BIS Media Briefing 29 June 2020 - Annual Economic Report 2020

Agustín Carstens, General Manager; Luiz Pereira da Silva, Deputy General Manager; Claudio Borio, Head of the Monetary and Economic Department; and Hyun Song Shin, Economic Adviser and Head of Research

Agustín Carstens: 

Thank you for joining us this afternoon to discuss this year's Annual Economic Report and Annual Report, our 90th.

The shock of the Covid-19 pandemic has turned out to be a defining moment. The containment measures are inflicting an enormous global economic blow, and the long-term effects will be profound.

The global sudden stop in economic activity makes this crisis unique. The worldwide lockdowns have crippled both supply and demand, crushing the production and exchange of goods and services.

Central banks have done their utmost to deliver within their mandates, as we discuss in the Report. As lenders of last resort, they have reacted promptly to stabilise markets. By providing monetary accommodation, even further expanding their toolkit, central banks have sought to support financial stability and supplied oxygen to the global economy, preserving firms and saving jobs.  Notably they have coordinated effectively with fiscal authorities to cushion the blow.

Nimbleness, boldness and decisiveness were called for. And central banks delivered. However, it has been quite challenging, given the limited policy space available before the pandemic and the build-up of underlying vulnerabilities, particularly in the non-bank financial sector.

Central banks have succeeded in many of their aims. Markets have stabilised and businesses have started issuing debt again. Even so, many challenges lie ahead.

We have only just overcome the liquidity phase of the crisis in countries that are now relaxing restrictions. In many others, the health crisis is still acute. And the epidemic could flare up again anywhere.

Financial markets may have become too complacent - given that we are still at an early stage of the crisis and its fallout.

The economic outlook is still highly uncertain.

Importantly, the shock to solvency is still to be fully felt. Business insolvencies and personal hardship may well increase.

In the solvency stage, the heavy lifting is expected to come from fiscal authorities.

Risks are especially high for emerging market and developing economies, which experienced a triple sudden stop: in domestic economic activity, in capital flows and, for several, in commodity exports and remittances.

Central banks face many questions and trade-offs. Let me mention four.

First, central banks have been forced to navigate within what is, in normal times, private sector territory.

This brings economic and political risks to the fore. For example, there may be painful but necessary downsizing in some sectors. What is the best way to differentiate between viable and non-viable firms?

Second, interactions between monetary and fiscal policies have become even more prominent.

In their crisis reponse, central banks smoothed the path for government financing. However, this should only be a temporary expedient. And it should only be tried by central banks with a credible record of adhering to inflation mandates. These types of policy are only possible because of the credibility that monetary policymakers have built up over the years.

When crisis management gives way to ensuring price stability, it will be critical that central banks remain independent and act without hesitation to fulfil their mandates.

Third, as soon as circumstances allow, central banks need to regain monetary policy space.

Eventually inflation will come back. As the recovery takes hold and the pricing power of firms and labour increases, upward price pressures will emerge. Staying ahead of the curve will be essential.

Finally, central banks need to continue to underpin financial stability.

As regulators and supervisors, they must balance the use of buffers and the need to support the economy, with financial stability.

Central banks also have to revisit the size and design of their financial systems. They strengthened the banks post-GFC; now they need to help ensure that the non-bank financial sector optimally supports the real economy over the medium term.

Bottom line. The global economy seems to be recovering, much remains to be done. The virus is far from defeated, and many countries, especially those with weaker defences, are still in the early phase of the struggle. The next tasks will be to address solvency, prepare for the recovery, and adjust the economy to the post-pandemic world.

Central banks are fully aware of the challenges ahead. Some of these challenges extend beyond their mandate. Monetary policy alone cannot deliver higher sustainable economic growth in the context of price and financial stability. Growth-friendly fiscal policies and structural reforms are still urgently needed.

So this is the main message, the thrust of chapters one and two, and now we are very happy to take any questions you might have.

In the report, you talk briefly about money market funds and about extending the regulatory horizon, or something, to asset managers. I just was wondering what you exactly thought should be done there and what the problem ... Obviously, various central banks have said that they've got an eye on money market funds. What, in your view, went wrong this time round, and what's needed to fix it?

Agustín Carstens:

The very blunt observation we made in the report is that for the second time in a little bit more than a decade, major central bank action has needed to be mobilised to underpin money market funds. They have observed some form of run-like activity, and of course, that could have a systemic dimension. Therefore, I think the least that central banks can do, and the other financial authorities, is to take a good look into this activity.

Hyun Song Shin:

I think, on the market-based finance topic, one thing that is a silver lining this time around has been the resilience of the banking sector. The banking sector was at the epicentre last time around, during the GFC. This time around, they were much more resilient, but what we did see was that market-based finance was more fragile. We saw that money market funds, especially the so-called prime money market funds that were financing private sector entities, especially banks, they were also subject to withdrawals with considerable knock-on effects elsewhere. Dollar funding is something that is interconnected with money market funds because it is also about short-term funding conditions.

Now, there has been a lot of progress since the GFC on market-based finance. It's not as if this topic has been off the radar screen. But I think what we saw was that, in spite of the progress we have seen, there were some vulnerabilities. And so I think this is one area where we would need to look into some of the underlying causes of the vulnerabilities a little bit closer, so that we can put in place remedial measures as they are deemed necessary.

I think central banks are particularly interested in this topic because what we saw was that during the acute phase, in March, it was very expeditious, very sizable central bank interventions in the market, which actually were pretty important in stabilising these funding markets. And so for the benefit of ensuring that we don't see these vulnerabilities again, I think this is something that we would need to look at fairly closely.

Obviously, there was a chapter you released a few days ago on digital payments and central bank digital currencies, and it's pretty much a message that we're embracing this world more generally. So just in light of the Wirecard scandal that's broken in Germany, what lessons need to be learned as a result of that?

Agustín Carstens:

What we do in chapter three is to anticipate that as developments in the payment systems area and innovation continues, one of the key aspects will be how different non-bank participants and payment service providers can be incorporated into the whole scheme. There is certainly a mushrooming of many of these participants joining into the payment system, and therefore I think that the regulatory and supervisory perimeter will have to be enlarged.

Now, in particular, very, very close to Wirecard, even though we are not experts and we're not the relevant authorities necessarily to follow this case, my sense is that most of it is plain and simple fraud, accounting fraud, malfeasance. Therefore, it's hard to extract at this stage, based on the information we have, if some particular regulation or supervisory action by some authorities will need to be undertaken. As more details transpire, I think that we will be able to pinpoint more, if, or not, further supervisory and regulatory action is needed. And in particular, also, it would be important to see how the accounting fraud took place and if there are any lessons that could be extracted from there and remedy the circumstances, if present elsewhere, immediately.

The report says that this inflation is likely to continue until the COVID-19 crisis ends, but when there is some return to normality, inflation could accelerate. You say that central banks should be independent, stay ahead of the curve, and raise interest rates, but multi-trillions of corporate and household debt will still be present, so won't there be a risk of further insolvencies and a sharp decline in financial asset prices? Are the FED, BoE, and other central bankers actually listening to BIS's warnings? There's no evidence of that. Before COVID-19, QE had caused asset price inflation and debt to soar.

My second question relates to emerging markets. They have some $4 trillion in US dollar and euro debt. That has now propped up the dollar, which has accentuated the strain on them. How do you overcome that particular problem?

Agustín Carstens:

Certainly, we are living under really unprecedented circumstances, and therefore the joint action between fiscal and monetary policy in this case was of the essence. At the end of the day, we strongly believe that the monetary arrangements based on inflation targeting with an autonomous central bank operating is still a relevant framework. What we are expecting is that, eventually, inflation will start recovering and that it will tend towards the objectives of central banks. And what we believe is of the essence is that, as we approach those limits or those objectives, central banks should start minding inflation seriously and start acting in consequence. It's too hard to say when this will happen, but eventually it will happen.

Now, of course, as inflation creeps up and so on, that means that economic activity will be picking up too, and in a way, this will come with probably a positive environment so that tighter monetary conditions would be achievable without having an undue impact on the recovery. The solvency issue you are mentioning, yes, it probably will come, but in some ways, more in some than in others. I think a lot of the action of fiscal and monetary policies in the last months is precisely to prevent or to reduce the incidence of solvency issues. But as this shows, basically, these need to be absorbed through fiscal means. This is not a task for central banks.

Now, in terms of emerging markets, yes, they have to be very mindful about the debt they have in foreign currency. I think, all in all, most emerging markets are capable of handling this. I think where more developments have been present is in corporate debt, and there, basically, it will be important to follow the capacity of different corporate tool services. We're not anticipating at this stage a widespread problem, but yes, it's an issue that we need to watch, and it's something that needs to be scanned permanently to see if a major vulnerability is building up in that margin.

I was wondering, in the corporate bond market, we saw some curious phenomena during the sell-off where we saw these deviations between the ETF share prices on net asset values, but these gaps have appeared to be resolved by markets using ETFs as a tool for price discovery, and we've also seen the Federal Reserve supporting market liquidity now in this market.

I guess, the question that I had from a research point of view is whether there is the possibility for this market, this capital market, the corporate bond market, to have been brought into the fold of public institutions just like bank lending is, and whether you think we'll see consequences of this both for the international funding market, global financial institutions, and the way that financial markets react to shocks.

Hyun Song Shin:

I think the one very important backdrop here is that there has been a very big shift from banking sector financing of firms to market-based financing. Much more so than in the lead up to the GFC, what we saw was that the corporate bond market, both directly held and through mutual funds and ETFs, were very important sources of funding for corporate. It was the market-based funding which saw the stresses in the acute phase back in March.

You're raising an interesting question here about ETFs. And as you say, there was a gap between the traded prices, and these are exchange-traded instruments, so there is a market price, but then there's the underlying net asset value. And what we saw was that, during the acute phase, there was a gap, there was a discount relative to net asset value. It reflected the underlying difference in liquidity between the bonds that are held in these ETFs versus the traded instrument itself.

Now, to some extent, we may see this as a very natural and a very helpful automatic adjustment mechanism in that one of the things we can potentially worry about in collective investment vehicles is that there may be a run incentive where, if you worry about other investors taking their money out first and leaving less value in the fund, you may want to try and head to the front of the queue. Now, if you on the other hand have a discount relative to net asset value, you may in fact be more relaxed because, when the investor redeems, or rather sells, it's taking away less than the underlying net asset value, so it actually somehow mitigates the run incentive.

In the emerging market ETFs, what we do see is that the outflows from emerging market bond ETFs were slightly less than the emerging market local currency mutual funds. So we do perhaps have a very natural stabilisation device there. Now, these exchange-traded products also have more exotic structures, and there, I think we saw, for example, with the oil ETFs and other volatility derivatives-based, exchange-traded products, that there could be other dynamics kicking in. So it's not a completely one-sided calculus, but I think there are some interesting lessons that we can draw from the March experience.

Following up on one of the earlier questions, sort of mentioning the thought, at the acute phase gradualism doesn't work. You also highlighted that there is a model hazard element in the later stage. I'm just wondering, the later stage cuts in the current recovery of later phases. Is there any guiding principle similar to the one 'gradualism doesn't work in the earlier era'?

You mentioned central banks need to mind inflation, but there are some discussions that nowadays, real inflation, given various circumstances, doesn't really pick up. All things showed up in the asset markets, causing a kind of asset market inflation. Are you suggesting as long as central banks don't take into account this potential financial stability concern and if government and fiscal authorities, don't step up to the plate given various considerations, do central banks need to forever support the economy or the real economy?

Agustín Carstens:

Certainly, central banks have been deeply concerned about financial stability. And as a matter of fact, I would say that many of the measures, if not the vast majority of the measures, that they have undertaken during this year have had financial stability in mind. Obviously, the liquidity problems that showed up in markets, if they were not taken care of, they risked augmenting the severity of the crisis and basically bringing contagion to other areas of the economy.

Now, of course, the way you take these financial stability concerns - and you saw them basically using their lender of last resort hats - at some point, as you create a lot of liquidity, yes, you might be creating some issues related to the pricing of assets, and we mention these in the report. Central banks need to be very mindful about developments in asset prices. And as we have said before in different fora, in different vehicles, central banks might need to use macroprudential policies to address also financial stability concerns, in particular when monetary policy still has some important tasks to be fulfilled.

Now, of course, in terms of supporting economic activity, the basic policy of accommodation of central banks so far has worked well, but as we mention or emphasise in the report, they by themselves, monetary policy by itself, cannot accelerate growth, and therefore here we call for additional support from fiscal action and also from structural reforms.

I think an aspect we haven't seen mentioned and discussed with the amplitude it requires is the aspect of structural reforms. Growth will be of the essence in the future, and therefore we need to mobilise more policies to induce that growth. At least, we should also prevent certain trends that might affect growth in the future to not be ingrained. For example, we're very concerned that protectionism at some point may affect potential growth in the global economy.

In a broader sense, your question reflects that it seems that monetary policy can be overloaded with too many objectives. And in a way, you're right, monetary policy cannot satisfy all of them at the same time. And therefore, collaboration, coordination, with other policies is of the essence.

I have a question regarding the issue of debt. You write in your report that debt restructuring will be required. I would be happy if you could elaborate a bit on this topic. To what extent should debt restructuring be fulfilled, and to what sectors do you see the most probability for debt restructuring?

Claudio Borio:

Well, it's inevitable to the extent that we are going to be seeing defaults. Debt will have to be restructured. And we know what the mechanisms are. They range from formal bankruptcy proceedings to more informal methods, out of the court methods. And here we can see that the role of the official authorities or public authorities in general, as Agustín was saying, is going to be critical from providing some kind of general guidance, sometimes going even to taking on some equity shares in the relevant companies.

Now, the general task can be put in very, very simple terms. You have to distinguish the firms that are viable and those that are non-viable. And to the extent that there is simply a debt overhang but the firm is viable, you're going to be restructuring the debt. That's easier said than done, not least because we know there's going to be huge uncertainty about what the pattern of aggregate demand across different sectors is going to be following the crisis. How much are people going to change their consumption habits and the like? But unfortunately, there is no magic wand, and here it's going to be a question of making the right choices.

I'd like to pick out the part in your report that's about prudential policy for banks because you say that remarkable ... Let me quote: "A remarkable development, prudential policy has played a key role in sustaining credit to the economy and preventing banks from deleveraging." Here in Europe, I've heard supervisors complain that banks haven't actually started lending more because they're terrified of digging in to their buffers, in part because they don't know when they'll have to bring them back up to norms. So they're being too prudent, more prudent than regulators would like. Is that a structural failing in the way banks' prudential policy is run, and what kind of features would you need to see in an exit strategy in order to encourage banks to lend more during a crisis that will have a very uncertain ending?

Claudio Borio:

I think that the first point to make is that it's the starting point of the whole crisis and how the crisis found banks. The fact that we're even contemplating this kind of policy response, which is to encourage banks to lend, could only have been the case, or it is only the case, because banks were quite strong to start with, and that's thanks to the post-GFC, great financial crisis, regulatory reforms. That's point number one.

Point number two is that it indeed is quite unprecedented for the authorities to respond in the way they have, which is to encourage banks to support the economy, as opposed to try and get them to become more risk-averse, which is typically the knee-jerk reaction that some supervisors might have. And this is testimony to the shift in general thinking that has taken place from looking at institutions on a standalone basis to looking at them as part of the system, what people have talked about in terms of going from a microprudential to a macroprudential perspective.

Point number three. Is there an issue about banks being reluctant to use buffers? Yes, there is an issue, and that's quite natural. When you see that the situation is deteriorating, you try to pull your horns. Having said that, supervisors have taken a couple of important measures.

First of all, what they can do is to try and make it easier for the banks to use the buffers, and they have done that by adjusting some regulations and adjusting the supervisory stance. Second, what you can do is to make sure that banks have sufficient resources to lend, and they have done that by taking a number of distribution restrictions. Third, you can make sure that those distribution restrictions do not inhibit lending, the incentives to lend, and they have done so by having distribution restrictions that are not a function of the size of the buffers.

But at the end of the day, banks will lend if they think they're not going to be making losses, and that's why government guarantees in that context of being essential. Is there a fundamental problem with the design of the buffers? I would say no. Can there be refinement? Probably yes, but that's not going to change the fundamental economics.

The report talks about looming bankruptcies. Is this corporate bankruptcies or personal bankruptcies?

For decades, we have known, around this time, baby boomers would be selling off their assets, and this would have a profound impact on the financial markets. What impact on top of that does the fact that many of the boomers are actually dying from COVID-19? How does the COVID-19 impact the effect that retiring baby boomers are having on the financial markets?

Agustín Carstens:

Claudio already mentioned different types of bankruptcies. I think this is an issue that has particular importance given the nature of this episode associated with COVID-19. As we describe in the document, one very important characteristic of this drop in global economic activity is that it was basically induced by the corrective measures to attack the pandemic. We have remarked that it has been of the essence to provide support for firms because many of them do not have enough cash to make it through this period of distancing and disruption in the markets. A lot has been done, but needless to say, there are firms that will not make it.

The other aspect that we're seeing is that, probably a more long-lasting, and still this is an undercurrent that is out there that is very strong, is that probably COVID-19 and this period of slowdown will accelerate the impact of, for example, technological change or deep-rooted structural issues with some sectors. Of course, every business, every institution will rethink how they are doing their business and how this will probably impact them. And of course, it might be that, for example, we'll see less travel in the future. It's very likely that we will see more e-commerce in the future. These are tendencies that were out there, but they are being speeded up by COVID-19. And of course, this might have some impact on some firms. So we need to be ready. Hopefully, this will be not as broad as we expect, but it will be there.

And this also will hit some individuals, regretfully, because there will be cases where jobs will be destroyed and will not come back. Therefore, some people will lose their maintenance of income, and they will have to reinvent themselves. These aspects are still ahead of us, and hopefully we will manage to navigate through them.

Now, baby boomers selling their assets, yes, they might have an impact on the markets. What we are seeing is a change in the composition of market participants. Of course, here, what is helping out is the liquidity provided by the different authorities. So that has helped stabilise markets. It's not a broad protection to protect specifically returns but to do some, I would say ... basically to look after financial stability.

Now, if some of the baby boomers will be dissaving now, the other thing that is to be expected is that others will be saving more. And as a matter of fact probably, that's a concern I might have because with the uncertainty surrounding COVID-19 and the future, it's very likely that the propensity to save of many firms and individuals might increase, and that by itself brings other sorts of macro considerations that are non-negligible.

On the resilience of CCPs, I'm looking back to the report you issued in May, and you also mention resilience of CCPs in the Annual Report as well. This was the report on CCP model risk, where you concluded that more skin in the game would reduce initial margin breaches. At the time, you said that the findings were relevant for policy, so I was wondering, since then, how those findings had been acted on since the paper was released, whether they'd been adopted by CCPs and forwarded to regulators or been used to influence regulators in any way.

Hyun Song Shin:

I think you're referring to the BIS Bulletin that we put out separately from the Annual Economic Report, but we had one on CCP resilience during the acute phase. I think the first point to mention is that the CCPs, the central counterparties, performed in the way that we would expect during episodes like this. We saw that the infrastructure continued to function. We saw that this was one part of the system that stayed resilient. And it was, I think, a good validation of the work that's been put in since the GFC in putting in place central counterparties so that we can reduce the reliance on bilateral margining and the complex web.

I think what you were referring to in your question was the finding in the report where the initial margins rose. And I think this is something that regulators have noted and taken note of. I think it's quite natural that margins would increase during periods of heightened volatility. The margins are there to take account of in a potential counterparty risk. I think the issue is, can we design it in such a way that the system works in a less pro-cyclical way? Overall, I think the experience in March was that the system came out of that particular episode quite well, but I think this is one area where we can still go into some of the details to learn some additional lessons as necessary.

And the objective here would be, make sure that the system works in a resilient way, make sure that the margins and the margining practices take account of the prevailing market conditions, but make sure that also you do not inject additional pro-cyclicality into the institutions. So I think those would be the broad objectives. Yes, we have had some very good feedback. And of course, we're at the intersection of many different strands of the discussion, and all of that is being fed in.

Correct me if I'm wrong, but I believe earlier, when you were addressing one of the other questions, you mentioned that emerging market debt is maybe not expected to be a widespread issue, at least compared to corporate debt. So I guess we've seen countries issuing new debt to fund fiscal policy measures using surpluses and so on. I wonder, how sustainable do you think this is given that tax revenues perhaps might take some time to recover and businesses and households, I guess, continue to suffer their own losses during this crisis? I suppose the question is, how do governments continue to fund additional fiscal policy measures? And, I guess, going back to your earlier point, why is it that emerging market debt is not expected to be a widespread issue?

Agustín Carstens:

This is a comment based on the perception of the asset class as such, but inside this asset class, certainly, there are always nuances, and so we need to differentiate. And we say this in the report, especially how active some countries can use, for example, fiscal policy in terms of having a counter-cyclical instrument to buffer the impact of the pandemic will depend on the underlying strengths of the economy. A clear example is, of course, oil-exporting countries. With the depression in the price and so on and so forth, many countries will not have the revenue that they were expecting, and therefore, that should limit their appetite to contract additional debt.

I think that what we say is that, generally, emerging markets have entered into this crisis period relatively stronger than, for example, before the GFC. That has given them some degrees of freedom both in the monetary and the fiscal area. But certainly, and we underline this in the report, by no means is it comparable to the degrees of freedom that advanced economies have. So I think emerging markets have to be more prudent, and they should be very, in a sense, conservative.

Of course, something that is helping them today in terms of that contracting and so on and so forth is the fact that there is plenty of liquidity in the market. They can borrow for long-term tenors. That implies probably less pressure in the future. And of course, the cost of financing is at an all-time low, and that will give them some degree of freedom. But all in all, they should mind a lot that sustainability and prevent, as much as possible, downgrades.