An unprecedented challenge

06.05.2020
The global financial crisis took economists, financiers and politicians by surprise, even though it should not have. The levels of household, government and corporate debt were soaring. But we knew how to alleviate the crisis. The current pandemic-related crisis is different.
slowdown covid 2

(Pixabay, Gerd Altmann, Public domain)

(Pixabay, Gerd Altmann, Public domain)

Back then politicians and bankers learnt from the mistakes of their fathers and grandfathers who had grappled with similar problems in the 1930s. The current crisis, however, is affecting the supply side, severely hit by the lockdown of millions of people in their homes, and the closure of borders, shops and companies. Since companies in many countries are more heavily indebted than in 2008, and the household debt is also high, the supply crisis may turn into a financial one. The uncertainty is further aggravated by the fact that the development of the economic and financial situation depends on the dynamics of the pandemic. Should the shutdown of national economies continue for months, the forecasts anticipating GDP to fall by a few per cent in the Eurozone and a global economic slowdown may prove too optimistic.

Deteriorating forecasts

According to UNCTAD, the coronavirus epidemic will cost the global economy USD1 trillion. Richard Kozul-Wright, Director of UNCTAD Division on Globalization and Development Strategies, forecasts that the global economy will slow down to under 2 per cent.

According to S&P Global Economics forecasts, the world economy will grow by 1.0-1.5 per cent this year. In December 2019, S&P forecast 3.0 per cent growth. The current projection for 2020 says that the Eurozone economy will shrink by 0.5-1.0 per cent, the growth in China will slow down to 2.7-3.2 per cent, and the United States will see zero per cent growth. But there are also more pessimistic forecasts. Pessimism is growing day by day.

The first official Chinese macroeconomic data reflecting the fallout of SARS-CoV-2 are much worse than expected. Industrial output in January and February 2020 fell is down 12.3 per cent as compared with the same period last year. This is a much deeper slump than analysts had expected. Nomura forecasts that the world’s second largest economy will grow at 1.3 per cent this year, The Economist Intelligence Unit forecasts 2.1 per cent growth, and the consultancy company China Renaissance — 3.0 per cent.

In March 2020, Goldman Sachs revised downward its earlier forecasts for the United States. The firm expects GDP to plunge in Q2 by 24 per cent, falling to a record low since WWII. “The sudden stop in US economic activity in response to the virus is unprecedented, and the early data points over the last week strengthen our confidence that a dramatic slowdown is indeed already underway,” the Goldman Sachs economist, Jan Hatzius wrote. Deutsche Bank forecasts that the American economy will shrink by “only” 12.9 per cent in Q2. The bank’s analysts stress that these are tentative forecasts. A 12 per cent fall is also projected by Bank of America. Throughout the year, GDP in the US will decrease by 0.8 per cent.

JPMorgan forecasts that the American economy will contract by 2 per cent in Q1, and by 3 per cent in Q2. But JPMorgan prepared its forecast before Goldman Sachs. For the Eurozone, JPMorgan projects GDP to fall by 1.8 per cent in Q1, and by 3.3 per cent in Q2. Deutsche Bank forecasts that GDP in the Eurozone will decline by 24 per cent, and even more in Germany. In the H2’20 the economy is expected to rebound, but the year as a whole will end with a recession.

Also, in March 2020, IHS Markit adjusted its forecast of global real GDP growth in 2020 down to 0.7 per cent. According to this forecast, in 2020 real GDP in the US will fall by 0.2 per cent, in the Eurozone by 1.5 per cent, and in Japan by 0.8 per cent. All these predictions are based on the assumption that the epidemic will die down in the second half of the year, and the economy will start making up for the losses.

Economic crisis

According to S&P Global Economics, the slump in global demand will inhibit cash flows, which creates the risk of incurring payment backlogs on an unprecedented scale. Companies, in an effort to maintain liquidity, will cut down on investment, dividend payments and job creation. The industries affected the hardest by the crisis are airlines, transport, hotels and restaurants, retail trade and the entertainment industry. In turn, disruptions in the trans-border supply chains are affecting the financial situation of such sectors as motor vehicles and capital goods production. The collapse in oil prices, as well as the anticipated fall in demand for oil is also generating credit risk and default risk.

Companies with lower ratings (“B-” and below), the number of which has risen in Europe and the US in recent years, are experiencing difficulties. Companies with these ratings will most probably not have the financial capacity to survive the crisis, which is bound to hit their income and raise their financing costs. They are also the most exposed to the risk related to the difficult situation in stock exchanges. S&P expects that companies rated above “B-“ will be resistant to the crisis.

The Chinese corporate sector, with the world’s highest debt-to-GDP ratio, will become even more dependent on loans from state-owned banks, which may substantially raise the non-performing loan ratio. The return of Chinese banks to normal standards could take years, which will have long-term implications for their credibility.

China accounts for approximately 30 per cent of the global manufacturing value added, but its share in payments in global value chains is far bigger. Credit Suisse economists think that the shock to the Chinese processing industry will have a disproportionately adverse impact on payments in the global goods sector. An additional threat stems from the fact that the shock is also being felt by services, which have normally been resistant to cyclical changes. Missed payments for services and production exacerbate the risk of a global financial crisis.

Credit Suisse economists, in their Global Money Notes in March 2020, present a number of threats to the global banking system. They indicate that central banks can quite easily deal with lack of liquidity in the local currency, but the USD funding is an issue amid the crisis, and the Fed is geared towards supporting the US economy, rather than liquidity outside the US. As a result of aggressive interest rate cuts by central banks, deposits in the money market are being depleted as they are moving to the bond market. This could worsen the liquidity problems of various institutions.

The regulations introduced after the 2008 crisis, including the Basel III measures, limit the possibility of lending by banks. They were intended to prevent banks from taking excess risk in banking operations, however, now they may be conducive to payment backlogs. Banks, which have to keep considerable quantities of high-quality liquid assets, are forced to reduce the number of transactions and switch to more traditional loans.

The financial crisis in 2008 was triggered by risky investments of banks. This time the trigger of the possible crisis may be the lockdown of consumption and business activity of companies that need credit to survive. They are trying to stock up on cash, regardless of whether they need it right now or not. The demand for corporate credit has risen to an unprecedented level, which puts the banks’ liquidity at risk and makes it more difficult for banks to maintain the ratios required by the regulators. If companies begin to file for bankruptcy, banks will run into difficulties as well.

The duration of the pandemic will be critical to the credit risk. A severe, but relatively short-lasting economic downturn will deteriorate the situation of the weakest banks and companies from affected industries, but it will spare the biggest, well-capitalized banks. Nevertheless, a persistent recession may have broader implications.

How are governments responding?

The shutdown of thousands of companies which have obligations towards their employees, banks and suppliers poses a risk of a deep liquidity crisis, which could result in a surge in bankruptcies. Such a situation can be observed in all the countries afflicted by the pandemic. The natural response of governments and central banks is to provide companies with funds in order to keep up liquidity.

On March 20th, 2020, representatives of the US President Donald Trump embarked on negotiations with both Republican and Democrat senators to prepare a rescue package worth USD1 trillion. The leader of the Senate Republican majority, Mitch McConnell, presented a proposal to provide taxpayers with cheques worth USD1,200 plus USD500 per child, USD300bn in loans for small companies to help them retain jobs, and USD208m in loans for airlines and other industries. The airlines alone would receive aid amounting to USD50bn. The benefits would not cover households with incomes exceeding USD75,000 per year (or USD150,000 per couple). Loans for businesses would be cancelled if the employers retain jobs.

Democrats argued that the plan is not sufficient, while some Republicans think that it goes too far. Democrats had different ideas on providing aid to Americans, namely by pouring more money into the existing unemployment insurance system.

On the same day, the UK government announced a rescue package for the UK economy. It promises that the state will provide up to 80 per cent to the salaries of the employees of closed workplaces. Up to GDP2,500 in subsidies is to be paid monthly for three months. Chancellor Rishi Sunak said that the rescue package — including allowing companies to hold on to GBP30bn of VAT till the end of June, cash subsidies for small companies and aid for the self-employed, tenants and the unemployed — was one of the most comprehensive schemes in the world.

If a million people apply for the support, the program might cost around GBP 3.5 billion. It is likely that there will be more applications as the most afflicted sectors, such as the hotel industry and tourism, employ 3 million people. Sunak declared that the government would support “as many jobs as necessary”. GBP 7 billion will be spent on strengthening the country’s social safety net. The whole program is to cost approximately GBP50bn, more than 2 per cent of GDP. The government is also working on a support scheme for airlines, including British Airways. The scheme is planned to be similar to the American TARP from 2008 — companies will be recapitalized by the state, which will take over part of their shares.

To calm down the financial markets, the European Central Bank announced an asset purchase program of securities worth EUR750bn in the Eurozone. Each country is preparing its own rescue scheme, significantly exceeding the 3 per cent deficit limit. The European Commission is planning to assign EUR37bn to counter the effects of the pandemic. It stated that EU countries have “full flexibility” with respect to tax regulations to enable them to increase spending.

In Germany, the government will allocate up to EUR500bn for loans for companies affected by the pandemic. Most of them will be granted via KfW, a state-owned development bank. Loans will be available to all companies, from SMEs to big corporations. In addition, the government promised to postpone tax payments. The Bundestag passed legislation extending access to the employee compensation program, known as Kurzarbeitergeld. According to Deutsche Bank data, during the 2008 crisis approximately 1.5 million Germans were paid wage compensation under the Kurzarbeitergeld program, which then amounted to EUR8bn.

Bavaria, where big companies such as BMW and Siemens are located, has launched a EUR10bn fund for the purchase of shares in companies facing difficulties.

In France, President Emmanuel Macron promised unlimited support from the budget for pandemic-stricken companies and employees. Finance Minister Bruno Le Maire estimates this will cost the budget EUR45bn. In his address to the nation, Macron promised to introduce a payment mechanism for employees temporarily laid off by crisis-stricken companies. Its most costly element will be the postponement of corporate income tax. Mr. Le Maire said that the economy-supporting measures will also include EUR300bn in state guarantees for bank loans extended to companies. Moreover, the government is likely to take over shares in companies at risk such as Air France.

In Italy, the first rescue package for the economy worth EUR3.6bn was introduced as early as in the beginning of March. It included tax reliefs for companies which suffered a decline in sales of over 25 per cent. Minister of the Economy Roberto Gualtieri promised one-off payments in the amount of EUR500 per person for the self-employed, and government assistance for the companies in lockdown that employ people. They also introduced loan guarantees for crisis-affected companies and a moratorium on credit and mortgage loan repayments. Financial aid will also be extended to Italian families with children staying at home, as well as to taxi drivers and post office workers who carry on their work providing urgently needed services during the pandemic. In addition, the Italian government declared that it would support Alitalia, the national carrier, which has already received EUR900m in state aid since 2017.

The Spanish government announced “the biggest mobilization of resources in the country’s democratic history” to fight the crisis. The major part of the government plan is EUR100bn worth of guarantees for government loans to businesses, aimed at supporting liquidity, especially in small and medium-sized companies.

The entire package, including private funds released by loan guarantees, would amount to EUR200bn. Prime Minister Pedro Sánchez announced a moratorium on mortgage repayments for citizens whose income is reduced due to the crisis and a similar moratorium on utility bills. EUR600m will be assigned to assist people in hardship.


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