Credit Guarantee Feedback Loop

The gap between the US and Europe on the pandemic front is becoming wider. True, large clusters continue to be discovered in the Euro area and the jump in the virus reproduction ratio in Germany calls for attention, but overall the decelerating trend continues. In the US the re-acceleration is spreading further. While the reluctance of political authorities to delay the re-opening of the US economy is crystal-clear, focus may shift from “top down” directives to decentralized decisions by businesses and behavioral changes by consumers.
Still, so far, every market wobble has been met by more policy support – we had another example last week with the Fed effectively moving to secondary market intervention for corporate bonds or the US administration mentioning yet another fiscal stimulus. In Europe policy-makers continue to show more restraint, but the success of the new TLTRO is a reminder of the extraordinary quantum of support provided by the ECB.
Government guarantees on business loans contributed to this success: state support has incentivized banks to lend a lot since the beginning of the pandemic, helping them to qualify for the most favourable conditions of the TLTRO. Still, even if we believe that pledging the governments’ balance sheet was the right thing to do in the emergency to ensure businesses could survive, the medium-term consequences of those guarantees need to be explored. In the Euro area, a 1% decline in GDP generally results in a 6% rise in the non-performing loans ratio. Some of these guarantees will be triggered, complicating the already thorny public debt trajectory of some of the member states, in particular Italy given the high starting point for NPLs there. Still, we think this has created a situation in which “ordinary” fiscal policy will be constrained to remain accommodative as long as the guarantees are “live”. Indeed, some of the benefit to public debt of converting to fiscal austerity could easily be lost to the resulting rise in non-performing loans the ensuing slowdown in growth would trigger.
Incentivising businesses to take more debt is no perfect substitute to traditional fiscal stimulus. On the EU’s Recovery and Resilience Fund’s front the “frugals” may be shifting to grudgingly accepting the principle of transfers, but focus is now on the allocation key and this could delay the finalization of the project even if a generic political agreement in July looks doable.