China/US trade

The third wave of the COVID-19: Risk of credit market squeeze

Macro

Christopher Dembik

Head of Macro Analysis

Summary:  The third wave of the COVID-19 could result in credit market squeeze and corporate defaults if financial conditions fail to normalize quickly. Policymakers are already planning rate cuts and emergency support to SMEs in order to contain this risk.


The first wave of the COVID-19 was the geographical contagion from Asia to the rest of the world and the market panic due to the expect high economic cost of the virus.

The second wave is just starting. Supply chain disruptions are being felt at the global level, especially for foreign companies that are dependent on Chinese SMEs. In the latest US ISM survey that was released yesterday, respondents pointed out difficulties in getting parts and materials due to disruptions in their supply chains. The supply shock is visible now, and it affects a wide range of industries, from electronics to food, beverage and tobacco, and will result in significant delays in production at least for some weeks.

The third wave is the risk of credit market squeeze due to a tightening in financial conditions that would primarily hit SMEs. The combination of lack of available credit and broken supply chains is putting increasing pressure on the private sector. At this stage, it is very difficult to estimate the risk of defaults and the related potential economic cost. But, given central bank reactions, it is bright clear that policymakers want to avoid that the current market tensions develop into a liquidity crisis. Most observers estimate that financial difficulty for SMEs could arise three months after the COVID-19 outbreak if conditions fail to normalize. A race against the clock is engaged because we are already two months into this crisis.

Over the past few weeks, almost all the major economies have experienced a tightening in financial conditions or at least serious risks that it materializes.

In the United States, the Bloomberg Financial Conditions Index is back to levels last seen in December 2018, when the stock and the credit markets faced a sharp slump forcing the Federal Reserve to change the course of monetary policy (the so-called “Powell Pivot). To address current tensions, we expect the Fed to cut rates in March (and it could be as early as this week given market expectations), which should compel other G-7 central banks to follow through in a “coordinated fashion”. The Federal Reserve might have to step in in June again if the economy is not back on the right track.

In the euro area, the ECB is discussing targeted measures to provide emergency support for European SMEs. A rate cut, which is considered as a done-deal by the market (the likelihood of a 10 basis point cut stands at 100% in April), seems to be out of the table for the moment. ECB watchers have pointed out that a targeted credit facility supporting SMEs is nothing new. There is actually a precedent: in 2011, the ECB launched the additional credit claims (ACC) framework, which allows Eurosystem national central banks to accept as collateral certain credit claims that are not compliant with the ECB’s credit quality standards. The specificity of this measure is that losses resulting from the ACC are not mutualised, but are borne solely by the national central bank accepting it. This special operation might be officially announced at the forthcoming ECB meeting, on 12 March.

In China, the risk of corporate default is obviously higher due to the sharp negative impact of the COVID-19 and the quarantine on economic activity. Only one third of SMEs, which represents roughly 60% of China’s GDP, is back to work. Companies operating in China need to deal with many challenges, including labor shortage, transport disruptions and a high level of maturing debt. According to Bloomberg, China’s private sector faces ‎$944 billion of debt maturities onshore and ‎$90 billion offshore this year. Before the outbreak, the level of private debt was already a worry mentioned by many investors. Based on the latest data, China’s corporate debt is close to its highest level at 150% of GDP, with a private sector debt service ratio near record high at 19.3%. The PBoC interventions have managed to reduce pressure on refinancing cost, pushing down corporate bond yield, but the risk of liquidity squeeze remains. That being said, the number of official corporate defaults should be limited in China as the government has encouraged local financial institutions to write off bad loans in order to reduce the NPL ratio. Thus, it should be difficult to assess the exact impact of the third wave of the COVID-19 in the country.

03_CDK_1
03_CDK_2

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)
Full disclaimer (https://www.home.saxo/legal/saxoselect-disclaimer/disclaimer)

Trade responsibly
All trading carries risk. Read more. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more

This website can be accessed worldwide however the information on the website is related to Saxo Bank A/S and is not specific to any entity of Saxo Bank Group. All clients will directly engage with Saxo Bank A/S and all client agreements will be entered into with Saxo Bank A/S and thus governed by Danish Law.

Apple and the Apple logo are trademarks of Apple Inc, registered in the US and other countries and regions. App Store is a service mark of Apple Inc. Google Play and the Google Play logo are trademarks of Google LLC.