Central banks in March – the first reaction to the pandemic

The central banks of the world’s major economies responded relatively quickly to the economic and financial threats caused by the pandemic by using several measures. The goal was to ensure the availability of preferential loan support for businesses and households affected by the pandemic.
Central banks in March – the first reaction to the pandemic

(Steve Parker, CC BY 2.0)

On the supply side, the effects of national quarantines, which were necessary to stop the spread of the coronavirus, include a significant decline in the productive capacity utilization and a disruption in the functioning of global supply chains. In addition, a growing number of coronavirus infections translates into reduced labor supply. The above-mentioned factors contribute to an increase in the cost of doing business and constitute a negative shock for productivity.

Meanwhile, on the demand side, the loss of income, the fear of infection and the increased economic uncertainty caused reduction of consumption. In addition, as a result of the pandemic and the social distancing measures, there has been a sharp decline in demand for services such as, among others, tourism, transport, hospitality and catering. The deterioration of consumer sentiment has led to cuts in corporate spending and investment. This, combined with liquidity shortages, could contribute to business bankruptcies and layoffs.

These phenomena are not without effect on the financial sector, which is evidenced, among others, by the significant weakening of sentiment, the high price volatility on the capital markets and the episodes of panic asset sell-offs. The increased uncertainty about the situation of enterprises and households in the subsequent months of 2020 could result in an increase in the cost of credit financing and, consequently, the further build-up of liquidity problems in the real economy, a significant impediment to capital accumulation/formation in the economy, and the intensification of the economic downturn caused by the supply and demand shocks. Moreover, among the observed or expected effects of the spread of the coronavirus, we should also include a decline in world trade (the optimistic forecast of the World Trade Organization assumes that in 2020 the global trade in goods will be about 13 per cent lower than in 2019, while the pessimistic scenario assumes a decrease of 32 per cent), a decline in prices on the world commodity and raw materials markets, and the outflow of capital from emerging markets towards countries perceived by investors as “safe havens”.

Crisis: V-, U- or L-shaped?

Due to the high level of uncertainty about the scale and duration of these shocks, it is still impossible to accurately estimate the size of the economic crisis caused by the pandemic. All the latest forecasts of international financial institutions, such as the International Monetary Fund (IMF), the World Bank (WB), and the Bank for International Settlements (BIS), predict a global recession in 2020. Its duration and depth remain an open question, and will depend on the further development of the epidemic situation and the effectiveness of the fiscal and monetary policy actions implemented in the individual countries. The positive scenarios assume — on the global scale — that the spread of the pandemic will be stopped in the next few months and that it will be possible to avoid catastrophic, structural economic consequences. In such a case, the recovery from the crisis would be V-shaped (a relatively quick rebound in GDP growth) or U-shaped (an economic slowdown, followed by a recession, and a slow rebound).

In the negative scenario which cannot be completely ruled out, the coronavirus could continue to spread throughout the year (which would only be stopped after the development and introduction of a widely available vaccine). In combination with the low effectiveness of the undertaken fiscal and monetary policy measures, the resulting economic crisis could be L-shaped (a sharp economic collapse followed by a long recession). It should be stressed that the course of the crisis in all the above mentioned scenarios could vary: the bottom of the V-shaped crisis may be deep or shallow, and the growth rate which the economy reaches after a U-shaped crisis may be higher or lower than the pre-crisis growth rate.

The key factor determining the trajectory of the crisis caused by the coronavirus is the strength of the shock impacting the supply side of the economy, including in particular the capacity for capital formation/accumulation. If the current crisis in the real economy leads to disruptions in the functioning of credit intermediation channels, a reduction in the availability of credit, and an inhibition of capital growth in the economy, then the road to economic recovery will be long, and the supply shock will become structural. It is possible, however, that at global level the crisis will assume a V-shape or a U-shape, and its bottom will be deep in both cases. On the other hand, at the level of individual countries, the crisis could assume each of the three above mentioned shapes, which is primarily due to the differences in the structural resilience of the national economies to the emerging shocks and in the ability of medical researchers and policy makers to implement new ways of responding to the unprecedented challenges generated by these shocks.

The representatives of international financial institutions unanimously emphasize that an effective response to this economic crisis requires effective, coordinated actions in the field of fiscal and monetary policy, implemented both at national and regional level, as well as global one. According to Kristalina Georgieva, the Managing Director of the IMF, it is important to provide direct fiscal support to the most vulnerable households, as well as large and small enterprises. But it has to be done in such a way that it protects jobs and prevents a broad wave of bankruptcies, whose effects would be felt over the next several years. Agustín Carstens, the General Manager at the BIS, spoke in a similar vein. He emphasized that one of the main objectives of the interventions undertaken by central banks in response to the COVID-19 crisis should be to ensure the availability of preferential loan support for businesses and households directly affected by the economic consequences of the pandemic. At the same time, Mr. Carstens pointed out that it was necessary for commercial banks to become involved — with the use of central banks’ resources — in providing the missing liquidity to companies, especially in light of the significantly reduced ability to obtain liquidity in the capital markets. According to Mr. Carstens, the banks should be a part of the solution, and not a part of the problem. In the current situation they should draw on their capital buffers and increase their lending capacity by not paying dividends or buying back own shares. The burden of mitigating the effects of this crisis rests primarily on fiscal policy, but monetary policy and the cooperation of the banking sector with fiscal and monetary authorities also plays an important role.

IMF crisis monitoring

In light of the vast scope of the pandemic and the global nature of the associated consequences, at the end of March 2020, the IMF launched a special tool tracking the fiscal and monetary policy measures implemented in various countries in response to the spread of the coronavirus. This tool is updated on a regular basis and constitutes a knowledge base on the member countries’ experiences in the fight against the socio-economic effects of the pandemic.

According to the information contained in the database, the central banks of the world’s major economies responded relatively quickly to the economic and financial threats caused by the pandemic and used several measures.

Interest rate cuts

The monetary policy was loosened in most of the major economies, and the monetary authorities of some countries (e.g. Saudi Arabia, Australia, Canada, the United States, the United Kingdom) lowered interest rates twice within a month. It’s worth noting the unprecedented scale of the actions undertaken by the United States Federal Reserve: on March 3rd, the Federal Open Market Committee (FOMC) decided to lower the target range for its Federal Funds Rate by 50 basis points, to the level of 1-1.25 per cent, and on March 15th, it reduced the range by a further 100 basis points to 0-0.25 per cent, thereby implementing the single largest interest rate cut in the history of the Fed. After two reductions of the base rate in the United Kingdom (by 50 basis points on March 10th, and by 15 basis points on March 19th), it now amounts to 0.1 per cent, which is the lowest level in over 300-year history of the Bank of England.

Reduction of the reserve requirement ratio

This step was taken, among others, by the central bank of Brazil, the central bank of Indonesia, the central bank of Malaysia, the Bank of Mexico, the central bank of the Republic of Turkey and the Fed, which reduced the reserve requirement ratio to 0 per cent, which is in practice equivalent to its abolishment.

Increase in the scale and the frequency of repo operations supplying banks with liquidity and the launch of repo operations with longer maturities (e.g. 6-month or 12-month)

One example could be the additional Long-Term Refinancing Operations (LTROs) of the European Central Bank, carried out with a weekly frequency, with the maturity date set for June 2020. The additional instrument used to support the liquidity of financial institutions was the Standing Term Liquidity Facility launched by the Bank of Canada.

Launch or expansion of the purchases of government debt on the secondary market

Such programs were launched by the Reserve Bank of Australia, the Federal Reserve, the Bank of Korea, the South African Reserve Bank, and the Bank of Thailand. Meanwhile, the Bank of England, the European Central Bank, the Bank of Japan, and the Bank of Canada. They all increased the value of the existing programs.

Implementation of instruments that provide funding for the financial institutions. The goal was to increase number of loans given to entities in the real economy, and especially to SMEs, or to enable the suspension of repayment of loans taken by SMEs prior to the pandemic

One example of such activities could be, among others, the Private Sector Financing Support program, which is worth a total of SAR50bn and is implemented by the Saudi Arabian Monetary Authority (SAMA). Other similar programs include the Special Funds-Supplying Operations implemented by the Bank of Japan in order to help Japanese companies in obtaining financing from financial institutions, as well as the SME Lending Support Facility program implemented by the Bank of Russia, with a total refinancing limit of RUB500bn.

Establishment of corporate debt securities purchase programs

The examples include the COVID Corporate Financing Facility implemented by the Bank of England and Her Majesty’s Treasury (the United Kingdom’s finance ministry), the Primary Market Corporate Credit Facility and the Secondary Market Corporate Credit Facility launched by the Fed, as well as the Pandemic Emergency Purchase Program, under which the European Central Bank (ECB) is purchasing private and public sector debt securities.

Carrying out interventions in the currency market

The goal of these activities was strengthening the management of foreign currency liquidity, as it was done by the central bank of Indonesia, or limiting the appreciation of the domestic currency which was the goal of the Swiss National Bank.

Coordinated efforts undertaken by the Fed together with the ECB, the Bank of England, the Bank of Japan, the Bank of Canada, and the Swiss National Bank in order to provide global USD liquidity

These central banks have agreed to lower (by 25 basis points) the valuation of all USD operations implemented under the existing swap agreements, and also started offering USD operations with 84-day maturity (with a weekly frequency) in their jurisdictions and decided to increase from weekly to daily the frequency of USD operations with 7-day maturity.

Establishment of temporary USD swap lines by the Fed

The swap lines were established with the Reserve Bank of Australia, the central bank of Brazil, the central bank of Denmark, the Bank of Korea, the Bank of Mexico, the central bank of Norway, the Reserve Bank of New Zealand, the Monetary Authority of Singapore, and the Swedish central bank.

Launch of the FIMA Repo Facility by the Federal Reserve

This is a temporary program of repo transactions for foreign central banks and other international monetary authorities, which is supposed to enable them to temporarily exchange their holdings of US treasury securities for USD. In the opinion of the Fed this instrument should help in the smooth functioning of the US treasury market by providing an alternative temporary source of USD other than the sales of securities in the open market. In practice this tool may be used by the central banks of countries whose currencies are characterized by lower liquidity or high volatility.

Loosening of macro-prudential policy regulations

Such a step was taken, for example, by the Hong Kong Monetary Authority, which lowered the countercyclical capital buffer (CCyB) by a half, that is, from 2 per cent to 1 per cent, and also by the Bank of England’s Financial Policy Committee, which decided to reduce the CCyB to 0 per cent.

Some measures were implemented prior to the pandemic

Just like during the global financial crisis, out of the above mentioned measures, the central banks most frequently applied interest rate cuts, repo operations, and quantitative easing, i.e. purchases of financial assets (including government and corporate bonds). It should be noted, however, that some central banks (e.g. the ECB and the Bank of Japan) had already entered the territory of negative interest rates and had been conducting quantitative easing (QE) before the outbreak of the pandemic, which could result in the reduced effectiveness of these instruments in the context of the COVID-19 crisis.

In light of these constraints, and perhaps in anticipation of the expectations expressed by the BIS’ General Manager, in the first round of response measures in March 2020 most central banks also reached for previously unused instruments which were supposed to provide — through the banking sector and the capital market — preferential financing to companies affected by the pandemic. These measures certainly complement the fiscal policy solutions, which are being implemented by governments. However, the full assessment of their effectiveness will be possible after the current crisis is resolved.

It seems that success depends on the further strengthening of responsible cooperation between fiscal and monetary authorities and the financial sector, the willingness to modify the implemented tools along with the further development of the epidemic situation, and on an adequately quick reaction to any new financial and economic challenges associated with the COVID-19 pandemic.

The views expressed in this article are the private views of the author and are not an expression of the official position of the NBP.

(Steve Parker, CC BY 2.0)