Morning Commentary: Moral Hazard

A daily summary and commentary of events and factors that affect the global markets, with a particular emphasis on the foreign exchange markets.

Moral Hazard  Share this story: 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.

If we can help you with any Foreign Exchange needs, please email foreignexchange@cnb.com or call (800) 447‑4133. Want to learn more about international finance, economics, and global events? Sign up for our other Foreign Exchange emails and videos!

Follow City National Bank on social media:

Non-deposit investment products: • Are not FDIC insured, • Are not deposits or other obligations of City National Bank and are not guaranteed by City National Bank, and • Are subject to investment risks, including possible loss of the principal invested. This report is for general information and education only and was compiled from data and sources believed to be reliable. City National Bank does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors as of the date of the report with no obligation to update or notify of inaccuracy or change. This report is not a recommendation or an offer or solicitation to buy or sell any financial instrument discussed. It is not specific investment advice. Financial instruments discussed may not be suitable for the reader. Readers must make independent investment decisions based on their own investment objectives and financial situations. Prices and financial instruments discussed are subject to change without notice. Instruments denominated in a foreign currency are subject to exchange rate and other risks. City National Bank (and its clients or associated persons) may engage in transactions inconsistent with this report and may buy from or sell to clients or others the financial instruments discussed on a principal basis. Past performance is not an indication of future results. This report may not be reproduced, distributed or further published by any person without the written consent of City National Bank. Please cite source when quoting.

Unsubscribe from this list  |  Update email preferences This message has been sent to bank@banking.offers.report. Please do not reply to this email. To ensure the delivery of future emails, please add foreignexchange@emails.cnb.com to your email address book or safe sender list. Copyright ©2020 City National Bank – All Rights Reserved. 350 South Grand Avenue, 12th Floor, Los Angeles, CA 90071 City National Bank is a subsidiary of Royal Bank of Canada. TERMS & CONDITIONS  |  PRIVACY STATEMENT NMLSR ID# 536994 | City National Bank Member FDIC