Week in Review
What We're Reading:
June 29, 2020
Financial conditions have eased, but insolvencies loom large. With huge uncertainties about economic outlook and investors highly sensitive to COVID-19 developments, pre-existing financial vulnerabilities are being exposed by the pandemic. (Seeking Alpha)
Mexican economy shrinks record 17.3% in April as industry swoons. Mexico’s economy posted a record contraction in April, official data showed on June 26, as the effects of the coronavirus lockdown devastated economic activity, particularly in manufacturing. (Reuters)
South Korean households, companies expected to face liquidity shortage over COVID-19. Both households and companies of South Korea are expected to face liquidity shortage on the back of an economic fallout from the COVID-19 outbreak, a central bank report said June 24. (Xinhua)
Trump threat to “decouple” U.S. and China hits trade, investment reality. Conflicting talk from Trump administration officials about “decoupling” the U.S. economy from China is running into a challenging reality: Chinese imports of U.S. goods are rising, investment by American companies into China continues, and markets are wary of separating the world’s biggest economies. (HSN)
Peru giving up on virus measures in face of sinking economy. Peru—which has reported the world’s sixth-highest number of cases in a population of just 32 million—has decided to ignore scientific warnings and opened many of the country’s largest shopping malls this week. (AP News)
No progress on trade, investment, Hong Kong as EU wraps up tense China summit. No tangible progress was made on several key issues as leaders from the EU and China met for a tense virtual summit on June 22, amid tensions over tariffs targeting Chinese firms and Europe’s fears over Beijing’s growing global authority. (EurActiv)
Libor transition progresses but the biggest hurdles remain. Meeting the end-2021 deadline is still possible, but the biggest hurdles remain, particularly in the U.S. dollar market. (Fitch)
Lebanese face food crisis due to economic collapse. The collapse of the economy in Lebanon is making it increasingly difficult for citizens to buy basic essentials, including food and fresh water, Arab48.com reported on June 24. The value of the currency has fallen to an unprecedented low. (Middle East Monitor)
In the new normal supply chain, firms must pivot quickly. What will our supply chains look like after the impact of the pandemic has turned from an all-hands-on-deck crisis to some sort of new normal? Will either demand or supply patterns return to pre-COVID-19 levels? And should that happen, will it be in carefully managed phases, or more rapidly? (Global Trade Magazine)
Wirecard: The timeline. How the payments group became one of the hottest stocks in Europe while battling persistent allegations of fraud. (Financial Times)
An Introduction to Incoterms. A look at Incoterms 2020—what they are and how they originated, how to apply them, how exporters and importers benefit from them, and why they matter. (Shipping Solutions)
China warns U.S. over actions against four more media outlets. China warned, on June 23, it will take countermeasures after the U.S. added four more Chinese media outlets to a list of organizations that should be considered “foreign missions” in the United States because of their ties to the government and ruling Communist Party. (Business Mirror)
Central banks have thrown many tools at coronavirus. What do they have left? To kick-start a world economy devastated by coronavirus, central banks have delved deep into their toolboxes and unleashed trillions of dollars in stimulus. So, what instruments do they have left, should they need to do more? (HSN)
Will Global Trade Ever Be the Same?
Chris Kuehl, Ph.D., NACM Economist
The short answer is “No.” This doesn’t mean that trade will vanish altogether, but the shifts and changes that had been developing before the COVID-19 outbreak have been accelerating. It is probably a good time to review the motivation for trade in the first place.
There are essentially two types of trade: One motivated by absolute advantage and the other motivated by comparative advantage. There is little or nothing that will ever change the motivation of absolute advantage because this means that a certain nation or region is the only place where that commodity or item is found. A country that has oil will always be selling it to those that don’t. The country that has some rare earth mineral that others do not have will always have that market.
The comparative advantage is more complex. This holds that each nation is better at some things than others. It is more efficient to do that which one is good at and buy other things from somewhere else. The U.S. could grow all its own bananas, but it would require extra effort and the fruit would be enormously expensive. The U.S. could manufacture anything it likes, but there is far more money in making high-value goods than making tube socks. So why not focus on the high-value stuff and buy tube socks from somewhere else (along with those bananas).
As logical as trade is, there have always been arguments against buying certain things from other nations—even if this would mean cheaper prices for the domestic consumer. High on the list of reasons to produce domestically is the notion of national security. A country does not want to depend on others for things that are key to defense. It makes sense not to buy weapons or crucial technology, but the concept is regularly stretched. The U.S. has limited or banned imports of such items as cars and car parts as well as electronics, medical devices and certain foods. Japan has banned imported rice for years on national security grounds. France limits the number of foreign films and other entertainments as protection of cultural security.
Very often, the move to limit trade is motivated by the desire to protect parts of the domestic economy. When a decision has been made to source outside the U.S., it inevitably means that a domestic producer will lose an opportunity. This can mean the loss of jobs. Politicians do not appreciate the reduction of jobs in their districts and states. In the majority of situations, the importation of goods will mean job gains somewhere else, but not in the place that lost out to the overseas competitor. The consumer will benefit from the lower prices, but that is a gain that is distributed throughout the economy, while the job loss is contained in a limited area. Much of the trade restriction that has taken place in the last several years has been motivated by this protectionism.
A third major reason for restricted trade is to protect the consumer and society in general from harmful or dangerous products. There are many nations lacking the kind of safety regulations that exist in the U.S. There are products that are shoddy and fail to work as promised, there are foods that are contaminated. These are products the U.S. (and every other nation) seeks to ban. As with the other two motivations for limiting trade, there are abuses of the system as companies seeking an edge over their competition will employ whatever strategy they can.
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Insolvencies in Europe: Amendments to Legal
Procedures Temporarily Postpone Due Dates
The decline in revenues due to the COVID-19 pandemic has deteriorated companies’ cash positions, fostering an increase in payment delays and, ultimately, payment defaults, noted trade credit insurer, Coface.
In most European countries, payment defaults must be reported to the competent authority within a given deadline by the company director, who would otherwise be held personally liable. The authority will then initiate insolvency proceedings, Coface explained.
However, in order to simultaneously protect the structure and the recovery capacity of their economies once the pandemic is under control, Coface said the vast majority of European governments have taken two major steps: (1) the implementation of measures to support corporate cash flow such as deferrals or cancellations of social security contributions and taxes, or state guarantees on loans granted by banks, and (2) the temporary amending the legal framework that regulates insolvency proceedings.
The German government has proposed the suspension until Sept. 30 of the obligation for company managers to initiate default proceedings within three weeks of the discovery of the insolvency or over-indebtedness situation. This measure could be extended until March 31, 2021, by a decree of the Federal Ministry of Justice. Spain has chosen to waive this requirement until Dec. 31 (initially two months after the cessation of payments). In Italy, only the Public Prosecutor's Office is empowered to open default proceedings until June 30.
In France, until Aug. 24, a company director is no longer obliged to begin insolvency proceedings within 45 days of the occurrence of the suspension of payments, failing which they will be liable for late filing for bankruptcy. Until that date, the existence or absence of suspension of payments will be assessed on the basis of the company's situation on March 12. Concerning the U.K., in the margin of the entry into force of the default bill, tabled on May 20, no default proceedings may be opened by creditors. If the measures in this bill were to come into force in June, then they would expire in July.
The Netherlands is the exception within Europe: the government has not implemented any emergency default measures since the beginning of the pandemic.
Nevertheless, given the magnitude of the economic shock and the temporary nature of these measures, the latter will not prevent a substantial surge in insolvencies once they expire.
According to Coface’s forecasting models, the number of insolvencies is expected to rise sharply across Europe in the second half of 2020, and in 2021. Germany, the least affected country, is still on track for a 12% increase in insolvencies between end-2019 and end-2021. France (21%) and Spain (22%) will be more affected by the crisis. However, the largest increases in the number of insolvencies are expected to occur in the Netherlands (36%), the United Kingdom (37%) and Italy (37%).
Although insolvency forecasts are roughly in line with growth forecasts, some discrepancies are apparent. The Netherlands and Germany should be the least-affected countries, with GDP in 2021 less than 2% lower than in 2019. France and Spain would do worse with GDP less than 3% and 4%. The GDP of United Kingdom and Italy will likely be respectively 5% and 6% lower compared to last year.
In some cases, these discrepancies can be explained by the lack of a temporary amendment of insolvency proceedings (like in the Netherlands). The responsiveness of insolvencies in periods of economic contraction is also linked to the cost of the procedure (lower in the United Kingdom and the Netherlands).
Financial Conditions Have Eased,
but Insolvencies Loom Large
Tobias Adrian and Fabio Natalucci, Monetary and Capital Markets Department, IMF
Amid the human tragedy and economic recession caused by the COVID-19 pandemic, the recent surge in risk appetite in financial markets has caught analysts’ attention. After sharp declines in February and March, equity markets have rallied back, in some cases to close to their January levels, while credit spreads have narrowed significantly, even for riskier investments. This has created an apparent disconnect between financial markets and economic prospects. Investors seem to be betting that lasting strong support from central banks will sustain a quick recovery even as economic data point to a deeper-than-expected downturn, as shown in the June 2020 World Economic Outlook Update.
Tug of war
In the newest Global Financial Stability Update, we analyze the tug of war between the real economy and financial markets and the risks involved. With huge uncertainties about economic outlook and investors highly sensitive to COVID-19 developments, pre-existing financial vulnerabilities are being exposed by the pandemic. Debt levels are rising, and potential credit losses resulting from insolvencies could test bank resilience in some countries. Some emerging market and frontier economies are facing refinancing risks, and lower-rated countries have started to regain access to markets only slowly.
Major central banks around the world have contributed to the substantial easing of financial conditions via interest rate cuts and a balance sheet expansion of over $6 trillion, including asset purchases, FX swap lines, and credit and liquidity facilities. These swift and unprecedented actions by central banks have restored confidence and boosted investor risk taking, including in emerging markets, where asset purchases have been deployed for the first time. Risky asset prices have rebounded since the precipitous fall early in the year, while benchmark interest rates have fallen. With the easing of global financial conditions, risk appetite has returned also to emerging markets. Aggregate portfolio outflows have stabilized, and some countries have experienced some modest inflows again. In credit markets, spreads of investment-grade companies in advanced economies are currently quite contained, contrary to the sharp widening seen during previous large economic shocks. Spreads have also narrowed significantly in emerging countries, albeit less so in frontier markets. On net, financial stability risks in the short term are little changed since the last Global Financial Stability Report, as prompt and bold actions by policymakers have helped cushion the impact of the pandemic on the global economic outlook.
A disconnect has emerged
The disconnect between financial markets and the real economy can be illustrated by the recent decoupling between the soaring U.S. equity markets and plunging consumer confidence (two indicators that have historically trended together), raising questions about the rally’s sustainability if not for the boost provided by central banks.
This divergence raises the specter of another correction in risk asset prices should investors’ attitude change, posing a threat to the recovery. So-called bear equity market rallies have occurred in the past during periods of significant economic pressures, only to unwind swiftly.
A number of developments could trigger a decline in risk assets’ prices. The recession could be deeper and longer than currently anticipated by investors. There could be a second wave of infections, with ensuing containment measures. Geopolitical tensions or broadening social unrest in response to rising global inequality could lead to a reversal in investor sentiment. Finally, expectations about the extent of central banks’ support could turn out to be too optimistic, leading investors to reassess their appetite and pricing of risk.
Such a repricing, especially if amplified by financial vulnerabilities, could result in a sharp tightening in financial conditions, thus constraining the flow of credit to the economy. Financial stress could worsen an already unprecedented economic recession, making a recovery even more challenging.
Pre-existing financial vulnerabilities are being laid bare by the pandemic. First, in advanced and emerging market economies alike, corporate and household debt burdens could become unmanageable in a severe economic contraction. Aggregate corporate debt has been rising over several years, and it now stands at historically high levels relative to GDP. Household debt has also increased in many economies, some of which now face an extremely sharp economic slowdown. The deterioration in economic fundamentals has already led to a corporate ratings downgrade, and there is a risk of a broader impact on the solvency of companies and households.
Second, the realization of credit events will test the resilience of the banking sector as they assess how governments’ support for households and companies translates into borrowers repaying their loans. Some banks have started to prepare for this process, and expectation of further pressure on their profitability is reflected in the declining prices of their stocks.
Third, nonbank financial companies could also be affected. These entities now play a greater role in the financial system than before. But since their appetite for continuing to provide credit during a deep downturn is untested, they could end up being an amplifier of stress. For example, a sharp correction in asset prices could lead to large outflows in investment funds (as seen early in the year), possibly triggering fire sales of assets.
Fourth, while conditions have eased in general, risks remain for some emerging and frontier markets that face more urgent refinancing needs. Their debts’ rollover will be more costly should financial conditions suddenly tighten. Some of these countries also have low levels of reserves, making it harder to manage portfolio outflows. Credit-rating downgrades could worsen this dynamic.
Mind the trade-offs
Countries need to strike the right balance between competing priorities in their response to the pandemic, being mindful of the trade-offs and implications of continuing to support the economy while preserving financial stability.
The unprecedented use of unconventional tools has undoubtedly cushioned the pandemic’s blow to the global economy and lessened the immediate danger to the global financial system—the intended objective of policy actions. However, policymakers need to be attentive to possible unintended consequences, such as a continued buildup of financial vulnerabilities in an environment of easy financial conditions. The expectation of continued support from central banks could turn already stretched asset valuations into vulnerabilities—particularly in a context of financial systems and corporate sectors that are depleting their buffers during the pandemic. Once the recovery is underway, policymakers should urgently address vulnerabilities that could sow the seeds of future problems and put growth at risk down the road.
Reprinted with permission from the IMFblog.
Week in Review Editorial Team:
Diana Mota, Associate Editor and David Anderson, Member Relations