What if it’s not V-shaped?

Further lockdowns threaten business failures and financial instability

27 July 2020 Stephen King, Senior Economic Adviser

    This page is about:

    Almost all economic projections assume that there will be neither a second wave of COVID-19 nor an extended first wave. Yet, what happens if future lockdowns or diminished confidence put paid to a V-shaped recovery?

    The health protocols of lockdowns – plus the nervousness of households and businesses – cause more economic damage than the disease itself. However, failure to get to grips with the virus will delay any sustained economic recovery, suggesting either a U-shaped economic path or a truncated V-shape whose uptick is much weaker than the downward leg. The risk is that the period when activity is below where it would be without COVID-19 is extended, threatening financial stability.

    Japan’s economy in the 1990s showed the danger of a widening gap between actual growth and prior expectations. By 1995, nominal GDP was 21 per cent below the historic trend, leaving firms with too much debt during the ‘lost decades’.

    Normally, interest rates decline as economies slow so that high debt is offset by lower interest payments. But that is difficult when rates are near zero – as they were in Japan – and the economy risks stagnating.

    Borrowers tend to repay more – and borrow less – when debt is high relative to depressed income, but their repayments drain demand from the economy, further depressing activity and keeping the debt-income ratio stubbornly high. The shortage of willing borrowers encourages lenders to accept reduced credit quality and banks’ bad-debts rise as companies fail.

    Stockmarkets recovered early in the pandemic thanks to massive government stimulus and hopes of a V-shaped economic recovery. Concerns about huge increases in government borrowing have made investors seek hedges against the risk of rising inflation.

    Plentiful liquidity lifts the value of risky assets, helping large listed companies, but lockdowns prevent that liquidity reaching the broader economy. Many smaller businesses, mainly unlisted, may thus fail.

    Government-backed furlough schemes, corporate grants and loan guarantees allow companies to go into hibernation in the hope that, post-COVID, normality will return.

    However, the longer hibernation lasts, the greater the problems. Many firms fail in normal times: a hibernation policy that supports them all would create corporate zombies – a ‘living dead’ that absorbs capital and lowers long-term growth.

    One solution for excess debt is ‘helicopter money’ – tax cuts funded by government bonds. The rise in corporate or personal post-tax income would reduce the risk of default, but it may boost asset markets rather than consumption, helping large corporations but not start-ups.

    Better would be a ‘bad bank’ that takes over commercial banks’ bad loans, leaving them free to lend unburdened by COVID-19 while companies could borrow without dwelling on past regrets.

    A bad bank would effectively immunise an economy from many financial risks associated with coronavirus by passing the burden onto future taxpayers better able to cope with it (and who might ‘profit’ if an eventual recovery allowed bad debts to come good again). It would, however, be the ultimate triumph of fiscal policy over monetary support.

    First published 23 July 2020.

    Would you like to find out more? Click here to read the full report.

    Disclosure & disclaimer

    More, collapsed
    Fighting the fear
    How willing are consumers to support the recovery?
    Join the conversation?

    Join our Linkedin group to get an unparalleled view of macro and microeconomic events and trends from a bank that is a leader in both developed and emerging markets.