The global COVID-19 pandemic has resulted in soaring infection rates, widespread lockdowns, record-shattering declines in output, and spiking poverty. But, in addition to these trends, a quieter crisis now gaining momentum could jeopardize economic recovery prospects for years to come.
The term “financial crisis” has long been associated with dramas such as bank runs and asset-price crashes. Charles Kindleberger’s classic books The World in Depression, 1929-1939 and Manias, Panics and Crashes, and my own work with Kenneth Rogoff, This Time Is Different, document scores of these episodes. In recent years, the term “Lehman moment” has stood out as a marker of the 2007-09 global financial crisis and even inspired a Broadway show.
But some financial crises do not involve the drama of Lehman moments. Asset quality can deteriorate significantly as economic downturns persist, especially when firms and households are highly leveraged. Moreover, years of bank lending to unproductive private firms or state-owned enterprises (the latter is not uncommon in some developing countries) take a cumulative toll on balance sheets.
Although these crises may not always include panics and runs, they still impose multiple costs. Bank restructuring and recapitalization to restore solvency can be expensive for governments and taxpayers, and new lending can remain depressed, slowing economic activity. The credit crunch also has distributional effects, because it hits small and medium-size businesses and lower-income households more acutely.
To be sure, the COVID-19 pandemic continues to deliver many moments of unwanted drama, including soaring infection rates, widespread lockdowns, record-shattering declines in output, and spiking poverty. But, in addition to these trends, a quieter crisis is gaining momentum in the financial sector. Even without a Lehman moment, it could jeopardize prospects for economic recovery for years to come.
Specifically, financial institutions around the world will continue to face a marked rise in non-performing loans (NPLs) for some time. The COVID-19 crisis is also regressive, disproportionately hitting low-income households and smaller firms that have fewer assets to buffer them against insolvency.
Since the onset of the pandemic, governments have relied on expansionary monetary and fiscal policies to offset the steep declines in economic activity associated with broad-based shutdowns and social-distancing measures. Wealthier countries have had a decided advantage in their ability to respond, although a surge in lending by multilateral institutions has also helped to finance emerging and developing economies’ response to the health emergency.
Unlike in the 2007-09 crisis (or most previous crises, for that matter), banks have supported macroeconomic stimulus with a variety of temporary loan moratoria, as the International Monetary Fund has documented in its Policy Tracker. These measures have provided some respite for households facing loss of employment and a decline in income, as well as for businesses struggling to survive lockdowns and general disruptions to normal activity (tourism-linked sectors stand out starkly in this regard).
Financial institutions in all regions have granted grace periods for repayment of existing loans, and many have re-contracted loans in favor of lower interest rates and generally better terms. The understandable rationale has been that, because the health crisis is temporary, so is the financial distress of firms and households. But as the pandemic has persisted, many countries have found it necessary to extend these measures until 2021.
Alongside the temporary moratoria, many countries have relaxed their banking regulations regarding bad-loan provisioning and the classification of loans as non-performing. The upshot of these changes is that the extent of NPLs may currently be understated, and for many countries markedly so. In many cases, financial institutions may be insufficiently prepared to deal with the hit to their balance sheet. The less regulated non-bank financial sector, meanwhile, has even greater exposure to risk (compounded by weaker disclosure).
Adding to these private-sector developments, downgrades of sovereign credit ratings reached a record high in 2020 (see figure below). Although advanced economies have not been spared, the consequences for banks are more acute in emerging and developing economies where governments’ credit ratings are at or near junk grade. In more extreme cases of sovereign default or restructuring – and such crises are on the rise, too – banks will also take losses on their holdings of government securities.
As I argued in March 2020, even if one or more effective vaccines promptly resolve the pandemic, the COVID-19 crisis has significantly damaged the global economy and financial institutions’ balance sheets. Forbearance policies have provided a valuable stimulus tool beyond the conventional scope of fiscal and monetary policy. But grace periods will come to an end in 2021.
As the US Federal Reserve’s November 2020 Financial Stability Report highlights, policy fatigue or political constraints suggest that forthcoming US fiscal and monetary stimulus will not match the scale reached in early 2020. Many emerging markets and developing countries are already at or near their monetary-policy limits as well. As 2021 unfolds, therefore, it will become clearer whether countless firms and households are facing insolvency rather than illiquidity.
Firms’ high leverage on the eve of the pandemic will amplify the financial sector’s balance-sheet problems. Corporations in the world’s two largest economies, the United States and China, are highly indebted and include many high-risk borrowers. The European Central Bank has repeatedly voiced concerns about the rising share of NPLs in the eurozone, while the IMF has frequently warned about the marked increase in dollar-denominated corporate debt in many emerging markets. Exposure to commercial real estate and the hospitality industry is another source of concern in many parts of the world.
Balance-sheet damage takes time to repair. Previous overborrowing often results in a long period of deleveraging, as financial institutions become more cautious in their lending practices. This muddling-through stage, usually associated with a sluggish recovery, can span years. In some cases, these financial crises develop into sovereign-debt crises, as bailouts transform pre-crisis private debt into public-sector liabilities.
The first step toward dealing with financial fragility is to recognize the scope and scale of the problem, and then expediently restructure and write down bad debts. The alternative – channeling resources into zombie loans – is a recipe for delayed recovery. Given the pandemic’s already huge economic and human costs, avoiding that scenario must be a top priority for policymakers everywhere.