Welcome to part two of our special series with EY on the economic response measures to the Covid-19 crisis. Part one is available here.
In this edition, we discuss the shock-and-awe measures deployed by governments to rescue their economies and the short and medium-term implications for their finance ministries. What are the paths out of the emergency schemes? How are governments planning to restart their economies and what will it mean for their finances? How is this crisis fundamentally reordering their priorities in both developed and emerging economies?
Joining us is David Barker from EY. An investment banker by background, David joined the consultancy firm in 2001, where he was global head of corporate finance for financial services for more than 10 years and was heavily involved in almost all the sovereign bailouts since the 2008 financial crisis. He has worked closely with many governments and supranational institutions over the last decade and so was asked to lead EY’s Covid-19 response across Europe, the Middle East and Africa. He has been addressing the intersection between governments and their treasuries with corporations and the public, often through the banking system.
Listen to the recording, or read the transcript below.
John Orchard: You have spoken to a lot of finance ministers over the past five or six weeks, David, what sort of advice are they looking for from EY?
David Barker: We have had a whole range of conversations to deal with the initial shock and what was intended as an awestruck response; large amounts of money to reassure the markets, corporations and employees. People are focusing on whether they have built the right sort of transmission mechanisms. Are they at scale? Are they working? What makes them resilient and what is best practice? Having built these mechanisms, the conversation has now evolved significantly to the second layer effect; the economics, and in particular the affordability, which is going to become the next big challenge.
JO: We’re going to look at the crisis and its responses through the prism of those conversations and we will break it down into three stages – firstly the shock and awe measures, then their short-to-medium term effects and finally the aftermath and impact. What have been some of the key initial responses from finance ministers and how have they come about?
DB: We’ve spoken a lot about expansionary monetary policy and the impact of lowering rates, the creation of swap lines, the implications of regulatory forbearance, the removal of counter cyclical buffers, deferral of stress tests, as well as practical matters including non-performing loan recognitions and provisioning. We discussed the architecture of this set-up and the fiscal policy interaction – both direct and through commercial banks. We are advising on state aid considerations, and setting up commercial paper asset purchasing programmes through central banks, grants and direct payments.
The biggest focus is the universal basic wage that so many countries have put in place for furloughed workers and what appropriate earning percentages might look like. A lot of those were predicated on expectations of a relatively gradual take up. A number of finance ministers have been really quite surprised by the demand and the impact it has had on their finances. We have had a lot of conversations about the appropriateness and the structuring of loan guarantees through the banking system – what is the right scale and how to get volumes of money moving quickly. In the UK, for example, which implemented a guaranteed loan scheme called the coronavirus business interruption loan scheme, there have been well documented concerns around the speed of deployment. The new smaller loans scheme has been much more effective. The volumes in the first couple of days are really quite substantial, with around £1bn issued already in the course of this one week. These are conversations about the breadth of the pipework and, longer term, how to build resiliency.
JO: So there has been a stronger take up of support schemes than originally anticipated? Where?
DB: We believe that a number of governments were looking at take up rates of 10% to 15% over time. We’ve seen multiples of that, three to four times, which is leading to what I call the ‘economic consequences problem’, including concerns over the long-term affordability of furlough schemes. How long can governments continue to plough a decent percentage of their debt-to-GDP ratio into structures that really are probably no more than delaying the inevitable consequence of what has to happen?
Once companies have got through the initial crisis, they will be forced to stand on their own two feet and deal with a world ahead of them which has massively changed. The furlough is merely a mechanism to taper into what for many countries will be a severe number of radical restructurings, with governments prioritising among industries and sectors. It has been an appropriate buffering but a lot more work looms ahead. It is almost as if the tsunami water is drawing back a bit, but there is certainly the next stage of restructurings to come.
JO: What are the paths out of the furlough schemes? What are the immediate challenges for finance ministers in terms of affordability, and the effects on the financial system and the economy as a whole?
DB: A number of economies had not restructured their banking systems, not only in western Europe. Coming into the crisis there were plenty of legacy non-performing exposures left on balance sheets, for example. Countries had capital raising measures in place through bank privatisations which have been interrupted, NPL disposal processes were disrupted. An early consideration for governance was around avoiding moral hazard by requiring the banks to underwrite 10%-20% of the risk in the guaranteed loan schemes. But with 10%-15% of GDP in terms of overall magnitude it is still a very sizable amount for a bank to be exposed to if it is not in good shape. So there is a question about how resilient they are going to be in some countries together with the longer-term conversations around so-called ‘bad banks’ [resolution vehicles for impaired assets], rejected so far in the euro area but on the minds of a number of countries.
JO: What are the similarities and differences with the crisis from 10 years ago? Banks may be under strain, but they are much better capitalised than in 2008. What risks are there to the financial system?
DB: It is certainly the sovereign banking ‘doom loop’, as it used to be called, and there is a danger that it may well remerge. There are lots of conversations on debt sustainability and affordability, where particularly in the euro area a number of countries have struggled to be convinced about the terms of supranational or European Commission or International Monetary Fund support measures. Many countries have focused very much on making their own preparations at a national level. That has been expressed by the number of people rushing to the Eurobond market to secure cash. I think that crowding out in debt markets is going to be an issue for the future.
Another thing we have noticed is that governments are keen to avoid the mistakes of the banking crisis, including negative perceptions of the sector’s behaviour itself. Most thoughtful governments have begun embedding social purpose and good governance and sustainability thinking into their response measures. This is focused around the intelligent, thoughtful and defendable use of taxpayer money. This will be particularly important as we go into the restructuring phase.
JO: How are finance ministries thinking about companies and banks that are not in particularly good health? Medium-term, how can they protect their economies from zombie businesses?
DB: Some transmission mechanisms are incredibly efficient and effective from inception. There are plenty of stories about how the Swiss managed within a matter of two or three weeks to initiate, set up and deploy a system that you would receive money the same day. The current small business system in the UK is actually deploying same day application funding, too. However, the funding was not evenly placed across the size of economies as there were a lot of ‘squeezed middles’.
We had conversations with several governments about setting up ‘field hospitals for corporations’ and how you might bring in a series of distressed and cashflow-negative companies, perhaps triage them with super-senior cash and evaluate their cash burn for a few weeks. Then we would find ways to classify them, from easy-to-resolve through to complex stakeholder restructurings with lawyers, bankers and accountants, and then on to those which unfortunately need to be administered.
The spread of stimulus was not necessarily even across the economy. Generally, the largest corporations were well catered for through commercial paper and the central banks. A lot of focus was put on furloughing the smaller companies. The middle section required rather more tinkering with than governments initially thought, and that brings back the role of commercial banks and them standing alongside government. An uneven distribution of stimulus was the first problem. From then on, by the time the scale of take up had been seen, there was a certain amount of gulping in finance ministries as they realised how expensive things would get. It would be no more than a buffer or a shock absorber to what some are calling a day of reckoning where corporations will have to stand on their own two feet in a changed world.
JO: There seems to be, as you say, a day of reckoning in the post. In the sovereign bond market some of that can be offset, perhaps, with monetary financing, which is controversial. How are finance ministries considering this issue of raising capital, whether it is sustainable and how to reduce it in the end?
DB: We have noticed that a number of conversations have shifted to philosophical thinking around sourcing asset pools for longer term financing. During the financial crisis we used to talk of bailing out and now the conversation is going to move more to bailing in to find those deep asset pools. These might include those much-vaunted private equity asset pools which I suspect might be much harder to deploy than governments perhaps understand, pools of insurance and reinsurance capital tied up in very strong balance sheets, sovereign fund money and supranational monies. This would also include things like transaction taxes, asset taxes and wealth taxes. So there are the beginnings of a discussion about how to rebalance policy, together with more immediate discussions in some smaller countries around the rush to finance. This brings with it the dangers of issuing government bonds to a banking system and reinforcing a negative loop of sovereign bank dependency.
But there are plenty of people rushing to the bond markets and there are extraordinary sums of money being talked about. In early May, the US administration said in the second quarter it has a need to finance $3tn. The markets will come to focus on gross financing needs and that is the appropriate place to think about sustainability. There are some concerns about longer term inflationary effects, but broadly, there is an expectation in this new world of close to zero rates for any sensible future planning horizon.
Therefore, you cannot look at simple debt-to-GDP measures as a way of figuring out sustainability as debt affordability is only part of the picture. If you look at gross financing needs globally you will find countries like the US and particularly Italy which have volumes which could even touch 20% this year, which is very high, dangerous territory, and as yet perhaps not reflected fully in government bond spreads. But there are complex and manifold reasons why that would not be the case as yet.
JO: How are finance ministers and governments deciding what help to withdraw, when?
DB: Let us divide that into two parts. I described at the beginning how we were talking about a medical vortex and a focus on virus reproduction rates. And now, the economic vortex and a focus on affordability. Governments are trying to figure out appropriate real economy reopening protocols and restarting protocols. EY has been doing a lot of work for ministers of finance and economy, in a number of countries, centred on the likely duration of social distancing. Several governments are taking the view now that without a vaccine and mass testing, there is very little chance of removing social distancing. We are entering into conversations with sectors of industry on governments’ behalf. Some have asked us to convene industry sectors with trade unions and trade associations to discuss burden sharing among them, as well as reopening protocols.
This is complex in practical terms – take an oil and gas company for example and consider the different scenarios for an oil rig, petrol station forecourt or head office on the 33rd floor. You must explain to different sectors how they need to translate social distancing into particular working environments and then set protocols amenable to everybody to reopen. As to timing of which sectors to go, I think countries are having different experiences with medical outturns.
There seems to be some degree of consensus that social distancing is here to stay and that it has implications for things like tourism, hospitality, and airlines. Take countries such as the Philippines, Thailand, Greece, Portugal and Mexico, which have close to 20% of their GDP broadly dependent on these sectors. To the extent those countries are running furloughing schemes – the UK has indicated that social distancing is likely to remain in place until Christmas, for example – you’re going to have to see a lot of focus on how long these furlough schemes can be maintained and how affordable they are.
JO: How are you seeing governments and finance ministries consider the trade-offs and the complicated cost benefit analyses for preserving social distancing and therefore limiting the health impact versus the considerable impact on the economy?
DB: There is a large amount of work to be done both by governments and their advisers about scenario planning and economic impact assessment by sector. That can be very interpretive and subjective. Developing economies with very little capital to spend need to prioritise not just between sectors but also individual companies. There are countries that can’t afford furloughing at all, where furloughing and social distancing are described as a somewhat Western luxury to consider. There’s a lot of work for governments – sometimes sponsored by multilateral banks and development agencies such as the United Nations Development Programme and working with firms like EY – to analyse economic impacts country by country, sector by sector.
JO: On to the day after the day after: how are these finance ministers looking to get their economies back as close as possible and as quickly as possible to business as usual? More importantly, what problems do they see being left behind that will need medium-term attention?
DB: I mentioned earlier the idea of creating things such as lender of last resort facilities. A lot of work is about to come into immediate focus around the restructuring and the clean-up. For example, what will the eligibility test be around governments becoming lender of last resort? Prior viability of the company will clearly be a major issue. As are the public interest, stewardship and governance. Will governments support companies that have foreign shareholders or that have private equity shareholders who don’t pay enough tax in their countries? These are immediate issues that governments are beginning to grapple with aided by firms like ours. In the longer term, there is an amount of reimagining about what does the future of commercial real estate look like, for example?
Having spoken with a number of bank heads around Europe, many have found it surprisingly easy to work from home, notwithstanding one or two instances where middle offices have been impacted by not having access to laptops at first. There is a desire in some cases to start reshoring certain core functionalities within industries; PPE and life sciences for instance. I do believe that the experience of Covid-19 actually has a few silver linings to it. Some are around institutions and sectors being able to be more productive and figuring out ways to operate which don’t need the number and the distribution of people that they have now. Perhaps they need fewer retail outlets and clearly more automation around their online and digital offerings. A lot of focus from governments is on reimagining city centres, where incidentally commercial real estate is one of the core collateral assets in the banking system. How are we going to think about future strategic planning there? What are alternative uses for these assets?
JO: A further challenge to consider, if businesses come out of this crisis more efficient or more productive, is less demand for employees. Are you having conversations with finance ministers that are starting to consider these structural issues in the medium term?
DB: The rate of acceleration of digitisation and automation has taken a real leap forward in the last two months and is planned to continue that at pace. That will necessarily improve productivity but as you say probably with fewer people. Some of the projections of unemployment rates are pretty startling. The US has suffered around 30m unemployed in four weeks. The Banco de España in the last 48 hours or so has looked at a worst case unemployment rate of 19%. With unemployment comes both a loss in revenue and an increase in governmental expenditure and so they are trying to get their minds around the issue of where the unemployment sectoral impacts will lie. They are beginning to think about retraining schemes and pivoting sections of the workforce.
A classic example which UK people often talk about is picking agricultural crops. That same argument applies, I learned, in Uzbekistan and Kazakhstan, where people migrate across borders, some of them to Russia, to pick the agricultural crop. But those borders are now closed and prospectively are likely to remain closed.
We have seen a number of airlines around the world encourage their staff on furlough schemes to actively get involved in local social relief programmes or in their national health system. So governments are looking at the development training exercises needed to redeploy excess pools of labour. I think there is some very strategic longer term reimagining going on and governments are looking to lock down even the vaguest sense of numbers around it.
JO: Notwithstanding the fact that budgets will be under strain, is there talk about investment into digital infrastructure?
DB: Exactly. I think of things like the Amazon technology to do cashier-less shopping: walk-in walk-out and experience the Uber effect of contactless shopping. You can see that as being an interesting way of even lowering the physical cost base of city centre retail premises. So I think digitisation en masse is on the way, however it is important to digitise in a resilient way. Resiliency – onshore, locally assured resiliency – is going to be another key component alongside all the other stakeholder value issues, making sure that, should lockdowns or future pandemics come back, you aren’t solely reliant on ‘just in time’ supply chains anymore.
JO: Let us go back to explore those countries that will take longer to recover and will struggle to do so on their own. Quite a few might need help from multilateral organisations, development banks, and other inter-governmental institutions. What are you seeing there?
DB: Quite a lot of effort, and real speed and progress to – shall we say – try to push ‘targeted money’ out of the door at speed. The World Bank has earmarked $150bn at a rate of $10bn or so a month for 15 months to be spent, for example, and the European Bank for Reconstruction and Development is doing similar things. These are very targeted to help the most disadvantaged in society, such as helping smaller micro community SMEs by getting micro lending to them. These schemes often having a prioritised focus around diversity and gender issues in those countries, so trying to pick up the most at-risk groups. The IMF has now publicly said it has over 100 bailout applications.
As with any global infrastructure, there is a need to build scale and resiliency into the processing and there’s a need to get requests for proposals to countries out at greater speed. So again, firms like mine have been helping to draft some of these and are working alongside multilateral development banks to try to accelerate what I think was very good start for many of them.
JO: Thank you very much, David. This has been a very interesting discourse on what’s taking place in finance ministeries, what they have to address today, tomorrow, and the years and decades to come. Thank you very much for talking to us today.