Part I. Recent economic developments
The real economy – Incoming monthly data (purchasing mangers’ indexes, EU business and consumer confidence indicators) and the EIB Economics Department’s coincidence indicators for May show some mild improvement month on month, but still point to a severe economic recession, with GDP levels below pre-COVID-19 levels.
The new European Central Bank (ECB) forecasts expect the euro area economy to contract by 8.7% in 2020 and expand by 5.2% in 2021 and 3.3%, in 2022, confirming a U-shaped recovery. Inflation is expected to slow substantially, falling to 0.3% this year before increasing to 0.8% in 2021 and 1.3% in 2022. The ECB also expects the unemployment rate to peak at 10.1% in 2021, and average general government debt for countries in the euro area to reach 101% in 2020.
Financial markets and access to credit – European stock markets strengthened in recent weeks. The stock prices of non-financial corporations have continued to rise from the lows of late March. Share prices have recovered about half of losses recorded since the beginning of the year. Conversely, banks’ stock prices have remained almost flat, 40% below December 2019 levels. Credit risk (measured in the spreads of credit default swaps) has continued to decline for banks, but remains higher before the COVID-19 pandemic. Turning to emerging markets, stock prices climbed to their highest level in almost three months at the beginning of June, curbing losses from since the beginning of the year to about 14%. In line with the higher risk appetite, the spreads on emerging market sovereign bonds also declined, while emerging market currencies strengthened.
Part II. Special topic: Corporate investment, debt and policy response
Corporate financing and corporate investment outlook – Our special feature below, “From liquidity shortfalls to increased indebtedness, a bleak outlook for EU corporate investment”, focuses the outlook for corporate finance and investment. Extending the analysis presented in a previous edition (15 April) of this bi-weekly series, we consider the impact of the prolongation of the crisis on EU corporate liquidity and medium-term strategies and estimate the impact of two different deconfinement scenarios, lasting three and six months, respectively. The crisis and the subsequent recovery process might lead to a cumulative reduction in net corporate revenues of €1.9 trillion and €3.4 trillion (13% to 24% of EU gross domestic product, or GDP). To compensate for this decline, firms will have to change their mid-term strategies, facing a hard trade-off between medium to long term business prospects (requiring more investment) or financial sustainability (implying lower leverage). They can either try to preserve investment, at the cost of higher leverage, potentially exposing themselves to solvency issues, or prevent substantial leverage increases, by substantially cutting investment.
In the less adverse scenario, EU corporate indebtedness rises by 4% to 6% of GDP, which would imply corporate investment shrinking by 52% and 31%, respectively. This drop in investment is more severe than during the financial crisis, when corporate investment fell by 19%. The drop in investment evokes some policy questions. In the first months of the crisis, access to liquidity was the main channel facing firms. In the medium term, however, support for the corporate sector with long term or equity instruments may help prevent excessive corporate leverage, while preserving investment and future business prospects.
Policy response – Public policy has an important role in tackling the corporate sector’s liquidity shortfall. The enhanced ECB measures as decided by the Governing Council on 4 June 2020 will further support funding conditions in the economy. When considering the specific dimension of corporate liquidity and funding, policymakers have acted swiftly, pledging support and stepping up measures such as wage subsidies, tax deferrals and loan payment delays that can alleviate the cash flow problems of both firms and households without increasing leverage. In addition, the provision of guarantee schemes (at the national and EU level) will allow the credit channel to continue to work. However, in the medium term, more structural issues of the EU financial ecosystem must be addressed. Equity instruments will be an essential part of the package, helping preserve firms’ investment, while avoiding excessive corporate leverage. As a matter of fact, equity-type of instruments represent an integral part of the EU recovery plan put forward in the Next Generation EU package (see Box). Public support to the corporate sector raises the risk of moral hazard. It is important that sufficient safety nets are put in place to prevent it. Finally, improving business environment to attract investment and support inclusive recovery should remain high on the policy agenda.
The authors of this note are: Simon Savsek, Joana Conde, Laurent Maurin, Rozalia Pal, Andrea Brasili, Matteo Ferrazzi, Aron Gereben, Emmanouil Davradakis, Koray Alper, Ricardo Santos, Sanne Zwart, Luca Gattini and Patricia Wruuck. Reviewed by Barbara Marchitto and Pedro de Lima. Responsible Director: Debora Revoltella.