Covid-19: Analysis by Michala Marcussen

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23/03/2020

Covid-19 has spread across the globe with tragic human loss and severe economic consequences. Hope is now that social distancing and closures will prove effective; both in flattening the epidemiological curve, to ease pressure on health care systems and save lives, and to buy time for medical advances. These preventative measures, while necessary, come at an economic cost, and will be achieved through four main channels.

Michala Marcussen, Group Chief Economist and Head of Economic and Sector Research

1. On the supply side, closures of factories have disrupted supply chains, with domino effects felt around the globe. More broadly, closures of businesses, be it manufacturing or services, come at a cost to employment and household income, and not least in countries with weak social security systems. Business sentiment in China, measured on the PMI, nosedived to its lowest level on record at 28.9 in February, consistent with a deep slump in the world’s second largest economy. Faced with uncertainty, businesses everywhere have frozen investment and hiring plans.

2. Over on the demand side, sales have taken a severe hit as consumers stay at home. Adding up the hardest hit consumer sectors, including accommodation, entertainment, retail trade, travel related activities and food services, we find that these account for 25-40% of total consumption in the world’s major economies. Zooming in on France, we find that if these sectors were to suffer a one-month closure, this alone would knock just under 1.5pp of full year GDP growth. A two-month closure would see this number double to around 3pp.

3. Asset prices, such as equities and corporate bonds, have in turn suffered sharp decline, triggered both by the prospect of significant economic loss and heightened uncertainty. In tightening financial conditions, this then feeds back negatively to the real economy. Real estate markets are also coming under pressure, as economic prospects weaken. Compared to 2008/09, it worth note that banks enjoy much stronger capitalisation and liquidity; the main concern today is the high level and low quality of leverage on certain corporate balance sheets.

4. The final shock relates to oil prices. Faced with the prospect of a significant decline in demand, prices already began to soften in January, but Russia’s lack of support for supply cuts and Saudi Arabia’s subsequent decision to open production valves, sent oil prices plummeting to around $25/b. While lower oil prices all else being equal support consumer spending power, they at the same time weigh on producers. For those producers with higher extraction costs and leveraged balance sheets, as we observe notably in the United States, this is a concern and triggers a further negative feedback loop to broader financial markets.

There can be little doubt that the Covid-19 crisis, even if relatively short lived, will have a profound impact on the economy, and it is no surprise that policymakers are rushing to deliver policy offset.
To be successful, these policies must ensure three actions.

1. The first port of call is to ease liquidity strains and prevent a cash flow squeeze from morphing into a vicious spiral of capital default and soaring unemployment. Delayed payments of taxes and social charges, credit guarantees, prudential measures, debt moratoriums and support for technical unemployment all fall into this category; as do various measures to support household incomes. Europe’s extended social security systems, and not least free health care, are particularly valuable at such a time.

2. The financial system is an integrated part of the capital and credit flow equation, and aggressive monetary policy action from central banks serve to keep these key arteries open. The latest action from the ECB, allowing for over €1tn of asset purchases over the remainder of 2020, has been particularly valuable in calming strains on sovereign debt markets. Without these measures, governments in Italy and Spain, and even in France, would have faced much higher funding costs, placing unacceptable strains on public finances and endangering government rescue plans.

3. The third leg of action is fiscal stimulus to boost recovery once the preventative measures are lifted. It is likely that consumer spending and business investment will take some time to fully recover. Having kept businesses alive during the Covid-19 outbreak, fiscal support during the recovery phase is critical to long term survival and full recovery.

Zooming in on France, we have seen a flurry of measures to support corporates and ease liquidity strains. Such measures include delayed payment of taxes and social charges to the turn of €32bn (or 1.3% of GDP), a solidarity fund of €2bn (0.1% of GDP) to support those companies with annual turnover of less than €1m and simplified partial unemployment support totalling €8.5bn (0.3% of GDP). Key now is to prepare the fiscal support required in recovery. Hope is, moreover, to see this coordinated at the euro area level, something that France is pushing hard for. As warned many times by the ECB, monetary policy alone will not suffice; governments also need to play a role.

As with all crisis, this one will offer its own lessons and likely lead to structural changes, just as we saw in the wake of the 2008/09 crisis. Preparedness of health care systems and health care supply chains spring first to mind. Companies, more broadly speaking, may also rethink setups, be it supply chains, home working or virtual meetings, and consumer preferences may also change. The sudden stop triggered by Covid-19 also offers a deeper warning on the dangers of not addressing climate change in a timely manner. It is worth keeping in mind that a sudden stop due to climate change would likely cause more permanent damage. There seems to be a genuine opportunity here to use part of the significant fiscal stimulus need to aid recovery in the wake of the Covid-19 current health crisis in a way that also helps address climate change.