We have just been reminded about just how fragile the global economy is – Sydney Morning Herald

The Bank for International Settlements – the central bankers’ bank – puts the dimensions of that disconnect between markets and economies into perspective.

In its annual report, released on Monday, the BIS provided some reminders about the basic nature of this particular crisis.


Previous financial crises started within the financial sector and threatened to topple real economies.

This is a health issue with an impact on real economies that threatened to topple the financial sector with “potentially devastating knock-on effects as financial sector problems spill back onto the real economy.”

It is, as was recognised at the onset, a shock to both the supply and demand sides of economies, with the lockdowns impacting both the capacity to produce and the ability and willingness to consume. Investment has been hit by the uncertainty and the supply disruptions.

The initial financial market response reflected the severity of those threats, with equity markets diving in the March quarter and credit markets almost freezing before the Fed and its peers poured liquidity into their systems.

The BIS suggests central banks might have been too successful in calming markets and shoring up confidence, saying it had sparked some ‘’market exuberance,” with equity prices and corporate debt spreads seeming to have decoupled from a weaker real economy.

“Even so, underlying financial fragilities remain: this feels more like a truce than a peace settlement,” the bank said.

“And more fundamentally, what first appeared to be a liquidity problem, more amenable to central bank remedies, is morphing into a threat to solvency,” it said.

There has been a dramatic increase in downgrades by credit agencies and a surge in corporate defaults on loans.

Already this year there have been more defaults globally than in all of 2019 and there are about double the number of credit rating downgrades to the lowest rating – CCC+, which implies a substantial risk of default – than there were at the same stage of last year.

As the BIS noted, coming into the pandemic there were pre-existing vulnerabilities. As a result of the ultra-low interest rates that have been in place since the financial crisis there were high levels of financial leverage in governments, companies and households, sharemarket valuations were “frothy” and credit risk was showing “clear signs’’ of being under-priced.

Those pre-conditions have exacerbated the impact of the pandemic’s shock to economic activity.

The BIS said there are three possible phases to an economic crisis: illiquidity, insolvency and recovery, but the dividing lines between them are fuzzy. The phases over-lap.

The current crisis, it said, is generally on its way out of the illiquidity phase, with the risk of insolvencies looming and the timing and shape of recovery uncertain.

The underlying condition of real economies, once the masking effects of the monetary and fiscal policies’ initial responses to the pandemic have waned, has been downplayed or ignored by investors during the June quarter surge.

Recovery could be relatively swift if containment measures were relaxed quickly and successfully but could falter or stutter is there are new renewed lockdowns and would be weaker if the shocks were prolonged and corporate productivity and the consumer psyche were scarred and weighed on supply and demand for a long time.

The post-crisis pattern of demand could be quite different from the pre-crisis one, with significant implications for resource allocation, with some sectors and firms having no viable future. Others might thrive. Policy choices would be complicated by the non-economic nature of the underlying forces, which were “unfamiliar and impervious to economic remedies.”

The BIS said the worst outcome from government interventions would be to fail to address the debt over-hang and allow a permanent misallocation of capital, which would be aggravated by “low-for-long” interest rates and sap productivity.

The pandemic raised tricky challenges for policy buffers: banks would at some point need to replenish capital buffers, not draw them down further; central banks could face the “unpalatable’ choice of moving even deeper into negative rates and increase their already outsized ownership of financial assets and fiscal policy would need to change tack to prevent fiscal positions becoming unsustainable.

The legacies of the pandemic will be even higher levels of debt and government deficits and central banks’ ability to manoeuvre will be constrained by their inability to normalise interest rate without igniting a wave of insolvencies and blowing up financial markets.

It is the conviction that central banks, and the US Federal Reserve in particular, will keep interest rates at negligible levels for the foreseeable future that has underwritten the sharemarkets’ remarkable rebounds from their March lows despite the mounting evidence of economic damage even before governments’ fiscal support begins to run down.

The BIS says markets have become too complacent, given the early stage of the crisis and its fallout and the probability that the shock to solvency has yet to be fully felt. That will come when the ‘’cliff effects” of the expiry of initial fiscal support programs and loan repayment moratoriums run out.


The underlying condition of real economies, once the masking effects of the monetary and fiscal policies’ initial responses to the pandemic have waned, has been downplayed or ignored by investors during the June quarter surge.

Whether they can remain as sanguine as the fallout from the pandemic becomes clearer is a multi-trillion dollar question with significant implications for the finances of economies, companies, institutions and individuals.

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