Coronavirus vs Global Financial Crisis
How is the current economic stress different from the 2008 stress.
With the spread of the virus, after the collapse of oil prices and the subsidence of all stock indices into the zone of investment armageddon, it becomes apparent that the current global economic crisis is still gaining in scale with the events of ten years ago. To understand how the response package from governments and central banks should be designed, it is necessary to understand clearly the similarities and differences between present and past stresses. Otherwise, appealing solely to the formal figures of contraction of economic activity or the collapse of markets may lead to incorrect economic methods of mitigating the crisis and overcoming its consequences.
What really brings these two together is the scale. The global resonance of shock is staggering, and now we see no sign that the waves of the spread of the virus, and with it restrictive measures are losing their destructive power for the economy and finance. This means that the depth of the economic downturn and the collapse of markets in 2020 can really compete with the events of 2007-2009. Substantial cooling of the financial markets will continue for a long time to come, especially given that in many countries the role of market finance has increased.
However, both crises are radically different: in terms of prerequisites, nature of accumulated vulnerabilities, distribution channels, etc.
What was the key feature of the global financial crisis? The over-elasticity of the financial system, which coupled with a too soft monetary policy has unwound the flywheel of global liquidity expansion. The subprime mortgage crisis in the United States was just one aspect of a larger problem: the global economy already in 2006-2007 signaled the accumulation of huge financial imbalances. Asset prices, commodity prices (not just oil, but also metals and food), domestic credit (especially to households), global capital flows and foreign exchange reserves have grown exponentially. The United States and China have demonstrated an unprecedented imbalance in current accounts. And yet ... In most countries of the world in 2008, inflation started to accelerate due to rising food and energy prices. This inflationary leap for many countries was quickly eroded by post-crisis fears of deflation.
Regarding macroeconomic policy, rates in many countries were raised late, but generally responded to rising inflation. But the public debt in the midst of low rates slowed down. The regulatory environment, under the influence of market-oriented approaches to risk assessment, facilitated financial expansion more quickly.
Following the escalation of the subprime mortgage crisis into a full-blown crisis, it became apparent that the latter has classic signs of "collapse after the boom", characterized by the following: a huge accumulation of bad debts; distortions in the resource misallocation mechanism; the need for large-scale deleveraging (reducing the level of debt in the private sector); Substantial slowdown in further recovery rates (so-called L-shaped recovery) due to reduced investment and productivity. It is no coincidence that the anti-crisis measures concerned the reduction of interest rates and the support of liquidity by the central banks and the inclusion of automatic stabilizers of fiscal policy in the beginning. But such measures have quickly evolved from supporting liquidity to unconventional monetary policy and shifting private debt to taxpayers through financial sector rescue and resuscitation programs. Countries with emerging markets are faced with a similar set of dilemmas, but with typical restrictions in the form of devaluation, loss of foreign exchange reserves, pro-cyclical fiscal policy. And if in developed countries inflation slowed, in poorer countries it accelerated.
The response to the global financial crisis, subsequent reforms and structural changes, in many respects, led to radical differences in the initial characteristics of the global economy at the time of the coronation crisis.
First, the introduction of Basel III has changed the regulatory landscape of banking. Yes, the regulatory burden has increased, banking has become less profitable. But the banking system has become less pro-cyclical. It was not a generator of systemic risk compared to the events of 2007-2008.
Second, the expansion of responsibility for financial stability on the part of macro-policy makers entailed the introduction of macroprudential practices. The latter significantly narrowed the possibility of price fluctuations and an appetite for asset risk to loosen the quality of bank balances. In addition, macro-prudential instruments allowed to limit the expansion of financial imbalances.
Third, the governments of many countries have never been able to return the levels of public debt to positions before the global financial crisis. It is no secret that the fiscal space has been maintained recently due to low (and sometimes negative) central bank rates. Fiscal policy starting positions for 2020 turned out to be worse than in 2008.
Fourth, monetary policy space has also narrowed significantly. Abnormally low and often negative rates have shown a known barrier to further decline. Even for many emerging markets, the last decade has been characterized by the entry of extremely low real central bank rates. Oddly enough, it is for this group of countries that the window of opportunity for monetary stimulus has opened, although to the extent that the achieved level of financial development enhances the adaptive role of the flexible exchange rate, removing some of the burden from foreign exchange reserves. Nevertheless, the stock of the latter continues to determine the area of monetary maneuver of many middle- and low-income countries.
Fifth, there have been some shifts in the correction of external imbalances. Recently, the United States has not shown a threatening current account deficit, and China has also narrowed substantially in the course of the real convergence process in China. However, China's share of global GDP and trade has increased. Just as the role of global value chains as drivers of trade has grown. Naturally, corporate financing for current activities has become much more sensitive to the resilience of such chains and the value of short-term dollar funding. Sixth, the prolonged period of low rates has affected structural changes in corporate finance. The global burden of corporate debt has increased significantly. And it has increased mainly in emerging markets.
These differences clearly characterize that the profile of the current crisis is absolutely not identical to the events of 2007-2009. Its characteristic feature is, first of all, the shock of supply, where epidemiological measures limit economic activity, breaking supply chains, increasing pressure on the labor market, subject to further contraction of aggregate demand due to uncertainty with the duration of quarantine measures and deteriorating expectations. The oil price response was a reflection of the discord in the mechanisms of global cartel collusion and only then began to adjust due to negative expectations about the magnitude of the crisis multiplied by the price war. Stock markets have reacted in this way and are highly sensitive to news related to the announcement of crisis management programs and the spread of infection. Formed strength stocks now allow banks to hold on. However, it should not be ruled out that the deepening of the crisis and its entry to the next level will occur when protracted restrictive measures loosen corporate debt, and the liquidity crisis will turn into a crisis of corporate solvency.
Another significant difference is the nature of expectations. Koronashok is not considered by many to be one that was triggered by distortions in the resource allocation mechanism, the supply chain breaks are temporary, and China has already begun to recover from the effects of the epidemic. And this is very important, because such a perception of events implies strong expectations about the rapid recovery (V-shape recovery), and if so, the incentive packages can be significant in volume, but one-off. It is on these considerations that in many cases the design of crisis management programs is based.
Such programs have already shown clear differences compared to the events of the global financial crisis. Along with standard measures of central banks to maintain liquidity, such as lowering rates (where possible) and expanding instruments that are acceptable for pledge, macroprudential instruments are almost in the first line of reaction. Most countries with macro-prudential practices have announced a significant easing of the relevant requirements (disbanding capital buffers, etc.) precisely to prevent pro-cyclical contraction of domestic credit. Microprudential instruments are also expected to be used proactively to stimulate banks to quickly restructure the debt of shocked companies and to prevent the corresponding negative impact of the reserves created on bank capital.
That is, policies to influence liquidity and prevent credit pro-cyclicality are not so much focused on solving solvency problems or creating incentives for a redistribution plan, but rather on emphasizing the need to support the operating activities of companies that find themselves in a situation of disruption of supply chains and sharp restrictions on access to working capital financing. This nuance is fundamentally important. As the desire to extend credit support packages under the auspices of coronation crisis can lead to unwanted erosion of target groups of recipients and inefficient use of scarce resources. Fiscal measures are similarly different. In addition to the significant increase in health care costs (rather than financial sector support, as in 2008-2009), they focus on reducing the burden on companies' operating activities and creating incentives to maintain employment. Yes, the global economy will again face the challenge of growing public debt. However, the more relevant issue is not the feasibility of increasing it now, but the options for fiscal consolidation then when the epidemic is overcome. Otherwise, public finances in many countries will be on the verge of confidence in the ability to increase debt in the future.
And of course, capital flows, exchange rates and foreign exchange reserves. In both cases, capital flows clearly demonstrated their pro-cyclical nature. Exchange rates and foreign exchange reserves have taken the brunt of relocating global portfolios. But what is striking is that over the years between crises, the global financial system has transformed. Many emerging markets have developed financial systems. Their stock markets have become more accessible to non-resident portfolio holders, and bond markets have already been integrated into the assets structure of global financial companies. Exchange rates have become more flexible and foreign exchange reserves have increased, but growth rates are clearly not the same as before. Capital outflows from emerging markets turned out to be faster and larger, but were largely determined by the exit from the stock market. On the one hand, this indicates that global financial firms do not expect that fixed income instruments will lose their appeal in the light of the possible reversal of exchange rates after the epidemic has waned. On the other hand, the problem of corporate debt can really detonate, as the withdrawal of non-residents from stock markets significantly narrows the possibilities of financing in conditions of liquidity contraction. An exceptional focus on the accumulation of reserves will not produce results. Much more advantageous is the policy of improving the quality of institutions as a basis for deepening financial systems. More flexible courses work better where financial systems are more developed and dependency on reserves is lower. Nevertheless, the loss of reserves and the appeal to the IMF for liquidity support demonstrate that the world is not attainable in the near future without external assets of central banks and centralized mechanisms for solving the international liquidity problem. The mechanisms of bilateral and multilateral swaps between central banks effectively prevented the contraction of dollar liquidity on a global scale, but they are unable to effectively counter the sudden closure of access to budget deficits in many poorer countries at once.