Reviewing the current macroeconomic environment and the risk of stagflation and recession

Libor Krkoška, Deputy Director, Country Strategy, EBRD

Below is an insight into what can be expected from Volker’s session at Balance Sheet Management Europe 2023.

The views and opinions expressed in this article are those of the thought leader as an individual, and are not attributed to CeFPro or any particular organization.

How has the current macroeconomic environment impacted liquidity risk?

Both developed economies and emerging markets have been reporting lower economic growth as the strong post-Covid economic recovery was disrupted by the impact of the War on Ukraine and significant increases in inflation, driven by energy and food prices. However, these general global macroeconomic developments hide a significant degree of variation in the performance of individual countries, even within specific regions where one would expect that the impact of external economic shocks would have a similar impact. In addition, there is also a large degree of variance in macroeconomic policies in response to these external shocks, be it the pace of interest rate increases or fiscal policy adjustments. In the assessment of the impact of macroeconomic developments on liquidity risks, it is therefore important to make sure that we take proper account of regional and country differences, including significant changes in trade flows, particularly in energy and commodities markets. This is especially important for investors active across different geographies, such as the European Bank for Reconstruction and Development, which provides financing in 35 countries in Central and Eastern Europe, Caucasus, Central Asia, and Southern Mediterranean regions.

How can financial institutions better manage a stagflation scenario if there is no growth?

Low growth and high inflation environment should highlight the importance of looking in more detail than usual on differences between industries and markets. Management of the stagflation scenario by financial institutions requires realizing that there are always opportunities in some sectors, even in the context of low or no growth, including those opportunities that result from structural changes, such as those related to decarbonization and the move from fossil fuels to renewables. Of course, this also implies the need to have more elaborate stress testing exercises, analyzing different scenarios that do not look only at the macroeconomic level but also at the industry and individual market level risks. More sophisticated stress testing than even in the recent past is now enabled by our ability to build and test much larger economic models incorporating also recent advances in machine learning that we would not be able to process just a few years ago with our computing capacity at the time.

How does a recession impact financial institution’s credit and balance sheet management?

We are now experiencing the third unexpected global economic shock, outside the standard parameters of normal macroeconomic cycles, in the time span of 15 years, including the global economic crisis of 2008, the Covid-19 crisis in 2020, and the War on Ukraine that started in 2022. As a result of dealing with these extraordinary economic shocks, we are now much better prepared for dealing with crises than before the global economic crisis of 2008. Most importantly, lessons from those crises have led to stronger management, more robust corporate governance, better oversight of financial institutions, and more proactive macroeconomic policies. We can see that unlike in the past recessions, financial institutions today are more resilient, showing better credit and balance sheet management. Of course, it is also clear that financing conditions have tightened and close monitoring of financial performance as well as proactive balance sheet management are necessary.

Why is it important for firms to leverage macroeconomic information to drive decisions on the balance sheet?

The resilience of market economies lies primarily in the flexibility and speed with which enterprises and financial institutions can react to changing market conditions, including changes in the macroeconomic context. I am a strong believer in the need to look at general macroeconomic environment in the context of microeconomic developments, including structural changes that are often key for our understanding of main macroeconomic trends. For enterprise level decision making, information on macroeconomic conditions provides a particularly useful benchmark against which to measure their own performance and make judgement about the relative performance of their customers, suppliers, and other market participants.

How can institutions effectively optimize their balance sheet management margin on inflationary scenarios?

Key question everybody asks or should ask themselves is whether higher inflation and higher interest rates are a temporary or a more long-term phenomenon. Your answer to this question will then determine how you will manage your balance sheet and what business strategy you will implement. Or in other words, do you believe that we are now coming back to pre-2008 macroeconomic environment with higher interest rates to stay for longer time period, or do we expect that we will go back to 2008 -2022 situation with interest rates at very low levels and central banks using quantitative easing as a default monetary policy to deal with economic slowdowns once interest rates are close to zero. If there is one lesson I have learned in my many years as an economist, it is the need to be prepared for the unexpected. We did not expect global economic crisis of 2008, and we were even less prepared to how the policymakers will react. Similarly, Covid-19 and War on Ukraine, were unexpected shocks nobody envisaged and was prepared for. The most important lesson from those crises is the fact that we are now both much better prepared for any future unexpected economic shock, but even more importantly our financial institutions and economic systems are more robust and crisis ready.