Morning Commentary: Moral Hazard

Foreign Exchange - Morning Commentary
Moral Hazard 
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
Policymakers have justifiably flooded the markets with stimulus to meet the unprecedented shock from COVID-19.  The coronavirus driven shutdown represented a massive liquidity shock to small and medium sized businesses (SME).  Policymakers addressed this through the CARES Act’s Paycheck Protection Program (PPP) and the Fed’s Main Street Lending Program that prevented liquidity issues from becoming solvency issues.  

Nevertheless, even justified policy support has costs.  One of the key concerns is that stimulus will keep “zombie” companies alive and lead to moral hazard or excessive risk taking by businesses that assume they will be rescued again in the future should it be needed.  

Some zombie businesses that were close to bankruptcy have survived longer than they would have otherwise because of government support, but we would argue that preventing a huge wave of SME bankruptcies outweighs the cost of keeping some zombie businesses alive.  Moreover, government programs shouldn’t stop the creative destruction process in which older businesses are replaced by new companies with fresh ideas.  Over the medium term, these zombie businesses are unlikely to survive as they face a demand landscape that is much weaker than before the outbreak.  

On balance, the concerns over moral hazards are likely overstated.  The current bailout resulted from a large, economy wide shock.   As long as companies only expect to be bailed out under these circumstances, the system should continue to work as designed.   One of the government’s roles in a capitalistic economy is to insure the private sector from “systematic” risks.  Otherwise, businesses will be discouraged from the healthy risk-taking needed to drive economic growth.  

In light of the long and difficult road back to a full recovery, policymakers will likely be more concerned about the inadequate stimulus than the long term costs.  Specific on the labor markets, PPP-related hiring was likely a key driver of upside surprise to May’s job report.  Beyond headline numbers, government support programs also helped with labor efficiency.  It is much easier for workers to go back to the same job and for companies to hire the same employee than it is for both sides to find a new match each sees as a good fit.  By preserving employment, PPP helped to mitigate an extended period of lost income and skill erosion that typically occurs at the start of recoveries.  That said, what happens once government support fades remains a key risk factor.  
HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT:
  • Virus headlines continue to be negative with the hospitalization rate picking up in cities such as Houston and Los Angeles and more states stepping back from re-opening plans.  Arizona has closed bars and New Jersey is stopping plans for indoor dining.  A partial lockdown has also been reinstituted in Melbourne, Australia.
  • Fed Chair Powell will speak to the House Financial Services Committee today and is expected to warn that the US economy is “extraordinarily uncertain.”  Treasury Secretary Mnuchin will join Powell to discuss the fiscal and monetary response to the COVID-19 related shutdown.  
  • China has approved its controversial national security law for Hong Kong.  In response, the US has suspended Hong Kong’s special status and suspended preferential treatment there.  On the data front, China’s PMI numbers surprised to the upside, but external demand continues to be a drag. 
  • In the UK, PM Boris Johnson will lay out the details of his GBP5 billion infrastructure plan.  Additionally, German lawmakers are walking back the German Constitutional Court’s challenge to the ECB’s QE program.  A cross-party coalition has accepted the proportionality check of the ECB’s public sector purchase program.  
  • European Union countries extended a travel ban for US residents as they deemed the US response to the pandemic to be insufficient to travel to the EU for non-essential travel.  The EU will reevaluate this decision every two weeks.  
  • Canadian GDP contracted -11.6% MoM in April.  Needless to say, this is an unprecedented level of contraction with big declines across the board.  
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