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Covid-19: a First Estimate of Its Economic Impact

Three Questions to Eric Chaney

INTERVIEW - 20 March 2020

The Covid-19 crisis is only at its premise in many countries. Still, the economic impact of the crisis is already being felt, and no one knows when the situation will return to normal. China, the first country to be affected by the epidemic, is also the most affected economically – for the time being. European countries, Italy in first position, and the United States will also suffer greatly from the consequences of the pandemic. What can we therefore expect in the coming months? How can each affected country, but also the European Union as a whole, cope with this health and economic crisis, which has created more panic on the financial markets than was ever seen before? Answers from Eric Chaney, economic advisor for Institut Montaigne.

Now that the pandemic has reached all parts of the world, can we try to quantify its economic impact?

We are starting to get Chinese data that give an idea of the crisis’ impact on this country. Since China suffered the pandemic before the others, it provides a starting point for estimating what the impact on other countries, France in particular, might be.

Chinese figures for value added in industry and services (excluding government) show a 13% drop for the January-February period compared to January-February of the previous year, and it is hard to imagine things could have been much better in March. Since growth in the previous quarter was 6% compared to one year ago, the value added drop is in the order of 20%. Taking into account the fact that government output probably did not fall by much – in the healthcare sector, it probably even strongly increased – we can estimate that the fall in Chinese GDP in the first quarter of 2020, compared to the last quarter of 2019, is somewhere in-between 10 and 15%. As a median point, a quarterly decline of 13% would translate into a 9% drop compared to the first quarter of 2019. Assuming that a return to normal levels of activity takes six months and is followed by sustained growth, Chinese GDP could decline by close to 3% in 2020 before rebounding above trend in 2021.

Even if economic structures are different, the Chinese experience can serve as a benchmark for countries who, like China, have finally resolved themselves to implementing a strict containment of their citizens forcing many companies in most sectors to shut down.

Let us take the example of France. No statistics on actual activity in March are currently available. Business surveys conducted by the French National Institute of Statistics, INSEE, will provide a qualitative idea of the impact of the government's containment decisions at the end of the month. But in the meantime, it is not absurd to assume a Chinese-style scenario, shifted by one quarter. To set the scene, a 12% drop in activity in France in Q2 2020, followed by a return to normal over the rest of the year and the beginning of 2021, would translate on an annual basis – the only figure that counts for public finances – into a drop in GDP of around 5% in 2020, followed by a strong rebound to 6% in 2021.

The return to normal will take time given that a share of final demand is lost, especially for services such as hotels, cafés, restaurants, transport, etc.

The crucial assumption underlying these estimates is that of a sustainable and sustained recovery once containment is lifted. To be sustainable, the end of containment must be carefully prepared to avoid a relapse of the epidemic, which means protection for workers and a large virus testing capability. On the economic side, a necessary condition for a sustained recovery is that companies, especially small ones, are able to get through the crisis without going bankrupt, while their turnover plummets, their debts and charges accumulate, and high uncertainties surround future demand. From this point of view, measures decided by the government – deferral of taxes and charges, compensation for short-time working, bank guarantees, etc. – which could be summarised under the banner of "No Bankruptcies" are the right ones. Still, these need to be implemented without delay and without bureaucratic obstacles.

Even then, return to normal will take time given that a share of final demand is lost, especially for services such as hotels, cafés, restaurants, transport, etc. As the government strategy is to guarantee business survival, and therefore employment, household income will be relatively spared, while their consumption capacity will be reduced, thus increasing their savings rate.

The mirror image of this anti-bankruptcy plan, and the implicit employment guarantee during the crisis, will be a sharp increase in the budget deficit. The simple effect of automatic stabilisers – mainly lower tax revenues, especially VAT revenues – is likely to inflate the budget deficit by 3 percentage points of GDP. Add to this, newly decided discretionary spending. If the package reaches €45 billion, as the Prime Minister has indicated, the deficit would rise by a further 1.9% of GDP. Based on a deficit forecast of 2.2% of GDP, the French public administration deficit could reach or exceed 7% of GDP, as such had been the case in 2009 or in 1993.

It should be noted that countries which, like South Korea, have implemented strategies based on targeted but systematic and massive testing, without resorting to generalized containment, will be less affected. 

Are the reactions of central banks, and the ECB in particular, up to the task?

As with all policymakers and analysts as well, central bankers did not immediately grasp the scale of the pandemic and the massive shock of containment policies. Initially, the Fed reacted to the downturn in the financial markets and to signals of liquidity stress – a rising gap between bid and offer prices for even the safest and most liquid assets – by lowering its rates and buying Treasuries.

Then, as the news from Europe worsened and the Trump administration, after a period of denial and inaction with highly adverse consequences for the population and the economy, decided to embrace a more active policy, the Fed entered the fray. On March 15, it reduced its key rates to virtually zero, resumed a large-scale bond purchase programme with a target of more than $700 billion, and announced actions to support markets providing loans to households and businesses.

As with the Fed, liquidity is at the heart of the ECB's concerns, which made clear that it would guarantee it "whatever the costs are"

Moreover, in coordination with other major central banks, it has opened swap lines of credit in order to guarantee dollar liquidity to the global economy. Let us note in passing that only the Fed can guarantee global markets’ liquidity and welcome the fact that it is still doing so, despite a prevailing climate of inward withdrawal! 

On its side, the ECB has launched a bank refinancing plan, aimed at refinancing companies’ debt, particularly targeted at SMEs, on a large scale, and at a rate of -0.75%, which is nothing less than a massive subsidy to companies in the Eurozone, via the banks that finance them. It also increased the size of its asset purchase programme, aimed at both liquidity and debt relief. As with the Fed, liquidity is at the heart of the ECB's concerns, which made clear that it would guarantee it "whatever the costs are". It is central banks’ most important duty in crisis situations. The financial crisis that broke out after the Lehman bankruptcy was, at its outset, an acute liquidity crisis, the very first signs of which had appeared a year earlier.

Asked about yield spreads between Italian and German sovereign bonds, President Lagarde had an unfortunate, though technically correct, word to say that it was not the ECB's task to reduce spreads to zero. In doing so, it seems that she did not fully realise that she was addressing the financial markets, which temporarily concluded that the ECB would not come to Italy's rescue, an erroneous interpretation that was quickly corrected by Philip Lane, Chief Economist of the ECB. On March 18, the ECB went a big step further, by announcing a much larger ‘Pandemic Emergency Purchase Program’ worth €750bn aimed at both sovereign and corporate bonds. Doing so, the ECB met the challenge set by the Fed, which is good policy, but in substance, it would be unfair to overwhelm Ms. Lagarde, who climbed up very quickly this peculiar crisis learning curve. Besides, the Covid-19 epidemic shock is a massive supply shock that affects all Eurozone countries, and it is indeed up to member States to organise their own solidarity, first by authorising increases in budget deficits and then by mobilising resources to help those most affected, starting with Italy.

The Covid-19 epidemic shock is a massive supply shock that affects all Eurozone countries, and it is indeed up to member States to organise their own solidarity,

The fact that the German Chancellor has shown herself open to the joint issue of bonds to finance emergency measures, according to some sources, shows that solutions are indeed to be sought at the level of member States, rather than the ECB.

To sum up, it seems to me that the central banks’ reactions are more or less living up to what is at stake. I doubt that the same could be said of all public authorities’ health policies.

Are we soon going to see the bottom of the descent into the underworld of the financial markets?

Clever fellow who can answer that question with confidence. The U.S. stock market, as measured by the S&P 500 Index, has experienced five successive declines and such extreme volatility that it has made it impossible for investors to position themselves. Even the best algorithmic funds, which had done well in 2000 or 2008, have lost value. It seems to me that markets are still unconvinced that governments’ strategies, especially that of the U.S. administration, are up to the task. If the crisis was to both deepen and last, a large number of companies would disappear, and profits of "survivors" would take a long time to offset losses. If, on the other hand, the authorities were able to convince of their credibility in aiming to "flatten the curve" of new Covid-19 cases, markets would once again look to the future and growth prospects. I will not venture to predict when this turnaround will occur, but I am convinced that current valuations present investment opportunities.

 

Copyright : FRANCOIS GUILLOT / AFP

 

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