We are not out of the woods yet

Published: 22/9/2021

Article by Governor Vujčić for "Views – The EUROFI Magazine", September 2021.

In horror movies, every time that the main character seemingly escapes a suspenseful situation, you can expect a jump-scare to immediately follow. On the way out of a dark forest, there is always something awaiting the main character at its very edge. The audience knows this, but never fails to get shocked when the plot delivers on expectations. First, the emergence of a pandemic after the GFC, and now even the potential implications of the current pandemic crisis for financial stability appear to follow such a script. The remarkable recovery on the back of vaccines and extremely supportive economic policies have prevented the fallout in the financial sector. Reforms pursued over the post global financial crisis decade also helped to turn the financial system into a part of the solution, rather than the source of problems. However, the potential issues that are lurking in the background while we are heading for the exit are worrisome. And very much like in a horror movie, we cannot know in advance whether a sudden strange noise in the bushes will turn out to be just a small animal passing by or a Roubini-style mother of all crises.

The first warning sign of trouble ahead is an "overwhelming silence" - the number of corporate bankruptcies tanked during the pandemic, which is in a sharp contrast to any previous crisis episode. Exceptional public support and temporary regulatory forbearance allowed for the continuous operations even of the companies that would have exited the market under normal circumstances. Certainly, when faced with such a major shock it makes perfect sense to postpone corporate bankruptcies until uncertainty created by the pandemic somewhat recedes and to spread the inevitable bankruptcies over time in order to ease labour reallocation. But maintaining the support for too long – in another apt reference to the movie industry – creates a zombification risk over the large swathes of the corporate sector. Also, at the moment we cannot be sure how large the final tab for corporate bankruptcies will be, once it comes. Banks have heavily provisioned for potential risks arising from latent non-performing loans, but until the ending we cannot assess residual risks with a fair degree of reliability.

The unprecedented fiscal expansion has supported the corporate sector and shielded household incomes from the crisis. But it has saddled governments with substantial additional debt. The rise in indebtedness comes on top of an unfinished banking union, where the sovereign-bank nexus remains one of key vulnerabilities of the monetary union. Admittedly, the prolonged low interest rate environment eased the management of government debt, but the cost savings have already been to a great extent absorbed by government budgets and the remaining risk is for the CBs asset purchases to come to an end and rates to rise. Even if such a scenario turns out to be benign as economic growth keeps track with higher inflation and interest rates, it exacerbates the risk of a sudden asset price collapse.

There is a long and constantly evolving list of things to do and things to avoid for any movie character. Unfortunately, in the case of a financial crisis, the to-do list for policymakers mostly comprises actions that need to be taken well in advance. Yet, there are still some things than can be done in order to cushion the blow.

The first on the list are bankruptcy procedures. In many European countries it takes far too long to complete a bankruptcy, which incurs losses for creditors and destroys economic value in the process. Improving these procedures may not yield much gain under normal conditions, but there is a large upside in terms of economic recovery in the crisis aftermath. Moreover, we need to take a fresh look at nascent risks, such as bubbles in the residential real estate market. Indeed, a number of countries has already resumed their previous course of tightening macroprudential tools aimed at real estate, in a sharp contrast to what was done during the pandemic crisis. Finally, the same principle applies to all other policy tools: in order to be able to use them effectively in another crisis, we need to start regaining policy space as soon as realistically possible. Only if we take these steps, we will be able to shrug off the jump-scare that awaits us at some point before or at the edge of the forest.