#166. Lines of contagion

COULD THIS BECOME A BANKING CRISIS?  

Whilst the world watches the wild gyrations in stock markets, and investors try to absorb the economic implications of the Wuhan coronavirus, it’s important to remember that market falls are neither the only, nor indeed the most important, financial effects of this situation.

It doesn’t take all that much joined-up thinking to spot the lines of financial contagion that threaten to transition this from an industrial problem into a threat to the banking system.

What matters now isn’t how much theoretical asset value investors may have lost, but the real, cash-flow consequences for businesses and, by extension, to their lenders.

Essentially, slumps in equity prices simply reduce the amount that owners could get for their shares now, compared with those that they could have realised a week or so ago. Except where stocks have been acquired using debt, there are few immediate, cash-outflow effects. Shares that were once worth $50 might now be worth only $40, but no money has actually flowed out of the typical investor’s bank account.

The real (and systemically-hazardous) damage being inflicted by the epidemic is happening, not in stock prices, but in business activities ‘at ground level’. With systems in lock-down, workers idled and supply-chains ruptured, a large and growing proportion of the world’s businesses are unable to produce, sell or deliver goods and services – which also means that they don’t get paid.

Just because revenues dry up, obligations do not. These include wages, rents, administrative overheads, sums owed to trade creditors, maintenance costs, tax payments and – in this context, most critically of all – the servicing of debt. Fundamentally, then, what looks to a watching world like an asset pricing drama is, in reality, a cash flow or liquidity crisis.

This in turn puts the banking system in the eye of the storm.

What affected businesses need now is financial support. They need lenders to give them more time to pay and, for the duration of what might turn out to be a very protracted loss of revenue, they also need additional funds to cover their various outgoings.

Firms which do not get this support face collapse, either because they can’t meet their debt service obligations, or because they simply run out of money. This is where the notional losses of value on the market’s ticker-boards turn into a real, systemically-damaging destruction of value.

This doesn’t mean that firms are powerless supplicants over whose fortunes their lenders sit in judgment. If businesses do start to fail, the banks could face rapid and crippling losses. Slashing interest rates, the central bankers’ prior preferred tool, can do little or nothing to resolve this issue.

Rather, governments and central banks have to find ways to ‘support the support’ that businesses need from commercial lenders, and they need to do it urgently.

A reduction in the rate of interest that you’ll be paying in the future doesn’t help you to pay wages, creditors, taxes and overheads now, and neither does it solve a liquidity crisis compounded by scheduled debt service outgoings.

It may be obvious that lower borrowing costs aren’t going to tempt frightened travellers back on to aeroplanes or into the shops, but it’s equally true, and even more important, that the simple lowering of rates doesn’t, and can’t, keep businesses going. Banks, then, need to be lending more – and this at the very time when both inclination and prudence might be counselling them to lend less.

Decision-makers in government and central banking need now to be asking themselves two critical questions.

The first of these, of course, involves working out ways to push support through the commercial banking system to the businesses that need it.

But the second is what do to if ‘operation support’ either fails, or is only a partial success. If cash-strapped companies start to fail to any significant extent, the inevitable consequence will be a compounding cascade of defaults.

This isn’t a problem that can be solved by putting yet more borrowers into the limbo of “zombie-ism” – being allowed to add owed interest to outstanding capital balances doesn’t enable firms to meet their ongoing cash needs.

The likeliest outcome at this point is that the authorities will recognise and react to the business liquidity crisis, but won’t be able to do so in ways that are sufficiently comprehensive, and which meet the urgency of the situation.

This, I suspect, is when a lot of recent history starts to be regretted. The scale of stock buy-backs in the United States, for example, has effectively replaced large amounts of shock-absorbing equity capital with inflexible debt. China has spent ten years almost quadrupling its debt in order to slightly more than double its GDP. Globally, monetary policies adopted during the GFC, and then kept in place for far too long, have paid people (and businesses) to borrow. Cheap liquidity has created huge areas of exposure, with stock markets just one example amongst many.

Anyone who thought that over-inflated asset prices were the only hostages handed to fortune by credit and monetary adventurism could now be drawn face to face with an uncomfortable reality.

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PLEASE NOTE

11th March 2020

As you’ll have seen, there’s been a big jump in the number of comments posted here.

This has happened because I’ve just found out that the system which notifies me of comments awaiting approval has stopped working, seemingly a couple of weeks or so ago.

Please accept my apologies for this (and my grateful thanks go to the person who worked out what was causing this glitsch).

Until this is sorted, I’m going to do the approvals process manually, looking regularly at the list rather than waiting to be notified. I hope this won’t be much slower than the normal process.