Central banks respond aggressively to COVID-19, how effective is this?
Synopsis: Central Banks have cut interest rates to historic lows in an attempt to reduce the adverse impact of COVID-19, while unprecedented liquidity infusions have been used to reduce funding constraints and frictions in financial markets. Monetary policy will lessen the economic and financial fallout from the virus, policymakers should emphasize the need for targeted fiscal measures to complement accommodative monetary policy and central bank liquidity. These should culminate in fiscal transfers, wage subsidies and a significant reduction in social security contributions for households. Nevertheless, central banks should begin stemming structural vulnerabilities in financial markets and ensure that liquidity infusions are a short-term measure designed to improve the transmissions of monetary policy rather than create financial market dependence, as has been the case since the financial crisis.
The Coronavirus or COVID-19 has caused the global economy to grow at a slower pace, government yields have tumbled and liquidity constraints have increased in financial markets across advanced economies. Prior to this, the United States and China were locked in a geopolitical, economic and technological rivalry that caused a synchronized cyclical slowdown as businesses to postpone investment decisions. This trend of slowing capital investments into productive sectors such as green technology and renewable energy saw productivity wane, and global woes were compounded by Brexit amidst sluggish growth in the single market.
Following the signing of a phase one of the trade agreement and the USMCA, COVID-19 began to spread in Wuhan, the capital of Hubei province. Since then, the virus has spread to Italy, North America and Africa. In the meantime, global manufacturing supply chains for cosmetics, the auto sector, consumer and industrial products stalled, business and consumer sentiment plummeted in some advanced economies and the service sector spanning tourism, transportation, restaurants have been adversely affected by the virus. Central Banks can assess the impact of the Coronavirus from two standpoints;
1) In the medium term, the virus will increase funding stress for businesses and the financial sector, but small and medium-sized enterprises are most adversely affected as they tend to rely on overdrafts, funding mechanisms or other forms of variable finance that have a more significant impact on their operating costs or overheads. For listed firms, funding constraints are contingent on the extent of supply chain linkages into China, Europe, and North America. Such businesses might be exposed to china for components such as apple, or demand for the likes of Adidas and Nike. Take South Africa for example, with a debt to GDP ratio of 66%, its yield curve suggests a risk premium as its outlook from Fitch is currently negative with a BB+ credit rating. As such, domestic firms with no recourse to international debt markets will see their funding sources dry up if the country fails to adopt Chinese approaches to stemming the virus. The latter has currently treated 70% of the cases according to the GDP. Furthermore, central banks must loosen funding constraints via liquidity infusions via extended bond purchases, lower interest rates as repo facilities seek to reduce financial frictions.
2) Furthermore, some central banks will likely seek to stem the adverse impacts of the virus on the real economy as accommodative monetary policy has caused unemployment in advanced economies such as the United States and Britain to fall to 3.6% and 3.8% respectively, reaching historic lows. As such, central banks will utilize crisis-era responses as COVID-19 has caused a country-wide quarantine in Italy, France, and England, while the service sector which drives most advanced economies has come to a grinding halt as restaurants, travel, tourism, and public spaces are deemed high-risk areas. As such, some central banks will seek to assuage the fallout of the virus by cutting interest rates in other to reduce interest rates for households that currently own property. In the United States, over 65% of households own property, while the credit-to-GDP ratio currently stands at 287%. For emerging and developing economies the disconnect between policy rates and the housing sector suggests little if any, positive spillovers from changes in the key policy rate. The transmissions are more evident in investment decisions and corporate sector interest payments, which can have an impact on investment in human capital. Furthermore, countries such as Cameroon, Central African Republic, and Congo have large informal sectors, which suggest that lower interest rates are unlikely to stimulate demand. As I argue in an earlier paper, fiscal policy will play an indispensable role in the coming decade in facilitating the effectiveness of monetary policy.
Central Banks cut interest rates in other to counter the negative impacts of COVID-19
The Coronavirus has bought global manufacturing and supply chains to a grinding halt, while the service sector which drives most advanced economies has been severely affected. In an earlier article discussing the implications for developing economies and discuss the extent of economic damage to China’s economy. China is a main importer of commodities, but also consumer goods ranging from British Range Rovers, Italian cured Salmon, French solar panels and Cameroonian petroleum. Admittedly, COVID-19 will cause economies to grow at a slower pace and falling external demand will cause lower imports, while interest rate differentials will have differing effects on terms of trade. Nevertheless, the rationale and extent of the response for central banks are contingent on funding risks in domestic markets, the interlinkages between respective domestic economies and major import economies such as China and the U.S as well as negative spillovers of the virus to the household sector. For example, as manufacturing activity recovers in China, commodity exports will likely see a less marked fall as China will continue to import commodities such as oil and petroleum products, which form a vital component of manufacturing supply chains spanning deodorants, watches and electronic products. As illustrated below, stock indices fell significantly across emerging markets and advanced economies as the effects of the virus became increasingly palpable, while long term yields fell lower due to asset rotations and the credit spreads increased as investors fled into safe assets. The financial fallout from COVID-19 as illustrated in Chart 1 prompted a wave of monetary stimulus measures.
The financial sector fallout has triggered varying central bank responses
Worries of a global pandemic caused stock prices in the advanced economies to plummet, credit spreads widened somewhat while long-term government bond yields declined as investors fretted over the economic outlook and fallout from COVID-19. Following this period of risk-off, market sentiment recouped and asset prices stabilized in February despite remaining subdued across Asia. This was, however, short-lived and renewed uncertainty caused a wave of equity sell-offs in the U.S and European stock indices (see chart 1), with the former erasing year-to-date gains and the probability of default for sole producers in the energy sector rising significantly. All this is consistent with a pullback in risk-taking behavior, which saw a capital flow switching into safety assets culminating government bonds, the Swiss Franc, Japanese Yen and Gold.
Yield spreads added to concerns of a looming and structurally amplified financial crisis
Risk appetite goes hand-in-hand with steepening yield curves as was the case in October 2019, when markets experienced an upturn. As news of the COVID-19 hit markets, longer-dated yields dropped, pushing the 10 year — 3-month term spread back into negative territory. The decline in 10yr yields appear driven by a significant drop in the risk premium. Meanwhile, 5yr — 3month spread declined further on the news, reaching levels last seen during a heightened phase in the U.S — China trade dispute. The rush into government paper (safety asset) saw the yields for German bunds and peripheries also trimmed.
The economic impact of the virus was muted on credit markets, which appeared fairly resilient in January. Nevertheless, both investment and speculative-grade widened as investors began pulling away from riskier assets, triggering funding constraints in the United States and a selloff in February as the adverse impacts of the virus became increasingly evident. Central banks such as the Fed, Bank of England and Bank of Canada began cutting policy rates in response, and huge liquidity injections lessened funding constraints for financial companies. Given the heterogeneity in credit and equity markets, are we going to see a coordination from central banks in developing economies? This paper postulates a tentative response from the Bank of Central African States, responsible for setting monetary policy for Cameroon, Republic of Congo, Central African Republic, Chad, Equatorial Guinea, and Gabon.
A CEMAC response should stimulate the economy and ensure targeted fiscal responses support the domestic economy
COVID-19 will have a profound impact on macroeconomic outcomes for CEMAC member countries, as the negative spillovers from advanced and developed economies will be caused exports to slow, the currency to depreciate and debt servicing cost to rise. Additionally, CEMAC countries on exports of primary products to China and Europe significantly, with commodity exports comprising 20% of the region's GDP. Its largest member, Cameroon, exports 14% of its goods and services to Italy, 12% to China and 11% to France. Given two of its largest trading partners have seen significant disruptions to their supply chains, funding constraints in financial markets and a slowdown in the service sector, the economy will likely grow at a slower pace due to lower tourism revenues and falling oil sales. Such an outcome justifies an accommodative monetary stance — lower interest rates and central bank intervention in interbank markets — adverse impacts of the virus. Furthermore, as the economy grows at a slower pace, funding constraints will become increasingly evident, justifying a targeted intervention in money markets to ensure that banks with significant dollar liabilities and liquidity mismatches are sufficiently liquid to lend to SMEs in the economy and ensure they can rely on commercial banks to fund their operations, which are likely to be severely hit from the lockdown. While lower policy rates, targeted intervention in interbank markets and specific liquidity arrangements for SMEs are indispensable to counter the adverse impacts of the virus, the Bank should call for an explicit fiscal response in other reduce structural vulnerabilities such as a quantifiable and measurable increase in the number of people employed in knowledge-intensive sectors of the formal sector, whilst prioritizing higher value-added sectors such as green energy and technology (specifically off-grid solution), manufacturing of consumer and intermediate products as well as knowledge sectors that will boost the potential growth rate on a much more sustained basis. Not only does such an approach draw legitimacy from Article 25 and CEMAC zone economic convergence, but a targeted and quantifiable response to COVID-19 will also increase the contributions of the formal sector to economic growth, improve the quality of exports and facilitate the adoption of key technologies that are indispensable to ensuring sustained competitiveness of the industry. Rather than simply stimulate the economy, the monetary policy committee should explicitly communicate the need for fiscal policy to provide a short-term cushion for the businesses that will be adversely affected by COVID-19, as 51% of the economy is driven by services spanning tourism, travel, recreation, and education amongst others. Meanwhile, the should continuously emphasize quantifiable fiscal outcomes to facilitate the transmissions of monetary policy into the real economy.
Lower oil prices (see chart 2) will cause the currency i.e. FCFA to depreciate; the latter corrected by 3.5% since the outbreak of the virus, which will cause inflation to rise in the near term. This trend could also be exacerbated by higher imports if consumers shun markets, considered high risk, in exchange for supermarkets. The broad-based decline in commodity prices will see central banks between a rock and a hard place as they must balance price stability and economic growth. Whilst BEAC (Bank of Central African States) is mandated to pursue price stability, support economic growth and money supply) higher inflation and slower economic growth suggest that accommodative monetary policy could cause a spike in inflation outcomes, which is counterproductive to the central banks’ objectives. This can occur as an increase in money supply, slowdown in economic activity and higher imports cause prices to rise at a much more marked pace. As illustrated in chart 2, when the Vix — a volatility index rises- commodity prices tend to fall as illustrates in Q3 2019 due to heightened trade tensions and Q1 2020 as COVID-19 spread across advanced and developing economies. Nevertheless, the Vix — commonly referred to as the fear gauge might cause a more marked fall in U.S stock indices, whilst a gradual recovery of economic activity in Asia can cause heterogeneity between outcomes in the vix and oil prices. What is more, the current oil price war between Saudi Arabia and Russia will place further downward pressure on oil prices, overstating the short-term relationship with the vix index.
The ECB is at once pragmatic on monetary policy as it pre-empts the fallout from the virus
Rather than follow the trend of cutting interest rates in other to reduce the adverse impact of COVID-19, the ECB is opting to use other mechanisms in its toolbox in an attempt to lessen the negative spillovers from the virus on profit margins, interest expense and broader macroeconomic growth in the Euro Area. The ECB added 750 billion Euros of liquidity via the pandemic emergency purchasing program, in addition to the 120 billion it added in March. It also added 3 trillion in liquidity through refinancing operations, with the interest reduced by 25 bps to -0.75% to support bank lending activity in the Euro Area and counter the depressive effects of COVID-19 that is at once an exogenous shock affecting all Euro Area member countries, also detached from economic fundamentals.
These targeted measures intervene in the whole yield curve, in other the lower interest rates for refinancing operation provide some respite to the longer end of the curve as they are designed to facilitate the transmissions of monetary policy to real and monetary variables such as credit, consumption, and employment. The targeted longer-term refinancing operations are designed to reduce the adverse impact of negative interest rates, which have a much more profound impact on the shorter end of the yield curve. Nevertheless, the TLTRO’s are reflationary from a credit standpoint as they serve to ensure continued bank lending into the real economy. As such, the forgone income to the ECB ensures a faster economic recovery amidst interest rates close to the zero lower bound, but this approach tends to reward bank lending behavior and is therefore not a long-term depressor of the yield curve as asset purchases tend to be. Furthermore, these ad-hoc interventions would prevent financial fragmentation and distortions, ensuring that balance sheet vulnerabilities do not compound the adverse impact of falling industrial activity in the Euro Area. European banking supervisors have fed 120 billion in extra bank capital in other to lending to SMEs in the Euro Area.
Canada catching a cold from COVID-19, rail line blockades, and winter storms
In North America, the Bank of Canada lowered its key policy rate by 50 basis points (bps) to 1.25% while the deposit rate is 1.0% in other to reduce the negative fallout from the virus on exports and domestic economic activity. Meanwhile, rather than cause a slowdown, the virus could amplify adverse domestic trends While Canada’s economy has been operating close to potential with inflation on target, the COVID-19 virus is a material negative shock to the Canadian and global outlooks, and monetary and fiscal authorities are responding. Meanwhile, average hourly earnings averaged 1.1% between Jan-Feb 2019 and 2.1% in the first two months of 2020 due to falling unemployment and increased labor market participation. Nevertheless, COVID-19 suggests downside risks to the near-term outlook and the drop in Canada’s terms of trade, if sustained, will weigh on income growth. Meanwhile, business investment does not appear to be recovering as was expected following positive trade policy developments and the signing of the USMCA agreement with the United States. In addition, rail line blockades, strikes by Ontario teachers, and winter storms in some regions are dampened economic activity in the first quarter of 2020. As such, lower policy rates target slowing economic activity and downside risks from COVID-19 will reduce the adverse macroeconomic spill over into investment, domestic demand and credit growth. Furthermore, an expanded bond purchase program of Canadian mortgage bonds and a new standing facility are also being used in other to provide sufficient liquidity to financial markets. In doing so, banks will be able to provide liquidity to SMEs and continue to provide vital services such as credit, savings, and insurance. Banks can pledge a broader set of collaterals, including mortgages which increasingly increase their funding capacity. Meanwhile, the bank rate was lowered from 1.25% to 1% between March 4th and March 13th to ensure sufficient monetary accommodation to reduce the spillovers from COVID-19.
The Fed addressing funding constraints and achieving its mandate
In response to COVID-19, the Federal Reserve kick-started the trend of monetary accommodation to achieve its mandate of maximum employment and asymmetric 2.0% target; lowering the Fed funds rate by 25bps to 1–1.25%. In addition, the FOMC directed the FRBNY to continue rolling over at auction all principal payments from the Federal Reserve’s holdings of Treasury securities maturing during each calendar month, and reinvesting all principal payments from the Federal Reserve’s holdings of agency debt and agency mortgage-backed securities (MBS) received during each calendar month. Small deviations from these amounts for operational reasons are acceptable. The Federal Reserve used open market operations (OMOs) to adjust the supply of reserve balances so as to keep the federal funds rate — the interest rate at which depository institutions lend reserve balances to other depository institutions overnight — around the target established by the FOMC. The Bank previously injected 150 million in financial markets to address funding constraints and it plans to add 1.5trn to reduce funding constraints caused by tax and payrolls in the coming months. This move equally seeks to improve the transmissions of monetary policy to the real economy. As such, it can be argued that funding constraints play a more significant role in justifying the FED’s move; the rationale of this argument rests on the fact that the correction in financial markets has not been accompanied by a sudden increase in unemployment or lower wages. Nevertheless, initial claims have increased dramatically and businesses might seek to reduce their operating costs in the face of COVID-19 if the fiscal response proves less efficient than currently expected. Nevertheless, the latter falls well outside the remit of the FED, who continues to ensure an ample supply of reserves and liquidity in financial markets. As such, its decision to lower interest rates is pre-emptive, but additional measures are designed to reduce funding stress in financial markets exacerbated by COVID-19.
“In light of recent and expected increases in the Federal Reserve’s non-reserve liabilities, the Committee directs the Desk to continue purchasing Treasury bills at least into the second quarter of 2020 to maintain over time ample reserve balances at or above the level that prevailed in early September 2019. The Committee also directed the Desk to continue conducting term and overnight repurchase agreement operations at least through April 2020 to ensure that the supply of reserves remains ample even during periods of sharp increases in non-reserve liabilities, and to mitigate the risk of money market pressures that could adversely affect policy implementation.” Rather than pursue a balance-sheet constrained approach, which culminates “Circular monetary economic”, the balance sheet expansion will ensure ample reserves and lower monetary policy reduces funding stress whilst the Fed funds rate trades in the mid-range of the FED’s target. As such, the Fed is pre-emptive in protecting domestic demand even as the investment will likely remain weak in the coming months as the effects of the virus and readjustment of supply chains to support domestic value chains in the United States change at a gradual pace. As manufacturing companies adjust to the virus, they are more likely to move to other manufacturing centers in developing economies such as Vietnam, Rwanda, and Ethiopia.
Fiscal policy will have to play a more active role in responding to COVID-19
In an earlier article, I argue that wage subsidies and sector-specific tax cuts will support the economy in the near term against the virus. Nevertheless, I also argue in the paper that developing economies like Cameroon should prioritize the carbon transition to reduce the adverse impacts of climate-related risks, ensure a higher percentage of the workforce are employed across the clean energy supply chains such logistics, manufacturing, software development, energy storage, and installations to name a few. Furthermore, several emerging and advanced economies have taken steps such as providing wage subsidies in France, Japan and Korea to reduce the burden on firms. Meanwhile, China is reducing social security contributions in an attempt to support businesses and Italy, the most badly hit country in Europe is providing tax relief to the corporate sector (see table below).
Policymakers in developing economies such as Cameroon, South Africa, and Congo should employ targeted measures based on the number of employees in each firm in the private sector in other to reduce the adverse impacts of the virus on economic activity, wages and domestic demand. Furthermore, businesses in the manufacturing sector that export to China should be prioritized under such an approach to protect their competitiveness over the long term. In doing so, the impact of the virus will be lessened and a larger deficit or higher public debt will be increasingly justified. Meanwhile, public health should liaise explicitly with Chinese policymakers in other to replicate the 70% recovery rate while they await vaccines from firms such as Takeda in Japan. Under such a scenario, should central banks stimulate the economy and/or use credit facilities such as the targeted longer-term refinancing operations at the ECB, the 150 bn liquidity injection at the FED or adhoc liquidity infusions in the case of the Bank of England following Brexit? Answering such a question will require uniform financial and economic impacts of the virus. But South Africa, Cameroon, Europe, and the United Kingdom are all exposed to China at varying degrees.
The Bank of England leaves no stone unturned with a 74 bps cut, a new term funding scheme to support lending to the private sector
The BoE coordinated its response with policymakers to ensure the additional government spending via grants and infrastructure spending support the domestic economy. The Bank cut interest rates by 50 bps to 0.25% (see chart) in other to support the domestic economy, reduce interest expense for households and ensure that businesses can lend at favorable rates. It cut interest rates further by 24 bps in March to 0.1% as the adverse economic impact of the virus heightened. Furthermore, it has instituted a new term funding scheme to support SMEs who do not have access to market-based sources of finance or are unable to tap equity and debt markets. It is important to note that the Bank of England is nearing the zero lower bound (see chart), which reduces the ability of the Bank to respond to a downturn in the near term. The Bank cut interest rates further by 24 bps in other to preempt funding constraints in financial markets, facilitate the transmissions of monetary policy to the real economy. While financial engineering reduces the adverse impact of the virus on financial and the spillover into the real economy, members of the monetary policy committee also voted to increase the Bank’s holding of sterling non-financial investment-grade and UK government bonds to £200 billion.
In addition to lower interest rates, the bank proposed a new term funding scheme (TFSME) at its February meeting, designed to achieve the following;
· Help reinforce the transmission of the reduction in Bank Rate to the real economy to ensure that businesses and households benefit from the MPC’s actions.
· Provide participants with a cost-effective source of funding to support additional lending to the real economy, providing insurance against adverse conditions in bank funding markets.
· Incentivise banks to provide credit to businesses and households to bridge through a period of economic disruption.
· Provide additional incentives for banks to support lending to SMEs that typically bear the brunt of contractions in the supply of credit during periods of heightened risk aversion and economic downturns.
Meanwhile, the release of the countercyclical capital buffer will support up to £190 billion of bank lending to businesses, equivalent to 13 times banks’ net lending to businesses in 2019. Together with the TFSME, this means that banks should not face obstacles to supplying credit to the UK economy and to meeting the needs of businesses and households through temporary disruption. This should reduce the deflationary and contractionary impact of the virus in the real economy.
Furthermore, the Bank of England used its liquidity facilities to alleviate financial frictions observed in financial markets. To that regard, the new contingent term repo facility will serve as a predictable and reliable source of liquidity, lend reserves for three months and bridge the point from which drawings can be made from the term funding scheme. This, in addition to the countercyclical buffer, will lessen the impact of funding constraints that could increase the risk of defaults at such a delicate time when global supply chains are in a post-COVID-19 hangover and manufacturing is in recession in most advanced economies including China.
While Central banks have cut policy rates to historic lows, their response has, in some cases be coordinated with fiscal policy, as seen in the United Kingdom and Canada. I argued last year, that fiscal policy should play an increasingly quantifiable role in supporting monetary policy, facilitating transmissions and ensure a sustained convergence of inflation towards the 2.0% target. It is worth noting that the funding constraints in Europe and the United Kingdom are less structural than those at the FED. The Federal Reserve began ad-hoc repo market transitions following an escalation in the U.S — China trade tensions that exposed vulnerabilities amongst listed U.S companies. This explains why the bank’s interventions served as a buffer for financially strained lenders, which caused its non-reserve liabilities to rise. Not only did this trend persist, as trade tensions between China and the United eased, but it was also exacerbated by COVID-19. In response, the Federal Reserve cut interest rates twice, it also ensured continuous liquidity to improve the implementation of monetary policy.
Central banks are undoubtedly going to assuage the impact of COVID-19; funding constraints have driven the response in some markets and the need to prevent significant spill over to the real economy justify the broad-based interest rate cuts and liquidity infusions. Nevertheless, fiscal policy must be targeted as the implications for developing economies will be much more pronounced due to the nature of their exports that are predominantly comprised of commodities and low value-added exports. Consequently, the response function of central banks around the world are warranted, but developing economies should ensure their response, monetary or otherwise, is targeted in other to improve the resilience of domestic economies. Covid-19 has tested the resolve of most advanced and developing economies, but while central banks have moved to avert a crisis with the unprecedented stimulus, more might be needed from targeted fiscal response to ensure a double-dip doesn’t trigger a financial crisis.
1) Bank of England measures to respond to the economic shock from Covid-19, 2020. Available here
2) Stephen Poloz, 2020. Labour market is key to Canada’s resilience. Available here
3) Federal Reserve, March 2020. Implementation Note issued. Decisions Regarding Monetary Policy Implementation