12 March 2020: The Covid-19 virus outbreak now represents a serious risk to the global economy
In the space of a few weeks the crisis has shifted from a supply shock predominantly affecting mainland China to a global demand and supply shock that threatens to push the global economy into recession.
Parallels are being drawn with the global financial crisis of 2008/09 which resulted in the deepest world recession since the Great Depression of the 1930s. Volatility in financial markets as equity prices gyrate while “safe haven” assets such as gold and government bonds enjoy strong demand underline the precarious state of the world economy.
There is no doubt that the short-term economic effects of the virus and attempts to contain it will be significant with many institutions downgrading economic growth forecasts for this year. The OECD has cut its global GDP growth forecast to 2.4% from 2.9% for example. But the OECD warned that on a worst-case scenario growth could fall as low as 1.5% this year – indeed a global recession[i].
There is great uncertainty about the scale and duration of the crisis with a lot depending on the effectiveness of public health measures across the globe. What can be said for certain is that China, which is around a month ahead of other countries in suffering the economic effects, will record an economic contraction in the first quarter of this year, possibly at an annualised rate of 10% or more.
Outside China the economic impact is still to be felt, but business and consumer confidence has fallen sharply. Already there is evidence of reduced consumer spending with leisure, travel and tourism already suffering greatly reduced activity in many countries. Moreover, if a country goes into “lockdown” as Italy has recently done for example, with severe restrictions on the movement of people, then discretionary spending will come to a virtual standstill.
Moreover, an epidemic affecting a significant proportion of a country’s population would temporarily reduce labour supply and cause a general reduction in economic activity. In addition, there is the potential disruption to global supply chains caused by factory closures in one country affecting output elsewhere – carmakers and technology companies are especially vulnerable in this respect.
Small and medium sized enterprises (SMEs) are likely to experience particular difficulties in dealing with this virus outbreak. With fewer employees and generally less of a financial buffer, SMEs will face disruption to their business activity and face financial difficulties much more quickly than larger companies. For this reason, much of the policy response across the world should be concentrated on these companies.
The damage to economic activity caused by Covid-19 calls for a major policy response. Fortunately, there is plenty that monetary and fiscal authorities can do to mitigate although not fully offset the economic effects However, the most important task for policymakers is to ensure that the present health-related crisis does not become a wider liquidity squeeze or credit crunch that greatly exacerbates the initial negative economic impact. For example, this would occur if otherwise viable companies collapsed because banks failed to provide credit to cover a temporary cash flow problem.
Already several central banks, including those of the UK, US, Canada and Australia, have cut policy interest rates. In March both the US Federal Reserve and the Bank of England reduced interest rates by ½ percentage point at non-scheduled policy meetings. There are other monetary tools that can be deployed to sustain the credit channel and boost liquidity. Many of these measures were used in the wake of the financial crisis. For example, cheap central bank loans to commercial banks, offered on the condition that the funds are made available to private borrowers is a policy that could prove effective in the current circumstances.
The Bank of Japan has already used this as part of its response. And there is quantitative easing (QE) – the purchasing of private sector assets with money created by central banks – which has the effect of boosting liquidity in the financial system. Of course, in 2008/09 the banking system itself was in danger of collapse and was a major element of the crisis. Today the major banks are well capitalised, more tightly regulated and in better shape to help households and business to weather the Covid-19 crisis.
Fiscal measures will also be important both at the macro and micro level. In many countries governments can borrow either at historically low rates of interest (the US and UK) or even at negative interest rates (Japan and Germany). There is a strong case for governments to borrow and to use public spending as a temporary replacement for reduced private sector activity. In effect this would be old-fashioned Keynesian pump-priming.
There are also microeconomic measures that governments can take to ease cash flow pressures on companies and households. These include delaying tax receipts, temporary tax cuts, wage subsidies and increased benefit payments to those suffering economic loss.
The recent UK Budget announced a fiscal stimulus worth 1.4% of GDP specifically to deal with the likely effects of the virus. Measures announced included refunding companies’ sick pay, guaranteeing loans and providing a cash boost to small companies in vulnerable sectors.
If appropriate policy action is taken on the necessary scale, then the economic effect of the Covid-19 crisis may well be severe but it should also be temporary. Once the crisis is past its peak and confidence substantially restored, then we would expect economic recovery to be swift with strong momentum.
In this case economic growth should regain the rate it would have been at, had the Covid-19 virus never existed. By contrast recovery after the financial crisis was anaemic and prolonged since balance sheets had to be rebuilt through higher savings and reduced borrowing over a period. Today balance sheets are generally in good shape. So, the onus this time is very much on policymakers to do the right thing and facilitate a strong rebound when conditions permit: the early signs at least are fairly encouraging.
[i] World GDP of 1.5% is considered to be a global recession because it implies a fall in world GDP per head.