From the Economist's Chair: Damned if they do, damned if they don’t

Author David Fyfe, Argus Chief Economist

Recent banking sector turmoil has raised concerns over sector contagion and a repeat of the Great Financial Crisis of 2008. Although more substantial financial buffers in place this time around will likely prevent a repeat of events seen 15 years ago, these sectoral strains merely re-emphasise the chilling effect that rising interest rates could have on credit, economic growth and oil demand in 2023.

The idea that the world economy could seamlessly transition from a sea of financial liquidity towards tighter and more normal fiscal and monetary discipline was always likely to prove fanciful. Central Banks have moved rapidly in the last 12 months to try to staunch rising inflationary pressures. These pressures have derived from a decade of virtually free money, followed by a splurge of government fiscal largesse during the pandemic and then by unprecedented support for energy consumers following Russia’s invasion of Ukraine and subsequent sanctions.

A climate of rising interest rates should generally be a healthy one for bank profitability as long as the cost of customer borrowing rises faster than the rates offered to savers. However, some smaller banks, on becoming awash with cash in recent years, have invested heavily in long-term government bonds without hedging against the possibility of a significant decline in value, now coming to fruition as Central Banks raise interest rates. Alongside rising customer default risk as rates have risen, a number of under-hedged and over-leveraged institutions have confronted a run on their deposits, necessitating rescue packages. This has led some to point out the dangers of moral hazard should the impression take root that governments will always foot the bill, undermining market discipline and the prudent assessment of risk.

Bank contagion contained?

Notwithstanding the philosophical elements at stake here, implications for the real economy and for commodity markets could be profound. Central Banks have been quick to deny parallels with 2008, citing banking systems that are better capitalised than 15 years ago, with broader access to liquidity in cases of crisis, simplified inter-bank linkages and with reduced exposure to bad loans. However, with several significant institutions having already required rescue, the market is clearly concerned about the risk of contagion, and investment has clearly shifted into “risk-off” mode. Gold has taken on renewed lustre, while European banking stocks, US Treasury Yields and crude oil have all slumped. Even the Shanghai CSI300 index, which should otherwise be strengthening amid China’s economic re-opening, has lost ground in recent days.

Investors are fearful that further rate hikes from the US Fed this week (now seen likely at +25 bp after the ECB’s +50bp hike last week), while necessary to continue the battle with inflation, will reveal further banking sector fragilities. This is the quandary the Central Banks face:  to pause rate rises so as to avoid further turmoil in the commercial lending space, but at the cost of resurgent inflation or to stay the anti-inflationary course but in so doing choke-off lending appetite at a time when rate rises are already chilling economic activity. Six central banks have already responded by pumping more US dollars onto global markets, which may imply that rate rises will indeed continue.  Nonetheless, there remain significant concerns over a potential vicious circle of tighter credit conditions, a weakening real economy and rising default rates.

Further downside risk for oil demand

It is too early to be sure whether broader financial sector contagion will occur, or conversely if recent developments are simply a necessary corrective to prune weaker and exposed institutions from the system. From a macro-economic standpoint, volatility in the banking sector, tighter credit and elevated default risk are likely to augment the already-apparent chilling effect of rising interest rates. Higher rates are already baked-in to our assumption of, at best, 1.7% real global economic growth this year. A full-blown banking crisis could obviously drag GDP growth even lower and reduce our current expectation of +1.7 mb/d of oil demand growth for 2023. Demand-side impacts for the crude market would be likely to dominate any such scenario. However, some limited offsetting supply tightness could also arise if reduced access to credit for smaller trading and shipping entities hampers the so-far resilient flow of Russian oil to Asia. Fellow OPEC+ producers too would likely endeavour to cushion any resultant fall in crude prices. As we’ve noted before, tightening financial liquidity may ultimately demand the same from the world’s marginal supplier of physical barrels.

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