Balance Sheet Recession Is Taking a Toll on the World Economy
1. Balance Sheet Recession Is Taking a Toll on the World Economy
The COVID-19 pandemic has forced the world economy to come to a halt. As firms struggle to service their debts, creditors are likely to see a steep rise in bad assets - a typical source of financial risks.
Since the novel coronavirus crisis erupted, monetary and fiscal authorities around the world have taken a multitude of relief measures to (i) tide over firms and financial institutions; (ii) boost public confidence; and (iii) assist the poor who have lost their livelihoods. The third aspect is of particular importance to social stability, which is why many governments have issued cash assistance or consumption coupons to the public. In the absence of a national cash payout scheme, there have been similar schemes in China at provincial and city levels.
The basic law of financial operation is that one must pay back what one borrows. Financial intermediation boils down to the lending of money with an interest charge for its use. After a firm borrows money, it manufactures and sells goods to make a profit and repay its debt in principal and interest. Yet as COVID-19 puts a break on this chain, a large portion of existing assets will become bad assets. The balance sheet effect of bad assets will deal a heavy blow to the economy. While firms cannot default on every penny they borrow, their underlying assets will depreciate amid the pandemic, forcing them to revise their balance sheets. Asset impairment and depreciation will weigh heavily on the economy. A key development in macroeconomics over the past decades is that economists have started to recognize the vital role of “balance-sheet shocks” in economic cycles. Today, such shocks are being felt globally.
2. Beware of Inflation
In the wake of the crisis, governments have doled out huge sums of cash, chiefly to tide over struggling firms and households. Will the additional money lead to inflation? Many compare the COVID-19 challenges to those during the SARS outbreak in 2003. One major difference is that SARS did not halt production apart from squashing demand. After the SARS outbreak, the world economy continued to experience deflation. In contrast, COVID-19 has shut people indoors in much of the world, and forced entire cities and even countries into lockdowns. All production factors became immobile. Most production activities ground to a halt, causing supply to shrink.
Put simply, inflation means too much money chasing too few goods. With goods in short supply and more money still being issued, there is “excess money chasing a fixed amount, or even fewer, goods,” which is a recipe for inflation. Over the past few decades, deflation held sway in the world economy as oversupply co-existed with lack of demand. Yet COVID-19 is likely to crimp supply more than it does demand. China’s Q1 data suggest a sharp rise in both CPI and PPI. An uptick in CPI means higher living costs for average people, especially those who are low-income. The consequent social impact warrants great attention.
3. Yawning Gaps between the Rich and the Poor
Who are the recipients of the money released during COVID-19? Desirably, the money should go into the real economy, prompting people to work, invest, hire more hands, sell their goods, pay salaries, and earn more profits. Yet cash released from financial and fiscal avenues during COVID-19 would not follow this path. With lockdowns in place, firms loathe to invest, causing funds to flow elsewhere.
Many surveys suggest that a large portion of the population is without property income. They must work to keep food on the table. The smaller firms are, the less likely they are to generate income on properties. Without “helicopter money” as an ideal form of quantitative easing, most funds will find their way to capital owners without reaching average people and SMEs. As shown in extensive Chinese and international studies, for all their stimulus effects on the economy, relief measures offered via financial intermediation are likely to widen income inequalities and the social divide.
Capital will flow into sectors other than the real economy - such as the stock market, bond market and real estate - that is, the virtual economy. Those in possession of assets such as stocks, bonds and housing properties tend to be high-income, and stand to gain from an influx of capital that buoys their net worth. The poor, however, are left out. In a market economy, capital always boasts a dominant position over labor. This capital-labor disequilibrium has been particularly striking over recent decades. The Capital in the 21st Century authored by French economist Thomas Piketty in 2014 dwells on the theme of capital-labor contradiction. Without doubt, COVID-19 will make life more difficult for the poor.
4. As the Real Economy Shrinks, Financialization Is on the Rise
The grim outlook of a secular recession looms larger as economic activity grinds to a halt amid the pandemic. For the pandemic to recede, an effective vaccine has to be developed, which may not happen until 2021 or even 2022. That is to say, economic stagnation will persist for a long time. As capital shuns the flagging real economy and rushes into the virtual economy, the “financialization” of our economy will further deepen with ramifications for every facet of our economic life.
This is how “financial cycles” come into play. In economic cycles driven by excess output and characterized by price swings, some firms thrive and others decline. As most capital avoids entering the real economy, today’s economic cycles are characterized by changes in financial variables such as stocks, bonds, and the real estate market. In this context, our regulatory policy enforcement has been followed by changing prices in assets such as stocks, bonds, and housing prices. Such “financialization” is harmful. It causes our macro-regulatory instruments, policies, and theories, however sophisticated, to fail. Yet in a crisis, policymakers still resort to those imperfect policy responses despite the consequences. In fact, they are left with little alternative.
5. Beware of China’s Marginalization in the World Financial Sphere amid a Scramble for the US Dollar
In the pandemic-triggered backlash against globalization, we should be alert to the tendency to marginalize China. De-globalization has been discussed extensively. COVID-19’s disruptions to the supply chain and value chain are real. Lockdowns have posed barriers to trade and brought capital flow to a halt. Amid this de-globalization, there has been a rising tendency to decouple from China.
The COVID-19 crisis began with a scramble for the US dollar. Historically, the dollar squeeze has occurred more than once, including, most recently, the global financial crisis of 2007-2009. Each “dollar squeeze” was followed by a definitive result. For economic analysts, it means a strengthening in the dollar’s international reserve currency status, from which the United States stands to gain.
For now, the only way to cope with the dollar squeeze is currency swaps among central banks led by the US. Soon after the dollar squeeze, nine central banks entered into currency swap agreements. Two things about this warrant our attention: First, these central banks do not include the Chinese central bank; second, the currency swap network does not include renminbi. Amid COVID-19, countries are forced to decouple economically from each other, giving rise to “de-globalization,” but they are financially bound together as the crisis fuels demand for the dollar. In this monetary and financial network, China, along with its currency, renminbi, is left out. Such a dangerous tendency can be regarded as “de-sinolization” in the international financial sphere.
As noted in the Libra White Paper 2.0, Libra’s value is tied to a basket of five to six government-issued currencies, from which renminbi is absent. We have good reason to believe that there is an international coalition, especially in the financial sphere, of countries, which excludes China and its currency, renminbi. The only way for us to cope is to add to renminbi’s strength, and of course, China’s underlying national strength, and turn renminbi into an international currency.
6. Deepen Economic Reforms and Propel the Internationalization of Renminbi
COVID-19 has deeply shocked the global financial system. In its aftermath, the Chinese government took swift action to curb the outbreak and minimize the impact on the economy. With COVID-19 under control, the nation is going back to normal after a brief period of lockdowns. In this context, reforms in the real economy should gather speed. For the Chinese government, the present priority is to turn China into a modern socialist market economy in accordance with the blueprint delineated at the Third Plenum of the 18th CPC National Congress.
In the financial system, we must expedite the internationalization of renminbi based on our country’s economic clout and through financial reforms. Instead of prodding international investors to hold renminbi currency, we should encourage their holding of renminbi-denominated financial assets such as stocks, bonds, and real estate properties. By furthering financial openness and marketization of financial systems, we should make renminbi-denominated assets attractive and available to international investors, so as to steadily advance the internationalization of renminbi.
In a nutshell, COVID-19 has brought myriad contradictions into the spotlight. In the face of those contradictions, Chinese policymakers are committed to speeding up reforms and bolstering economic development. With these efforts, I am convinced that China will take the lead in overcoming the recession.