Speeches

“Covid-19 and the European Economy” - Speech by Bank of Greece Deputy Governor Professor John (Iannis) Mourmouras, at the OMFIF virtual roundtable

02/07/2020 - Speeches

1. Introduction

Let me first of all thank David Marsh and the OMFIF team for the organization of this webinar. We are facing difficult times. I wish to all of you to be healthy and stay safe and hopefully will get together soon in real seminar gatherings in great London and around the globe, OMFIF is global.

Three decades with the euro, three big economic crises, the global financial crisis 2008-2009, the euro debt crisis 2010-2012 and the current pandemic crisis, which seems to be the most severe of the three. It affects the lives and livelihoods of the entire human kind, global public health and at the same time it provokes a dramatic economic crisis with unique features: in macroeconomic terms, the corona shock is a triple shock, demand, supply and sectoral shock, giving rise at the same time across the board to a sense of a generalized uncertainty regarding the duration of the propagation mechanism and not only. Before coming to the impact on the European economy let me offer a few remarks on the global view, it’s a global crisis after all.

2. Global View: Real economy and Capital markets

According to June IMF forecasts, global economy is projected to contract sharply by almost -5% in 2020, as a result of the COVID-19 pandemic, far more than the first year of 2008 financial crisis (zero growth rate) with considerable uncertainty remaining about the strength of the rebound. This applies to US economy, where the IMF predicts a contraction by -8% this year and a rebound of 4.5% in 2021. Britain’s economy also is projected to shrink by -10.2% (IMF), the biggest annual fall in GDP since 1921, (2021: 6.3%). A similar picture can be found in the euro area. We will look at it in more detail shortly. Finally, the Chinese economy contracted by an unprecedented 6.8% in the first quarter of the year. Even with a sharp rebound in the remainder of the year and sizable fiscal support, the economy is projected for zero growth (IMF) in 2020.

On the state of global capital markets, now. it is true that, financial markets have retraced large parts of the losses from the severe shock following the outbreak of Covid-19. Apparently this is another divergence between equity markets and the real economy. On top of that, to me, two are the big unknowns. In the FX market the weak dollar and in the bond market the dynamics of corporate debt. More precisely:

Global stocks have recovered more than half of the losses triggered by the pandemic since March: the S&P 500 is up 37.8% since the lowest point mid-March while Euro Stoxx 50 is up 36.4% since its lowest point. Both the US and the euro area government bond yields remain at historical low levels (US 10-year 0.67%, German Bund 10-year -0.50%). Two are the big unknowns according to my opinion: a) if the recent weakening of the US dollar will continue throughout the summer and into September – October, when we will have a clearer view of the outcome of US presidential elections and b) the dynamics of corporate debt market.

Arguments in favor of the weak dollar in the 3-4 months ahead include:

i)   The US presidential elections in November,

ii)   Fed’s aggressive rate cute to 0% narrowed interest rare yield differentials between the US and the euro area

iii)  On the other hand, adoption of the EU Recovery Fund and reduced risks from the German Constitutional Court could provide strengthening of the euro vis a vis the dollar, etc.

Over the last two decades, the private sector has managed to issue massive amount of corporate debt at very low cost. Given elevated corporate high-yield bond and leveraged loan outstanding globally, the combination of rising leverage and slower earnings growth would erode the debt sustainability and could contribute to a considerable increase in ratings downgrades and defaults (for example, according to OECD, BBB rated bonds amounting to USD 261 billion could be expected to be downgraded to non-investment grade within one year, in case of a significant economic downturn).

3. A V recovery in Europe? The two opposing effects

If we look at the available forecasts, or scenarios, you will find rather diverging views on the pace of recovery next year in continental Europe. Although we all agree that the depth of recession this year depends very much on a possible second outbreak in autumn, a second lockdown etc., there is more controversy with regards to the speed of recovery next year and the question of reaching pre-corona virus GDP levels. For instance, according to the ECB basic scenario, output will contract in the euro area by 5.5% but will increase next year by 6%. This has been revised last month downwards to 8.7% recession in the June ECB staff macroeconomic projections (+5.2% in 2021). In the same spirit BOE forecasts for UK economy, a recession of -14% followed by a rapid recovery of 15% in 2021. Similarly, more or less, in the Spring Forecasts of European Commission, a recession of -7.4% will be followed by +6.5% increase in output next year. On the other hand, IMFs’ June forecasts are more cautious and project a more gradual recovery, a recession of -10% in 2020 to be followed by +6% in 2021.

What about the shape of the recovery in Europe then? I can see two forces at work here. They operate in different directions. On the one hand is the fear, quantified into deferred consumption, an increase in precautionary savings, delaying investment decisions, discouraging travelling for business, conferences, leisure and on the other hand, the fiscal and monetary bazookas. My own verdict is that the net effect from the two opposing forces will not be a V recovery but rather a U or a W one. Preliminary evidence tends to confirm the above conjecture.

Let me elaborate on this a bit further. Historically speaking, V-shaped recoveries usually follow negative demand shocks, while U-shaped recoveries usually come after negative supply shocks. A classic case of a V-shaped recovery is the one that followed the US recession of 1954. It was the Korean War followed by an inflationary period and high investment in national security, where the FED responded by raising interest rates in order to combat high inflation. On the other hand, a characteristic case of a U-shaped recovery is the one that followed the 1973 oil crisis (after the OPEC embargo), the tripling of crude oil prices, which led to a general increase in commodity prices, rocket-high inflation rates and stagflation. The embargo was lifted in March 1974, but oil prices remained high and the consequences of the crisis were there to be felt for many years. The recent financial crisis of 2008-2010 also had U-shaped features.

International experience has shown that, the deeper the recession, the longer the time lag for the rebound. The pace of financial markets is not the same as the pace by which the real economy is moving. Since 1960, if one examines the cases of recessions of around 5% in OECD advanced economies, it is evident that at least 3 years were required for GDP to return to its pre-crisis levels. Key to a swift and sustainable economic recovery is a steady improvement of employment, i.e. to avoid phenomena of hysteresis in the labour market. A double deep recovery (W) is a fragile recovery and the same applies to the so called jobless recovery.

Coming now to the current pandemic crisis which bears the complex characteristics of a triple shock, the first force at work, namely, fear and uncertainty will unfortunately prevail for some time, at least until a vaccine has been developed (12 months from now?), thereby affecting the return to normality for consumers, tourists and businesses. Enterprises will find it difficult to return to their normal operation, investments projects will take much more time to build, foreign tourists (especially the elderly) will not be keen to travel abroad, and consumers will need time to return to their pre-coronavirus consumption levels (negative psychology and lower expectations affect the confidence multiplier). It’s a negative demand shock amplified by an increase in savings.

But it is also a supply shock. Large disruptions in the global supply chains and global networks will require much time to proceed with necessary changes in terms of organisation, orders etc., thereby lowering production and total output in the short to medium term.

Last but not least, fiscal and monetary policy can solve many macroeconomic problems, liquidity problems and market pressure, but cannot ultimately prevent bankruptcies. Some sectors are in danger of partial destruction or bankruptcy (small-medium enterprises, but also larger ones, in the fields of hospitality, catering, entertainment, transport, trade), with negative effects that spill over into the economy.

In short, I would argue for a U recovery since consumption spending is going to be timid due to a persistent precautionary savings appetite, and /or a temporary fiscal stimulus (stops in 2021?) and for a W recovery if austerity starts soon after, in order to contain public debt dynamics (increasing taxes, high primary surpluses, etc.).

Latest Evidence

• Although the composite PMI improved further in June to 47.5 from a record low of 13.6 in April it remains well below the 50.0 no-change level and continues to indicate a rate of contraction in excess of anything seen prior to the COVID-19 outbreak.
• Industrial production decreased by 28% in the year to April (the deepest fall since 2000), after falling by 13.5% in March.
• Euro area exports of goods to the rest of the world in April 2020 were €136.6 billion, a decrease of 29.3% compared with April 2019 (€193.3 bn). An unprecedented decline is expected for the second quarter of 2020, as suggested by the collapse of the new export orders index to 18.9 in April (compared with 49.5 at the beginning of 2020).
• The euro area’s saving ratio is likely to rise sharply (13.1% as of end 2019). This is reflected by the 7.0% increase of the annual growth rate of deposits placed by households in May, which is an evidence of precautionary savings and credit constraints. May I remind that the unemployment shock has not yet materialized. Wage supplementary schemes, bans on firing workers, mortgage payments holidays, prohibitions on tenant evictions, all these measures will come soon to an end. People have already started to save money for the upcoming rainy days.
• Finally, euro area business investment is expected to contract in 2020 due to weak profits and cash accumulation. Faced with severe supply disruptions since mid-March, the production of capital goods in the euro area fell by 6.4%, quarter on quarter, in the first quarter of 2020 and capacity utilisation also contracted. Also, both construction and non-construction investment declined in the first quarter, -13.8% and -9.3% in France, -7.9% and -8.3% in Italy, and -9.6% and -2.4% in Spain respectively.
• There is still considerable uncertainty, the fog of uncertainty remains thick, as to what the new norm will be. We are talking about strong headwings something unprecedented happening once in a hundred years.

   

4. Past monetary policy decisions, what more can be done?

The macroeconomic policy response to the pandemic has been swift and expansive. The focus has been threefold from the macro point of view: a. boosting aggregate demand, b. prevention of a sizing up of credit markets that would magnify the shock and c. targeted supports to make sure that illiquid firms and households remain solvent. Plus a suspension of the limits of the Stability and Growth pact and a relaxation of the rules on state aid.

Compared to the 6% of GDP rise in the first year of the global financial crisis of 2008, G4 Central Banks’ Balance Sheets are projected to increase three times that by the end of this year. Moreover, there are differences also with regard to the scope of Central Banks’ balance sheet actions. It appears that these are now shifting away from the more traditional QE to a more credit easing paradigm where direct lending to non-financial entities shortens the transmission of monetary policy. Central Banks cannot prevent the Covid-19 recession but they can contain it and limit its magnifying impact on financial markets through keeping markets functioning and provide cheap liquidity to banks and why not prevent a new public debt crisis. It is true that the line between monetary and fiscal policies is getting blurred. European Governments are using loan guarantees to encourage bank lending to household and firms which is funded by ECB lending to banks.

The ECB’s response to the pandemic was bold and decisive. At the GC regular meetings (12 March 2020, 30 April 2020, and 4 June 2020, as well as the extraordinary meeting on 18 March 2020) increased its APP by 120 billion, reinvestments of the principal payments from maturing securities will continue, the envelope of the pandemic emergency purchase programme (PEPP) has increased to €1.35 trillion, set to run at least until the end of June 2021. Up to now, the Eurosystem has purchased EUR 315.5 billion of assets under the PEPP (APP current amount: 2.74 trillion or 22.8% of GDP, APP + PEPP current amount: 3.1 trillion or 25.8% of GDP). (2021 forecast APP+PEPP amount 4.4 trillion of 37% of GDP). At the same time it continues to provide cheap liquidity to commercial banks through the LTROs, TLTROs, and PELTROs (MPOs: 1.6 trillion or 13.3% of GDP. Even more importantly, against future sovereign rating downgrades government bonds will be grandfathered as long as their rating remains at or above a rating equivalent to BB+. What more can be done, if there is need for that:

• More QE rather than lower (negative) rates,
• More flexibility in PEPP across market segments (more purchases of corporate bonds) and across jurisdictions (e.g. deviations from the capital key to counter risks of fragmentation),
• More credit easing perhaps,
• Enhanced forward guidance,
• If it comes to the worse, after the pandemic QE (PEPP) is over and the problem remains, an idea is the activation of OMT by the ECB with unlimited support even beyond front-end yields with or without the ESM conditionality (so far any OMT intervention would require first the country in question to access the precautionary credit line of ESM). Unlike 2010-12, there exists today broader political agreement in the euro area, a sort of commitment to support countries during the corona crisis period. In view of the real threat posed by poisonous relations among Member-States that could ultimately lead to the collapse of the Eurozone, moral hazard, a core concept in the no risk-sharing argument of northern countries has been replaced by pro-cohesion EU politics.

   

5. European fiscal policy response

In terms of fiscal policy, national governments’ response includes direct support to households, payment deferrals and loan guarantees. Among the G20 nations fiscal measures to date amount on an average of 12% of GDP, three times that of 2000 financial crisis response. Worldwide, fiscal revenues could fall as much as 15% and the world will experience a global fiscal deficit in 2020 of around 10 trillion US dollar at least triple precrisis levels and equivalent to 12% of global GDP. In US, the total fiscal response of the various programmes amounts to $2.8 trillion (or 13.1% of GDP), while euro area fiscal response, the stimulus by national governments, amounts to €3.4 trillion (or 24.4% of GDP). Fiscal policy has an important role to play not only in terms of stabilising the economy but also to modernise the economy, for instance by investing in human capital, the digital economy and the protection of the environment.

 

European initiatives: Recovery Fund

Turning to common European fiscal initiatives, the so called Recovery Fund made the headlines recently. According to the European Commission proposal, the Recovery Fund’s financing is going to be up to 750 billion € (500 billion grants and 250 billion loans), hopefully in the July European Council meeting, two weeks from now, leaders will finalize the modalities of this important initiative. This package comes additionally to the earlier European support facilities (SURE, EIB, ESM) and the Multiannual Financial Framework (MFF) for 2021-2027 of 1.1 trillion €. It is quite interesting that around 50% of the 750 billion € of the Recovery Fund will be directed to the southern Europe and this allocation is taking place not by using the capital key, but through a special algorithm. {It is a weighted average of a country’s population, per capita GDP and the average unemployment rate of the last five years (2015-2019). It does not take into account public debt, I suppose for reasons of moral hazard in northern countries, while it anticipates a 7 year grace period and a repayment of loans until 2058.}

Of course, there are number of caveats to the Recovery Fund. Briefly, this is just a proposal by the European Commission, not a final decision. Standard European practices imply at the end a compromise between say the ‘frugal nations’ (Austria, Netherlands, Denmark, Sweden), who insist on 1 to 1 analogy between grants and loans and the rest. These four nations, but also Germany point to the extraordinary nature of the Fund, due to the pandemic and not something of a permanent nature, with no reference at all to mutualization of debt (in other words we are far away from Europe’s ‘Hamiltonian moment’), only some risk sharing through the ESM borrowing from the markets. Other open issues remain, like the issue of conditionality to loans, reform implementation through the European Semester, the method of repayment by Member States etc. Quite relevant on the fiscal front is a proposal I made earlier this year on spending QE savings on growth. Danae was kind enough to publish it in the January OMFIF Bulletin. The idea is for past QE savings and the ones that will come from the new round of QE and the corona-QE (PEPP) due to lower borrowing costs, to be used to finance smart public investment projects in the South, including research and development of innovative technologies such as artificial intelligence, cloud computing, bioinformatics, etc.

 

6. Two big challenges the day after: a) a rise in inflation? b) a new debt crisis in the euro periphery.

Turning now to two potentially negative side effects of the bazookas of monetary and fiscal policy due to the pandemic crisis lots has been written on the return of high inflation due to a massive monetary expansion by Central Banks in advanced economies and a new euro debt crisis in euro periphery due to rising debts and deficits.

On the inflation issue firstly. The arguments for a rise in inflation: These are well known: globalization is reversing, which means big firms have now more power over pricing and markups, trade unions over wages, etc. Fiscal stimulus is powerful, expansionary monetary policies are at unprecedented levels, etc. But the evidence from the financial markets is rather weak on this. Medium-term inflation in the Euro area as represented by the 5-year inflation-linked swap rate, shows a strong decline since February and the beginning of the pandemic, reaching a bottom at 0.72% on March 23 and stabilizing around 0.96% as of the end of May. Similarly, in the US, the sharp decrease in inflation expectations since February has corrected only partially, with 5-year inflation swap rate reaching 0.94% at the end of May.

Judging from expectations, namely psychology, the deflationary narrative does not change. In the euro area, headline inflation is foreseen at 0.3% in 2020 mainly due to energy inflation which should have a large negative contribution to headline HICP (by 0.8 pps.), 0.8% in 2021 and 1.3% in 2022. Core inflation in the euro area is expected to moderate to 0.8% on average in 2020 and to 0.7% and 0.9% for 2021 and 2022 respectively, a drastic downward revision from March projection 1.2% for 2020. Although broad money (M3) growth accelerated further to 8.9% in May 2020, from 8.2% in April with an average growth of 4.7% in the last 5 years, headline inflation in the euro area during the same period remained subdued near to 1.1%, namely money velocity is very low reflecting the fact that liquidity has been trapped within the banking sector and has not reached the real economy. Note that measured inflation is always higher than actual inflation (as high as 1 percentage point), making some analysts to talk about deflation in the Eurozone the last years.

The arguments against a rise in inflation: This is a huge recession; there is risk of deflation, not inflation! Nothing will be the same after the pandemic crisis. It will take some time, years for confidence to be fully restored. Everyone will be spending less and will save more. Precautionary savings is going to play a lasting role, leading to lower consumption levels. Recent FED research has documented that the main effect of pandemics over the last 1000 years has been a rise in precautionary savings.  As we return to normality, price elasticity of demand will return and the negative output gap will strengthen the pressure for price reduction. If we add on that the historically low energy prices, this is indeed a highly deflationary environment.

I have some sympathy to the view (and in order to build a short of consensus argument to the above two conflicting views) for a J-shape for inflation, namely the Covid-19 impact will be deflationary in the short-medium term and inflationary in the long term, I would add provided that fiscal stimulus is not temporary. In other words, inflation will be low and interest rates will remain low for quite some time.

On the second issue, my own view on the new debt crisis, which I don’t believe it will be happening in the foreseeable future anyway, is as follows.

Global Government debt will rise by 19% this year as opposed to 10% in 2019 (IMF). Public debt in the Eurozone could rise by about twenty percentage points of GDP in 2020 from 84% of GDP in 2019 (e.g. Italy 21% of GDP, Spain 18%, etc.). This is translated to an additional €2.5 trillion public debt this year, partly reflecting the economic costs of the covid crisis so far. These debt and deficit forecasts for the euro area point to potential increases in credit risk premia, especially in countries with high debt/GDP ratios, like in Southern Europe. It is a fact that a simultaneous new government debt issuance in the euro periphery will exert upward pressure on yields; we may have an upward shift of the yield curve, a few sovereign rating downgrades - but not the sort of the 2011 negative spiral - and a possible increase in euro periphery bond spreads vis-à-vis core euro area countries, but that is it. {it is a different story for poor nations, in Africa and elsewhere. Developing and emerging economies with large external debts to international organizations and other countries (World Bank, China, (400 billion US dollars etc.), should be given substantial debt relief.}

Contrary to some pundits who talk about a forthcoming debt crisis in the Eurozone, there exist four distinct arguments leading to the conclusion that there is a clear difference between what is happening now and what had happened during the 2012 Eurozone debt crisis, suggesting at the same time that a new debt crisis is a remote, if not negligible, scenario. These arguments are:

1. The 2010-12 euro debt crisis highlighted the vicious circle between banks and sovereigns. Since the introduction of the single currency, both EU officials and markets kept a false sense of safety as they failed to recognize that the elimination of exchange rate risk would lead to another systemic risk caused by either chronic structural problems or elevated government debt and deficits, being incorporated as credit risk premium in a county’s borrowing cost. This time the origin of the crisis is not sovereign risk, market failure or overheating. It is rather an exogenous symmetric shock in the real economy with negative externalities diffused outside borders, driven mainly by governments’ measures introduced rightfully so to contain the deadly corona virus and its contagion effects. That in turn, contrary to 2010, points to a common European action.
2. Europe is better prepared today, through the creation of new institutions, like the ESM, the SSM, the SRF, the ESRB with an aim to break the Gordian knot between banks and sovereigns. On top of that, it is the trillions of the first and the second QE, the €1.35 trillion of corona QE, the OMT and the very low interest rates, which are here to stay, and are now part, together with forward guidance and TLTROs, of the normal monetary policy toolkit.
3. In a low interest rate environment what matters for debt sustainability is the small – servicing costs rather than debt to GDP ratios.
4. Greece is no longer the Achilles’s heel of the eurozone. The reinstated waiver for Greek government bonds and the ‘protection’ afforded by their inclusion in the corona QE is sort of a game changer for the Greek bond market {Feel free to raise questions later on the greek economy and the state of the Greek banks}. In the future, any question of debt sustainability would inevitably involve large, ‘too - big - to - fail’ Eurozone countries; it would thus be expected that this matter would be addressed more smoothly, not only in terms ofausterity - like in the debt crisis of 2010-12 - but also by using some form of risk-sharing. It will be an existential matter for the present and future of the Eurozone as a whole.

 

Epilogue

Let me close with this. May I wish both Britain and the States a safe exit from the lockdown and hopefully better manage than the entry to it. In summertime, if you are going on holiday this summer, Greece is a safe place to visit.