Supermarket shelves are being cleared and in financial markets, cash is the only precious commodity. The hoarding of cash by banks, investors and companies illustrates the vast wave of deleveraging that is taking place across financial markets with the echoes of 2008 getting louder and louder.
The real economy and financial system are joined at the hip. Financial market dislocations have prompted emergency rate cuts by central banks, actions that have done little to ease financial stress. An increasing economic shock has also compelled governments to roll out spending measures that support businesses and consumers.
The economic shock triggered by the coronavirus pandemic is becoming a financial crisis, with companies preparing for a cash crunch as economic activity grinds to a halt. Many corporations are tapping credit facilities at banks, with these loans taking up space on balance sheets, thereby limiting the ability of financial groups to operate across financial markets.
That only intensifies the pressure to cut risk across financial markets, which is creating a nasty feedback loop. Stressed market conditions severely limit the ability of companies to sell corporate bonds or even secure funding at a reasonable cost in short-term funding markets, such as US commercial paper. The inability to refinance and roll over debt explains the widespread drawing down of bank credit lines by companies. A sharp rise in commercial paper borrowing costs on Tuesday finally prompted the revival of an emergency Federal Reserve lending facility from 2008 for commercial paper.
But this is also a global problem given the scale of US dollar-denominated borrowing over the past decade by companies and governments, particularly among emerging market countries. The Institute of International Finance notes that fund outflows from emerging markets since late January “are already twice as large as in the global financial crisis and dwarf stress events such as the China devaluation scare of 2015 and the taper tantrum in 2014”.
This represents a massive run on an important sector of the global financial system, flagged by the US dollar strengthening sharply against many other currencies. Together with the dramatic declines in global equities and other asset prices, a stronger reserve currency represents a severe tightening of financial conditions and one that may swamp the easing efforts from central banks.
The cracks in a US dollar-dependent financial system prompted the Fed to bolster swap lines with leading central banks over the weekend to alleviate a squeeze. But many observers think a lot more is required before short-term funding stress abates and reduces the risk of a far bigger credit crunch that — hopefully — reinforces the shockwaves hitting economic activity.
Zoltan Pozsar at Credit Suisse outlined the stakes. “The Fed needs to broaden access to the swap lines to other jurisdictions as dollar funding needs are large in Scandinavia, south-east Asia, Australia and South America, not just in the G-7.”
He added: “The dollar funding needs of both banks and non-banks is what’s at risk and the assets that are being funded are US assets — Treasuries, MBS and credit — so the Fed has a vested interest.”
Ultimately, any sign of infection rates from Covid-19, peaking in Europe and North America, will be the all-clear signal that everyone is waiting to see. Before that moment dawns, central banks and governments face the challenge of alleviating financial and economic shocks and preventing a deeper downturn. Time is not on their side.
