously Deputy Head of the Monetary and Economic Department and a member of senior management at the Bank for International Settlements.
Copyright: Project Syndicate, 2020.
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