Will Covid-19 cause an economic depression?

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Will Covid-19 cause an economic depression?
« on: April 30, 2020, 10:10:27 PM »
A look at monetary and fiscal policies in light of the current pandemic

The prevalence of the corona pandemic for a prolonged period of time, with a subsequent complete lockdown, may push the global economy towards depression. Even though the talk of economic depression might seem far-fetched, it is still a likely scenario.

It is evident that the global economy is in recession. Such is the severity of the situation that the IMF chief has already declared that the global economy is in recession, and it is worse than the global financial crisis of 2008.

As a part of the global community and one of the countries to be affected by the coronavirus, Bangladesh is facing adverse economic consequences. To mitigate the negative effects of the outbreak, the government and Bangladesh Bank (BB) are proactively using fiscal policy and monetary policy.

In that light, this article will try to evaluate the different measures taken by the government and try to understand whether those actions are sufficient to bring stability in the banking sector and rejuvenate growth in the short-run.

A prospect for Bangladeshi banks to face a liquidity crisis
Banks in Bangladesh are in a dire situation as a result of the outbreak of Covid-19. Recent literature highlights the liquidity shortage of banks. Given that, the question arises on how the banks will cope with the increased demand for money.

Even after the end of the pandemic, the question arises whether the banks will have sufficient funds to cope with investment demands, given their liquidity crisis? There is a high possibility government will try to maintain a low-interest rate. That will hurt their savings option.

Furthermore, because of autonomous consumption, households (HH) will continue to withdraw deposits from the bank. This will pile extra pressure on the bank’s liquidity. Banks can continue to use monetary tools to push money into the economy.

However, it increases the debt of the government and the possibility of inflation. Combined recession and inflation would result in stagflation, and this is a very unwanted scenario.

Is Covid-19 putting a strain on the banks’ liquidity?
According to the executives of the private banks, there has been indeed a spike in the demand for money. In  March, cash withdrawal had increased when compared to the previous months.

Furthermore, the sum of money disbursed from CC loans has also picked up, indicating the rise in demand for money. Panic buying and uncertainty regarding the future has led the HHs to liquidate their savings account and salary accounts.

Firms were also forced to utilize their existing CC loan accounts to pay off fixed costs such as salaries, rents because of the downturn in economic activity.

On another note, according to private bank executives, the pandemic has hurt their revenue streams. Interest payment forms a substantial part of revenue generation for the commercial banks.

As a result of the pandemic, many loan-takers would not be able to repay their dues because of delayed salaries, losses, or concern for their health. Moreover, because of the cancelled orders or downturn in global trades, banks are losing potential income opportunities from letter of credit services and foreign exchange transactions.

The bank management further noted that there had been a decrease in demand deposits and time deposits in their respective banks, thereby, limiting the funds for banks. As for public banks, they reported a decrease in the number of customers paying utility bills, tax payments, VAT, and other payables.

Amid coronavirus fears, several migrant workers have returned to Bangladesh or being laid off. Consequently, the remittance inflow took a slight hit, which again affected the banks’ income generation adversely. According to the central bank, remittance inflow decreased by Tk17.74 billion from January 2020 to February 2020.

Central bank reacting to Covid-19
It is apparent that there has been increased demand for money and a decrease in the money supply for commercial banks from the open market, creating a scope for a potential liquidity crisis.

To inject liquidity in the scheduled banks, BB has decided to reduce the Cash Reserve Requirement (CRR) by 0.5%, which would increase liquidity for banks by further Tk6.50bn.

This effectively means that commercial banks now have more money available for transactions because the volume of money required to keep as a reserve with the central bank has now decreased.

The Repo Interest Rate was also reduced by 25 basis points by BB, making it cheaper for the commercial banks to borrow from the central bank.

According to one of the respondents, the decrease in CRR is not sufficient as many banks have already crossed the allowed lending limit and the CRR should be decreased by 2%. This will be necessary if the pandemic and quarantine continue in the foreseeable future.

Is the on-going expansionary monetary policy enough to combat Covid-19?
Traditionally, monetary expansion was used to boost economic activities during recessions. The low-interest-rate was used to incentivize more consumption and investment. However, because of the pandemic, the role of monetary expansion to economic growth remains in question.

Even if there is an interest among the households to spend and businesses to invest, they cannot do it merely because of the lockdown and health concerns.

What fiscal measures are being taken?
The government has taken a proactive action to support the export-oriented industries through Tk50bn stimulus package.

The government has also taken the initiative to support Covid-19 affected industries by providing an additional stimulus package of Tk677.5bn. Out of which, Tk200bn will be used as working capital to support SMEs.

The commercial banks will provide the loan from their own pool of funds. The interest for this loan is capped at 9%, the loan-taking industry will provide 4%, while, the rest will be subsidized by the government.

The BB also decided to expand the Export Development Fund (EDF) to $5.0bn from $3.5bn. As a result, Tk127.5bn funds from the stimulus will be allocated in EDF. Furthermore, the interest rate for EDF will be reduced to 2% of the existing 2.73%.

“Pre-shipment Credit Refinance Scheme” is another initiative taken by BB to aid the economy. Tk50bn will be allocated for this loan scheme and it will provide interest up to 7%.

The rest of the Tk300bn will be utilized to support other sectors impacted by the virus. That fund will be used to subsidize the loans provided by commercial banks. Banks will provide loans from its own funds to business institutions.

The interest rate for this loan will be 9%, where the loan-takers will pay an interest of 4.5%, and the rest will be borne by the government. A portion of this money will also be used to widen the social safety net for daily labourers and informal workers.

Fiscal measures and financial schemes for business and industries will undoubtedly help to promote a business environment and ease the credit pressure. However, this will be true in the medium run when the businesses will go back to its full capacity.

When the normal economic activities resume, there will be another spike of money demand, especially on-credit as consumers will rush to make payments, spend on commodities. Whereas, businesses will also borrow to make payments, invest in raw materials and machinery to increase production.

On that note, the fiscal package and financial scheme will reduce the bottleneck and smoothen the economic recovery process in the medium run.

Is this fiscal stimulus and loan subsidy enough to support all sectors in the short-run?
In the short run, firms will be unlikely to avail funds because of the lack of businesses and consumer demands. Global trade is yet to pick up, and uncertainty among both enterprises and consumers prevail.

More has to be done to ensure the survivability of vulnerable working-class and firms. The social security package will indisputably help the extreme-poor or poor (PEP) population depending on daily wages or engaged in the non-formal economy.

As for the lower/middle households, whose income depends on their small businesses or salary from SMEs, they will be in a grim situation. Many trading and service sector SMEs cannot earn due to the disruption in the economy and are unable to generate incomes currently.

The benefits of loan facilities for them will not be feasible in the short-run because of the economic uncertainty. If the shutdown continues, it is highly plausible that these types of enterprises will be in a difficult situation as their fixed costs are not being addressed.

The interest from their outstanding loans, venue rents, and worker salaries are accumulating. Taking loans now would be futile for them as they would not get any return, and they still have to pay interest.

Ultimately, they have to resort to cost reduction through job cuts or vacating their business premises (if rented). This will create a chain reaction and increase the vulnerability of the households affected. Lack of unemployment benefits will hurt these households too. They are unlikely to take donations because of their moral views and ego.

Several sectors depend on seasonal festivals to generate profits that will ensure their operations for the next year. However, given the current scenario, the situation looks bleak for them. At this point in time, the government should try to focus on providing grants for SMEs.

Many MSMEs are not engaged with the banking sector, so it is not feasible for them to avail funds from banks right away. Our experience with the MSMEs shows that it takes over 40 days on average for a new applicant to get access to finance. This brings back to our previous concern about how will they keep afloat in the next few months.

Disbursement of working capital using the bank’s own pool of cash will put the risk of the defaulters on the banks. As a result, the banks will lend on a selective basis based on the bank-client relations, even with the interest subsidy from the government.

Governance is another grey matter on this decision because of the selective bias of loan takers by the banks. Subsequently, there is a possibility that most affected MSMEs will be excluded from the financial package and will be severely affected, even in the long run.

How should the fiscal package be designed?
While designing the financial schemes, the government should be mindful of not making it a blanket bailout. On a different note, the government should engage the services of the development institutions such as PKSF and other organizations to identify and disburse financial benefits to the poor and extremely poor population.

Because of their intensive work in the development sector, they have already mapped out the most vulnerable. Due to internal governance, they can do better tasks in reaching out to the most vulnerable in delivering social safety nets.

What should be the monetary policy in the post-pandemic scenario?
Coming back to the special loan packages, the government instructed that the banks should utilize their existing pool of funds for loan disbursements. As stated before, few of the bank management has already expressed concern regarding their liquidity.

Presently, they have enough cash to meet the demand, but they would need more when the loan request starts to pile up after the conclusion of the pandemic. The central bank should keep this into consideration to avoid bottlenecks situations and to keep the consumers’ confidence in the banking system.

Apart from reducing CRR, the central bank still has other instruments such as buying T-bills. Reduction in CRR will deplete the reserve funds for the banks; therefore, repurchasing government bonds from commercial banks could be another option for them to explore.

Other measurements that could be taken to inject liquidity: Lowering statutory liquidity ratio (SLR) and purchasing dollars from the banks. However, the latter policy can cause an appreciation of the currency, creating a negative effect in the exporting sector.

How should the government fund the fiscal stimulus?
For the fiscal year 19-20, Bangladesh’s external debt stands at Tk3,211bn, which is 12.5% of the GDP. According to Md Ruhul Amin, joint secretary of the Economic Relation Division (ERD), when the external debt of the GDP exceeds 40%, it becomes a concern for the economy.

Furthermore, for the FY18-19, Bangladesh’s debt-GDP ratio stands at 33.11%. It is comparatively lower than other developed economies. The statistics show that the government has the flexibility to borrow externally without causing much harm to the economy.

Considering the liquidity situation of banks and the possibility of increased money demand in the medium run, the government should opt for external financing to fund their fiscal stimulus.

Borrowing will be crucial as the revenue target of the government will be hurt because of the Covid-19. On that note, the pandemic is causing global recession and developed governments are launching their own fiscal measures to recover their economies.

There is a possibility that external funding will have no grace period. Hence, the Bangladesh government should consider deferring its status as a middle income to maintain its competitive edge in the global trade platform.

According to several economists, it will take quite a few years to recover from the pandemic’s impact. Graduating from the developing status means that Bangladesh will have to borrow at a higher interest rate from international organizations and will lose their preferential trade treatment.

Will the pandemic cause a policy revolution in Bangladesh?
Historically, there was never a crisis so severe that it caused both the collapse of the demand and supply side. Because of the quarantine state, economic recovery would not occur until the pandemic subsides; until then no monetary and fiscal stimulus can regenerate growth.

Consequently, it could also catalyze several much-needed reforms in the economy. Starting with the universal income. At the current rate, many might be forced to depend on social safety nets for their livelihood because of the low economic activities.

As a result, a universal basic income system might be required and developed if the pandemic continues for a prolonged period of time. Also, the majority of the SME formal financing depends on the banking institutions. As a result, the entire risk falls on the borrowing firm and the bank.

Furthermore, this causes the firms to incur additional fixed costs through interest payments. The post-pandemic period will be a high time to spread the risk through the promotion of venture capital.

Venture capital will not only provide equity for the MSMEs but also offer financial literacy and business management expertise. Retailer and supplier financing is another growing area in Bangladesh.

This sector should be scaled up with careful design and monitoring so that micro-merchants/entrepreneurs are included in the formal financial schemes. There has been quite a number of cases of epidemic and pandemic cases in recent times; it could also be a high time to initiate insurance policy against contagious diseases.           

FMS Abdal is a Research Associate, Innovision Consulting Private Limited.

Source: https://www.dhakatribune.com/opinion/op-ed/2020/04/29/will-covid-19-cause-an-economic-depression