Why the global banking sector faces a perfect storm

Poor economic performance combined with fiscal support and low interest rates will affect the sector's income in the medium term

Water is released from the Three Gorges Dam, a gigantic hydropower project on the Yangtze river in central China's Hubei province. China's financial regulators are concerned about the health of the banking sector as bad loans are on the rise amid slower economic growth. AFPShow less

Five months after the coronavirus pandemic started, the effects continue to pressure the world economy. This unique crisis has forced significant changes in the way governments, central banks and private sectors approach economic management.

Fiscal debt has risen to record levels as countries fight the spread of Covid-19. In parallel, interest rates are currently at record lows. The twin trends indicate that the $11 trillion (Dh40.04tn) in global public debt can be sustained in the medium term as loan costs remain manageable.

Amid the higher uncertainty, some bright spots can be seen, particularly for carbon emission goals and alternative energy sources.

In the EU and the US, fiscal policy and central bank policy work hand-in-glove to support low-cost lending and provide financial aid to keep the private sector afloat and limit unemployment as much as possible. As in China’s case, this has mitigated losses, which would have been much worse without the interventions.

China’s second-quarter growth after losses in the first three months of the year surprised to the upside, offering encouragement that recoveries can happen relatively quickly with timely fiscal and monetary policy support. Having said that, there’s no guarantee that a second wave of coronavirus infections won’t be back to pressure China’s economy again.

Other regions also face challenges: the Mena region, the EU and the US face the threat of recession in the medium term, not least because of lower oil prices and uneasy investor sentiment about the future.

Looking at the big picture, global Covid-19 cases have reached more than 14.7 million at the time of writing. Even in countries like Germany, which have largely beaten the initial infection curve, localised lockdowns are used to limit persistent outbreaks. Inevitably, this affects economic performance.

Poor economic performance combined with fiscal support and low interest rates add up to a perfect storm for the banking sector, which looks set to be weighed by lower interest rate income for the near-to-medium term.

In China, financial regulators are concerned about the health of the banking sector as bad loans are on the rise amid slower economic growth. This is only to be expected considering that the International Monetary Fund sees China’s full-year growth at 1 per cent compared to 6.1 per cent the year before. A cash flow crisis could happen at any time under the circumstances, puncturing cash buffers in the banks.

Lenders in other regions face similar prospects. The EU Council temporarily changed banking rules to support lending and the European Central Bank kept its key interest rate at zero per cent. The US Federal Reserve slashed rates to near zero and plans to keep them there possibly until 2022.

Paradoxically, the coronavirus crisis has elevated the level of understanding towards hard-hit consumers and businesses. With this in mind, as long as the situation is recognised and handled proactively at the fiscal and monetary policy level, even the sensitive banking sector could emerge in good enough shape to recover quicker than expected.

Amid the higher uncertainty, some bright spots can be seen, particularly for carbon emission goals and alternative energy sources.

The pressure on oil prices is unrelenting, so natural gas is emerging as a strong favourite for future growth. In a growing trend, energy giants are diversifying into natural gas and other alternatives in order to replace lost oil revenue. This also serves to prepare energy companies for long-term restrictions on emissions.

Oil prices themselves stabilised after the initial wild swings into negative territory in April. Opec’s mid-July move to increase production may be too early under the current circumstances. Still, with China back on track to growth and economies slowly reopening, oil prices can reasonably be expected to stay in the $30 to $40 range in the near term – barring any surprises.

Also on the brighter side, some economic indicators in the US are picking up. June retail sales were up 7.5 per cent compared to May as lockdowns ease. Unemployment also eased in the week ending July 4 and the National Association of Home Builders’ Housing Market Index rose to 72 in July from 58 in June.

Additionally, there are more promising signs that coronavirus vaccine testing may deliver a solution but even in the best-case, widespread distribution will take time.

Bright spots notwithstanding, the medium-term outlook for interest rates and energy prices is set to stay subdued.

Hussein Sayed is the chief market strategist at FXTM