A letter to Santa, the G7

Since the coronavirus outbreak became a pandemic, markets have plummeted. Global risk aversion has spiked, safe assets have becoming hugely expensive and the dollar – and gold – are kings. Against such a backdrop, central banks have scrambled to react, as quickly as possible, to the market deluge. But action is not enough and all eyes are on the G7 meeting.

Today, international cooperation is even more necessary than in 2008 for a number of reasons. First, the shock to the real economy is bound to be bigger, as the coronavirus pandemic not only affects demand but also supply. Second, its direct impact on companies’ cashflows as well as households’ income will worsen banks’ asset quality and solvency at a time where their regulatory constraints are much tougher than before 2008. Third, beyond banks, the non-banking part of the financial system has become huge and lacks direct access to central bank liquidity. Fourth, the global financial system is even more interrelated than in the past. In fact, the stock of foreign direct investment and portfolio flows had continued to increase and we are now seeing huge outflows from emerging economies. Finally, risky assets are a bigger asset class than in 2008, not only in the developed world with the huge surge in high yield credit but also those from emerging and frontier economies.

The market is expecting the G7 to meet soon. A strong signal of cooperation from the G7 is absolutely necessary to restore calm to the markets. No single central bank or government can alone pacify markets and get the crisis under control. In fact, G7 members should understand that if they continue to act at a national level, as has been the case for the past two weeks, there is a risk of a race to the bottom and beggar-thy-neighbor policies. This goes beyond the usual financial variables all the way to sanitary material. The CureVec story came as a shock to all in Europe and the world. Any company, no matter where it is located, should of course make the vaccine accessible to all people of the world. The G7 leaders therefore rightly should discuss how to pool their capacities and work together to above all stem the health crisis. But beyond that, bold economic steps are needed.

First, monetary policy coordination has been impressive but needs to go beyond the current agreement on swap lines. The lack of USD liquidity is more acute outside of the US than onshore but the instruments to inject liquidity are domestic. Cross-currency swaps have ballooned for Asia-Pacific currencies and especially the Australian dollar as banks scramble to cover their dollar funding needs. USD cross-border liquidity is needed. To that end the existing swap lines that the FED has kept with major central banks since the global financial crisis (ECB, BoJ, Bank of Canada, Bank of England and Swiss National Bank) need to be expanded and made even cheaper (there are another 25 more basis points which could be cut to reach the Dollar Overnight Index Swap) as well as extending the maturity of such swap lines beyond what has already been announced. In addition, central banks in the emerging world desperately need dollar liquidity which the FED will need to extend, as was the case in 2008, but probably with a larger number of countries. The IMF also has an important role to play.

Second, dislocations in forex markets are increasing the odds of a potential default of financial institutions. Furthermore, large swings in oil markets only make this situation more dangerous. In particular financial institutions outside G7 are vulnerable since they do not have access to the same kind of refinancing facilities at a central bank but are in need of FX. All in all, coordinated forex intervention should be high on the G7 agenda.

Third, fiscal policy will need to provide major support to all G7 countries. Liquidity and central bank action is crucial. But this crisis will lead to real losses in the corporate sector. And as these losses accumulate, defaults will occur leaving lasting damage. It is crucial therefore that fiscal authorities provide much needed relief to vulnerable individuals and underpin the entire corporate sector, for example by taking over part of the social security payments that companies pay. In situations like this, it is best that the government insures the economy. The cost of that insurance will be passed to all tax payers later on in one way or another.

The G7 should set an example of international cooperation and come out with a strong signal of unity and support for the euro-area. Only then will the cost of the crisis be temporary and manageable. This is our letter to Santa. I hope at least some -if not all -of these wishes can be fulfilled.