Global Financial Stability Report: Markets in the Time of COVID-19

After completing this reading, you should be able to:

• Describe the developments in financial and commodity markets during March-April 2020. 
• Discuss the global financial vulnerabilities intensified by the slowdown in economic activity and tightened financial conditions following the COVID-19 outbreak. 
• Explain the various monetary and financial policy responses to COVID-19 as well as the future steps that should be taken.

Developments in Financial and Commodity Markets during March-April 2020

Stress in Credit Markets 

During March-April 2020, pressures in the credit markets increased due to borrowers’ leverage and oil price collapse in the following ways:

• Rising credit and liquidity risks led to worsening corporate credit market conditions at an unprecedented pace. This was attributed to the rising market leverage as investment-grade bonds widened due to many investors sorting for downgrade-risk credits. 
• The primary market saw a dramatic rise in demand for US dollars, with a subsequent decrease in European issuance. The rising liquidity risks signified a precautionary demand for the dollar causing tension in the commercial paper market. Response: Many central banks responded to the corporate bond strains by deploying new programs through extending existing programs to support issuance and liquidity in the corporate debt and commercial paper markets.
• In early April, the risky credit market experienced stress; therefore, sectors hit hard by the pandemic, such as the transport sector and oil firms, experienced widening high-yield bond spreads.
• In the March sale-off, there were unexpected falls in leverage loan prices. Credit rating agencies then revised their speculative-grade default estimates from benign to recessionary graded against a trend of already high leverage and anticipated declines in earnings.

Strains in Short-Term Funding Markets during March-April 2020

Primary dealers experienced strained balance sheets intensifying pressures in short-term funding markets during March-April 2020, as presented in the following ways:

Freezing of the US commercial paper market: Commercial paper spreads widened dramatically due to the freezing of the US commercial paper market sought by companies to meet their operating expenses needs. Two reasons caused this development:

• In response to expected investor outflows, prime money market funds lowered their commercial paper positions to raise cash and create ample liquidity.

• Dealer banks experienced balance sheet strains and risk restrictions thus; they were less capable or willing to mediate these investor outflows.

Freezing of the US bond market: Dealers could not contain the spike in supply due to an increase in outflows from municipal bond funds, the US municipal bond market froze as a result. Response: Central banks responded by introducing a spectrum of emergency responses to provide relief to short-term funding markets.

Tightened conditions in the global US dollar funding markets: The tightening conditions in the US dollar funding markets caused (a) the spread between LIBOR and a risk-free rate to sharply widen, and (b) increased currency basis for most currencies.

The degree of tightening in funding conditions was harsher in economies with huge dollar funding demand but with no swap line with the US Federal Reserve. Intervention: Several central banks intervened by increasing their provision of dollar liquidity through an increase in their existing swap lines or the opening of new swap lines.

However, the strains of the US dollar funding market seem to have eased towards the end of March.

Selling Pressures Increase due to Financial Deleveraging and Strained Market Liquidity

Financial Deleveraging: Leverage investors faced significant margin calls in March, as:

• They encountered dramatically increased financial circumstances which forced them to close out some of their positions to meet margin calls or to rebalance their portfolios. It describes what caused the falls in asset prices, based on the perspective that investors targeting for volatility were forced to sell out some of their assets.
• The central counterparty (CCP) clearing houses balances with the US Federal Reserve experienced a large increase within two weeks, a clear indication that leveraged investors were facing substantial margin calls.

Strained Market Liquidity: The US Treasury markets’ liquidity conditions deteriorated sharply in March due to a sharp decline in the Treasury yields and intraday volatility increase since risk management practices and limits constrained the dealers’ ability to intermediate markets, hence exerting pressure on the need to sell assets at a discount. 

Therefore, to intervene, the US Federal Reserve initiated several responses focused on enhancing liquidity, preventing market disruptions, and mitigating upward pressure on Treasury yields. The interventions included:

• Increasing the scope of asset purchases.
• Introducing more broad open-market programs to boost liquidity.
• Allowing foreign central banks to repurchase their Treasury shares in return for dollars.
• Temporary exclusion of US Treasury securities and reserves from the calculation of the supplementary leverage ratio for bank holding firms.

Magnified Speed of Asset Declines due to Stretched Asset Valuations

• The unwinding of stained asset valuations possibly accelerated the sell-off in March before adapting sharply in late February and March. At this time, fair market value deviation had reached extreme levels across numerous countries and sectors.

• Share prices dropped sharply through mid-March following the COVID-19 outbreak, wiping out a large portion of the overvaluation in many markets and sectors as price-earnings ratios in stock markets had hit the highest levels since the global financial crisis in the last quarter of 2019.

• In credit markets, corporate spreads widened considerably after the COVID-19 outbreak, wiping out previous overvaluations that narrowed between October 2019 and early 2020, according to the Global Financial Stability Report (GFSR).

Emerging and Frontier Markets Developments 

The emerging and frontier markets experienced the following developments during March-April 2020:

• The unforeseen combination of shocks resulting from the fall in oil prices, the COVID-19 pandemic, a potential global recession, and increased global risk vulnerability intensified sell-offs in emerging and frontier markets.
• In the first quarter of 2020, commodity-producing economies’ currencies fell against the US dollar. Other emerging market currencies were relatively less.
• By the end of March, the spread of dollar-denominated emerging market, sovereign bonds had risen to the highest level ever since the global financial crisis. However, some weaker economies experienced extreme shocks as the number of distressed sovereign lenders rose to high record levels.
• Oil-importing economies performed better, but lower inflows, reduced availability of external financing, and lower external demand could overshadow the positive impact of lower oil prices.

Global Financial Vulnerabilities Intensified by the Slowdown in Economic Activity and Tightened Financial Conditions 

Even before the outbreak of COVID-19, financial vulnerabilities had risen in some crucial global economies, and with the current tightening of financial conditions, they may become exposed. These financial vulnerabilities include:

Corporate distress could develop in the non-financial business: Non-financial business vulnerabilities were already rising, indicating high levels of debt. These vulnerabilities were considerably higher than during the 2008-2009 crisis, which indicates that a long period of negative growth and high financing costs may lead to large-scale corporate distress.

Asset managers may become distressed sellers, intensifying asset price declines: Asset managers may be forced to sell assets, which could trigger a decline in asset prices; hence, fire sales. During the outbreak of COVID-19, the expectation of weaker liquidity conditions may have prompted some funds to sell less liquid and lower-rated credit assets early on to de-risk portfolios to raise their remaining portfolios’ liquidity. These acts may have intensified price drops in highly risky markets. In turn, a further deterioration in market conditions could lead to further redemption stresses, especially for funds with low liquidity buffers or an investor base that is price-sensitive.

Banks’ resilience may be put to the test as economic and financial market stress rise: In 2007-2008, the effects of the global financial crisis were worsened by the dramatic cut in bank lending due to liquidity pressures and banks’ losses. There is a threat that this could be replicated, causing leveraged firms to lose access to markets, increasing the possibility of default risks.

Since the global financial crisis, the following improvements have been made to enhance bank resilience in the face of a global crisis:

• Higher levels of capital reserves had been constructed since the global financial crisis, which may have helped banks withstand losses. 
• Bank monitoring had been increased, including stress testing to measure bank health, and regulations had been reinforced.
• Compared to the 2007-2008 global financial crisis, banks nowadays hold more liquid assets. 
• There is a substantial and coordinated central bank action to provide banks with liquidity in many economies, such as through repurchase operations and central bank swap lines for dollars. They could also help reduce liquidity pressures and mitigate the effect of higher market financing costs for banks. 
• Banks had improved access to liquidity that could also help them deal with declines in investment or fund of credit lines by companies.

Considering the stronger initial position of banks, they, however, are likely to experience both credit and mark-to-market losses as a result of the sharp slowdown in economic activity caused by COVID-19 in the following channels: 

• Decreases in asset prices are likely to result in losses on the risky securities portfolios of banks.
• Credit losses on their loans to households and businesses. For example, the fall in oil price has placed increased strain on energy companies, and banks may also see credit losses on these companies’ loans. Also, banks may face indirect liability through their loans to households employed in vulnerable sectors.
• Diminished bank profitability levels imply that banks will have fewer profits available to cover losses than in the past. The longer the unexpected slowdown in economic activity lasts, the more likely banks are to expect 

Insurance companies may suffer losses: The slowdown in economic activity and tighter financial conditions are amplifying insurers’ financial vulnerabilities, as credit risk and liquidity mismatches are increased. Insurers may also be faced with currency mismatches. The low-yield economic environment will increase the challenges of profitability and solvency. In addition, insurers’ bond portfolios may be subject to credit downgrade which further increase their losses.

Strong policy response and international cooperation are necessary to tackle challenges for emerging and frontier markets: The abrupt halt in economic activity and portfolio outflows coupled with the oil price shock present an acute stress test for various emerging and frontier market economies. It is even severe as most emerging and frontier market economies entered the COVID-19 crisis with more fragile conditions than in 2008 in the following ways: 

• Emerging market bond issuers are currently more leveraged than they were in 2008-2009, as new issuers with higher reliance on oil and other resources and lower-rated issuers are included.
• There is less policy scope in a substantial number of major emerging economies than in the great financial crisis of 2008-2009. For instance, the spectrum of fiscal policy is typically intense, with debt at relatively higher levels and greater structural budget deficits. These fragile conditions may be intensified by a rapid downturn in economic production. This can hurt economies with limited fiscal scope, higher financing needs, or external financing vulnerabilities through sudden growth in borrowing costs.
• Many emerging markets and frontier economies are now more widely dependent on foreign portfolio investors and external financing than in 2008-2009. Therefore, the tightened financial conditions could affect countries, particularly African countries, as they could be vulnerable to trade financing disruptions if cross-border financing and corresponding banking ties are disrupted in the process. 

Therefore, the emerging and frontier markets could be affected by the ongoing health crisis, and a significant slowdown in economic growth through intensified financial stresses in the following channels:

• Balance sheets for small and mid-sized banks have limited space to support their vulnerable and small private borrowers’ financial stresses and are likely to weaken further.
• There is a rise in credit and liquidity risks in the heavily indebted property developer industry due to increased pressure caused by dollar funding constraints and sharp sales slowdowns.
• Outflows from non-bank financial institutions that operate with substantial liquidity and maturity mismatches and, in some instances, high leverage, could be triggered by plummeting stock prices, increasing bond defaults and/or create a further decline in investors’ confidence. 
• Frontier markets mostly lack financial strength and have a relatively shallow domestic investor base, which can impede the transition of monetary policy and intensify market pressures in times of stress.

Monetary and Financial Policy Responses to COVID-19 and the Future Steps that Should be Taken

To maintain the global financial system’s stability, central banks have been the first point of call, leveraging against financial tightening. They did all they can to achieve this through decisive monetary policy actions in the following four main areas.

Eased Monetary Policy

Central banks have substantially eased monetary policy by cutting down rates. They have also provided forward guidance and widened their asset purchase programs to mitigate downward pressure on long-term interest rates and alleviate an increase in long-term borrowing costs for households and businesses.

Provision of Additional Liquidity

Most central banks provided banking systems with additional liquidity through:

• Lowering standards for bank reserves.
• Easing collateral standards.
• Revising repo operations for liquidity.
• Extending operations such as easing collateral terms, lowering bank reserve requirements, and upsizing liquidity repo operations.

Some governments also initiated or extended programs to provide banks with funding support.

Enhance the Provision of US Dollar Liquidity

Several central banks have agreed to increase the availability of the US dollar liquidity through swap line agreements to globally boost tighter conditions in the US dollar funding market.

Enhance Liquidity of Short-term Funding Markets

Several central banks have started buying municipal bonds, commercial paper, investment securities, and corporate debt programs to increase liquidity. They have done so by intervening in these markets as ‘buyers of last resort,’ essentially putting an upper limit on the cost of borrowing. 

The central banks’ primary objective for these initiatives is to ensure that households and businesses continue to access credit at an affordable cost.

Countering Foreign Currency Funding Pressures in Emerging Markets

For emerging markets, central banks have organized interventions that enable them to address foreign exchange funding strains and mitigate the damage to their economies through unprecedented capital flow reversals:

• Some countries have reactivated or continued foreign currency intervention strategies to alleviate extreme volatility in their domestic currencies.
• Several countries have lowered reserve requirements for foreign currencies.
• Some countries have increased access to repos and foreign currency swaps.

Practice Question

Which of the following is INCORRECT about the development in the credit market during March-April 2020?

A. Market leverage increased as investment-grade bonds spreads widened

B. The primary market registered a dramatic rise in demand for the US dollar

C. The transport sector and oil firms unexpectectly experienced narrowing high-yield spreads

D. None of the above

Solution

The correct answer is C.

The transport sector and oil firms experienced narrowing high-yield spreads are NOT TRUE about the development in credit market during March-April 2020 since due to the risk of credit market experiencing stress, sectors that were hit hard by the COVID-19 pandemic such as the transport sector and oil firms experienced widening high-yield bonds spreads.

Therefore, choice A, B, and D are TRUE about the development in the credit market during March-April 2020