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The Financial Express

Covid-19 warfront: Likely economic shocks and banking instability

Shah Ahsan Habib | Published: March 31, 2020 22:33:08 | Updated: April 04, 2020 22:05:34


Covid-19 warfront: Likely economic shocks and banking instability

Global economies are fighting Covid-19 pandemic at a significant economic cost. Though some policymakers are still searching for the right kind of response 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 economic jolt. The strategies resulted in slowing down economic activities and huge costs. Probably, this is the only option to minimise long-term economic costs and address the escalating economic and financial instability. However, upcoming policy responses and market intervention strategies would depend on the developments in the Covid-19 warfront.

Economists are forecasting severe contraction of gross domestic product (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 recent financial crisis during 2006-08. To fight the spread of the virus, several countries enforced strict regulations to avoid physical contact, and there are closure of schools, universities, factories and businesses. There are visible evidences of very weak production and business conditions and decelerating confidence level. IMF (International Monetary Fund) data show historic fall in production and retail sales in the globe since December 2019. With the stoppage of the production and growing consumption demand, price level might increase dramatically in the coming months, if not intervened appropriately. By all indications, slowdowns in China, United States (US), Italy, Spain, United Kingdom (UK) and other European countries in the first quarter of 2020 is going to be significant and will leave a profound impact 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 per cent in the second quarter, after experiencing a 4.0 per cent contraction in the first quarter; Euro-area GDP would suffer even deeper contraction, with double-digit declines of 15 per cent and 22 per cent in the first and second quarters.

As the expected outcome of the contraction and interruption in economic activities, firms of all sizes and banks started facing liquidity problems. With the reduction of cash flows, firms are struggling to pay their suppliers, employees, and ultimately their bankers, even though the business models have proven strength and potentials. A significant number of these firms have capabilities to come back if the situation gets 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 bank's failures among a section of depositors in some countries caused additional liquidity pressure. Ideally, the changes should affect non-performing loans (NPLs), loan-loss provisions, and capital adequacy positions of banks -- all very critical indicators of financial stability. As temporary measures, central banks in most global economies have introduced short-term options to inject money into 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, governments have already started preparations 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 the same.

Disruption of international value chain and trade transactions started following the spread of Covid-19 in China.  During the last two decades, China became the key trading centre of global economy not only related to its status as a producer and exporter of consumer products, but 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 (United Nations Conference on Trade and Development) report identified the most impacted economies to be the European Union or EU (machinery, automotive, and chemicals), United States (machinery, automotive, and precision instruments), Japan (machinery and automotive), Republic of Korea (machinery and communication equipment), Taiwan (communication equipment and office machinery), and Vietnam (communication equipment). Some developing countries have even greater trade dependence. Practically, all the major trading partners are now in the Covid-19 warfront and facing international trade contraction and supply chain uncertainties. 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 in the 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 have allowed waiver of service charges. Banks are forced to allow delay in repayment of loans. There are clear uncertainties of getting repayment of loans from 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. As a whole, the situation indicates 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 has 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 zone, Japan and in several other countries fell sharply and witnessed huge volatility. 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 very likely to transform into banking instability. We are observing the roles and responses of monetary policy authorities and central banks in addressing the changing situations and developments in different economies. There is no doubt that it is time for joint action of the fiscal and monetary authorities. However, it is the fiscal authorities that have to play crucial roles to save the economy and the financial sector. The extent of damage and required policy responses are not yet clear, and that might be very challenging for developing countries. It is important that developing countries identify and estimate the extent of damage in a transparent manner to get themselves and their citizens aware and prepared.  

Dr. Shah Md. Ahsan Habib is Director (Training) at the Bangladesh Institute of Bank Management (BIBM).

ahsan@bibm.org.bd

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