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Article by Governor Carlos da Silva Costa in Reuters: Time to collectively repair the pipelines while we have an umbrella

The pandemic crisis will have a profound impact on the world economy. Its duration and size are still surrounded by great uncertainty. Although temporary, this shock risks leaving long-lasting scars if policymakers and authorities do not coordinate their responses.

To an exogenous shock common to all economies, authorities initially responded uncoordinatedly. As the virus spread and the economic consequences of the pandemic became clear, efforts were deployed to coordinate policy response, but so far the burden has lain mostly on individual nations. Monetary policy eased significantly, cushioning the impact of the shock by providing ample liquidity.

Labour market policies, payment moratoria and government guarantees on loans to corporates, among others, have been deployed across countries. Regulators and supervisors have adopted complementary measures exploring the flexibility of the existing regulatory framework to mitigate the immediate impact on banks’ balance sheets. 

The impact of the adopted policies will be a function of the structural features of the economies’ productive sectors, the liquidity and solvency positions of economic agents, the available fiscal space, as well as timing and policymakers’ clairvoyance (linked to the timely identification of problems, quality of policies and sufficiency of response). A clear distinction needs to be made across four stages of policies: (i) relief (payment moratoria), (ii) repair (recapitalisation of viable firms), (iii) recover (launch of domestic demand and productive investment), and (iv) reorient (towards sustainable and digital development).

As economies emerge from the pandemic, pre-existing financial vulnerabilities will be compounded by additional public and private sector debt ensuing from policy action. Corporate and household debt burdens risk becoming unmanageable in case of severe economic contraction, putting at stake their solvency. Authorities and policymakers should make use of the oxygen balloon created by payment moratoria and regulators’ flexibility to implement solutions to reduce insolvency risks. 

In the European context, the Next Generation EU proposal is timely and goes in the right direction. However, it raises important challenges to companies and banks’ asset quality as it aims to reorient the economy but fails to timely support the repair and recovery stages: we will not be able to reorient business models if in the meantime companies go bankrupt. 

As the IMF recently noted, “policy support will need to gradually shift toward encouraging people to return to work, and to facilitating a reallocation of workers to sectors with growing demand and away from shrinking sectors.” Policy options need to be exploited to prevent the current corporate liquidity crisis from evolving into an insolvency crisis: avoiding the ‘zombification’ of companies and of the labour market is now of the essence. 

Before policymakers unwind measures adopted at the peak of the crisis, solutions need to be implemented to enable the capitalisation of companies and avoid cliff effects. Proposals have been put forward comprising the possibility to “convert government guaranteed credit into equity or quasi-equity in the form of preferred shares or, for privately held firms, higher profit taxes in the future”. Options to identify and triage unviable firms deserve careful consideration while mitigating risks to labour markets and social cohesion. For unviable firms, expedited insolvency procedures should be implemented to preserve value. At European level, these solutions need to be coordinated under the auspices of the Capital Markets Union development so as to avoid national solutions protecting local firms and economic sectors that would risk the singleness of the EU market. 

On the banking sector the impact will reverberate through asset quality dynamics with increased non-performing loan ratios. Systemic TARP-style solutions will be required at European level, even if implemented at national level. These will require additional flexibility concerning the interplay between state aid and the Bank Recovery and Resolution Directive compatible with the challenge at hand. Moral hazard issues related to pre-pandemic risk-taking behaviour will arise and need to be addressed politically as a means to gain trust to reinvigorate the Banking Union project. Unless Member States address this as a matter of urgency, we risk a repeat of the discussions post-sovereign debt crisis, with the ensuing consequences to the economic recovery and trust in European institutions, already stressed by the health crisis response.

Notwithstanding the improvements observed in the European banking system post-global financial crisis, the situation is uneven across countries. As asset quality and profitability deteriorate, over-capacity will reveal itself amid a renewed push for digital solutions fast forwarded by the lockdown period. 

In this context, to preserve (local) financial stability efforts must be made to establish an enabling European framework for the orderly management of failing banks of locally systemic importance, combining elements of the resolution and liquidation frameworks, with a view to minimising losses and protecting depositors and non-financial borrowers. Such a framework should include the definition of high-level principles to be agreed by all Member States for application at national level. For those banks assessed as not having (European) public interest, there should be room for manoeuvre in view of national preferences. Recourse to alternative measures as foreseen in the Directive on Deposit Guarantee Schemes or to public funds, as an ultimate backstop, should be thus considered. Without risk-sharing and pan-European banks, sovereigns need to find the means to protect competition in their local markets and to safeguard the flow of funding to the economy in the event branches and subsidiaries of foreign banks exit during a downturn.

Such options should be clearly decoupled from (past) bailout discussions and the ensuing political and social consequences. Few things can be more destructive to public trust in European institutions than threats to financial stability, and Member States can only avoid jeopardising European social and political cohesion by acting pre-emptively.

Confronted with a storm, we were able to take shelter (relief) but we now need to repair the damage and ensure that we are able to recover and reorient the economies to weather new storms. As we did not finish repairing the roof when the sun was shining, let us now collectively repair the pipelines while we have an umbrella, so as not to stifle the recovery.