ECB Fears Covid Could Trigger a Financial Crisis

There is a clear danger that the eurozone could relapse into a double-dip recession before it has regained more than half of the output lost during the first wave of the pandemic.

By Ambrose Evans-Pritchard and cross-posted from The Daily Telegraph.  

The European Central Bank is increasingly worried that economic damage from Covid-19 could mutate into a full-blown financial crisis, setting off a second downward leg in the recession and deep scarring of the productive system.

Christine Lagarde, the ECB’s president, warned that risks are “clearly, clearly, tilted to the downside” and pledged a fresh blast of stimulus in December using “all instruments”. Such a clear signal breaks with the institution’s long-standing rule that it never commits in advance. 

The ultra-dovish language pushed the euro to a four-week low of €1.1659 against the dollar and sent sovereign bond yields plummeting to historic depths. German 10-year Bunds dropped to minus 0.64pc. Even Portuguese bonds fell below zero for maturities out to nine years.

Mrs Lagarde said the recovery is “losing momentum more rapidly than expected” and tacitly admitted that the bank’s rosy forecast of 3.1pc growth in the fourth quarter now lies in tatters. She may regret having said in June that the “lowest point” of the Covid crisis had already passed.

There is a clear danger that the eurozone could relapse into a double-dip recession before it has regained more than half of the output lost during the first wave of the pandemic. 

Her tone was a crystal clear message to governments that circumstances have suddenly become more treacherous and that double-barreled fiscal and monetary support is urgently needed, with national treasuries carrying most of the burden.  

Krishna Guha from Evercore says a further €500bn of pandemic bond purchases is likely in September, buttressed by a fresh round of ultra-cheap lending to banks (TLTROs) at rates of minus 1pc or even lower.

Lagarde says the ECB is on high alert in case the second wave of Covid-19 triggers retrenchment by banks and a destructive squeeze in lending: “The whole eurosystem will be extremely attentive. We need to make sure that there is ample liquidity to respond to any kind of shock.”

Pablo Hernández de Cos, Spain’s central bank governor and chairman of the G20’s Basel Committee, said there is a risk that banks will become the channel for a further contractionary shock. 

“There’s no room for complacency. This began as a health crisis and then turned into an economic crisis, and it is vital that it doesn’t turn into a financial crisis,” he says. 

The ECB’s chief regulator, Andrea Enria, warned this week that non-performing loans (NPLs) in the eurozone could surge to €1.4 trillion in a “plausible scenario”, dwarfing losses seen after the Lehman crisis. He called for a pan-eurozone “bad bank” to clean up balance sheets and recapitalise troubled lenders. 

The International Monetary Fund said in its Stability Report that a double-dip downturn could set off a cascade of bankruptcies and blow through the loss-absorbing buffers of the banks, with contagion ripping through “the entire financial system”.

“Renewed liquidity pressures could easily morph into insolvencies, especially if the recovery is delayed,” it said. 

The ECB’s latest bank lending survey recorded a “considerable tightening” in credit over the third quarter despite the economic recovery during the summer, with 19pc imposing tougher loan terms.

It is clear that lenders were already looking beyond the mechanical effects of the V-shaped bounce, fearing a wave of defaults as support schemes wind down and debt guarantees expire. Spain faced an incipient credit crunch even before it spiraled back into a health emergency this week…

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