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Money, loans and solvency

As the Fed says, it is grants, not loans many need right now.

Word or phrase solvency in a dictionary: SOLVENCY

by
John Redwood

in Features

14.04.2020

Easter brought news of a deal to cut OPEC and Russian oil production by an unprecedented 9.5 million barrels a day,  but the oil markets decided the collapse in demand was still bigger than the supply cuts. As a result, oil held onto the rally taking  Brent crude above $30 but left investors nervous about volumes and prices for at least the next few weeks. We also saw many countries announce that their lockdowns will continue for longer than the initial three or four week periods. Those that have decided on a slow progress to liberalisation like Italy and Austria are still keeping many people and companies idle. China remains the only country to make decent progress with lifting controls.

A normal recession begins with a liquidity squeeze. The authorities seek to curb inflation by raising interest rates and limiting the supply of credit. Businesses that have been apparently trading well but have been borrowing large sums to do so are hit first. As they strive to generate cash by selling assets, so they trigger falls in asset prices. They claim they are just illiquid, but if assets fall too much and are difficult to sell the businesses concerned end up insolvent. The commercial banks rein in more, as they face deteriorating numbers. They have more bad loans, less asset cover for their lending, and more fear of the future. So it goes on, until the Central Bank and government decides they have squeezed enough. They then inject cash into the system, lowering rates and beginning to relieve the squeeze.

This is no normal recession. It is far deeper and more abrupt. We do not know if it will be much shorter than a usual recession or if it will drag on.  It flows from a large number of businesses losing all their revenue overnight, with no firm knowledge of when it might resume. They are of course illiquid, so the Central Banks have slashed interest rates and made large sums available to the markets and commercial banks in the hope they will lend it on at affordable terms. The problem the businesses have is that they are missing all their revenue, so as the Chairman of the Fed has said they need a grant more than they need a loan. Any borrowing will be to pay current costs which generate no revenue, a situation which leads to rapid balance sheet deterioration.

The issue before us is, therefore, can excess liquidity stave off insolvency? Knowing that illiquidity in a bull market can lead to insolvency when money tightens, can huge amounts of liquidity in a revenue freeze avoid insolvency for all those stopped from trading? It all comes down to an assessment of how long the impossible position of having costs and no revenues lasts. If it is a short period then bridging with cheap loans will work. It still needs cooperation from the banking system to pass the money on quickly with a minimum of fuss at low rates of interest in the hope that the companies concerned can soon resume profitable operations. If the lockdown or slow relaxation is over a longer time period there will be plenty of bad debts and insolvent companies in the system which will be bad news for their shareholders and lenders.

If the Fed carries out its plan to buy massive quantities of debts backed by the US Treasury they can keep markets up while they do so.  They may end up with a weak portfolio of assets if they pay little attention to credit quality, and if the period of impaired activity lasts. This delays market judgements on an absence of profits, dividends and ability to pay for loans in the more difficult cases. It cannot deny the logic that those who have lost a lot of revenue may go bankrupt. As the Fed says, it is grants, not loans many need right now. The last few days have confirmed our worry that this will not be a fast V-shaped recovery, as many parts of the world are still some way from allowing most businesses to trade again as normally as demand will allow.

As poor company turnover, profit and dividend news comes out so the share prices of the badly affected companies will adjust to the grim reality. Meanwhile, the companies like Amazon, the supermarkets and the food producers that can trade on will get stronger, as people stay at home and buy the basics with what income they can maintain.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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