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COVID-19 economic update – April 3, 2020


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Our Economics department keeps track of all the important developments in the financial markets in both advanced economies and emerging markets. We will be publishing weekly briefings with analytical assessments of the current macroeconomic and financial market situation. Find out more about the EIB Group's response to the crisis


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Economic data continue to point to a sharp contraction of global economic activity. The weekly initial jobless claims in the US, a forward-looking measure of unemployment, continued to rise up to April 2, with the number of first-time unemployment benefits seekers hitting an all-time high of 6.65 million (it was 3.3 last week – Figure 2). Further, the US economy shed more than 700,000 jobs in early March and the unemployment jumped to 4.4%, the highest in more than two-and-a-half-years. In France, a fifth of all private sector employees in 400,000 companies are seeking temporary unemployment benefits, with 4 million people taking up a government support scheme according to the data published yesterday. In Spain, the number of people filing for jobless claims rose to a record high of 302,000 (not seasonally adjusted), while employment (adjusted for seasonality) actually declined by more than 400,000 jobs. In addition, the final March PMI in the euro area was even lower than the flash one. The composite indicator, which includes services and manufacturing, fell to 26.4, down from 52.6 in February. The decline was broad-based across Europe and, based on currently available forecasts, the contraction of economic activity could reach between 5 and 10% in the euro area (Table 1) and potentially even more in case drastic containment measures persist for a longer time. On a positive note, China’s Manufacturing PMI surged to 52.0 in March from a record low of 35.7 in the previous month.


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The services sector - where a significant share of SMEs operates - will be hit particularly hard, as shown by the Sentiment indicator compiled by the European Commission. Indeed, services experienced the steepest decline (from 10.6 to -1.6) in March, followed by retail trade (from 1.3 to -6.1), while also manufacturing was strongly affected. At a more disaggregated level, travel agencies, tour operations, accommodation, publishing activities, and rental and leasing services experienced the sharpest drop (Figure 3). Turning to manufacturing (not shown in the chart), repair and installation of machinery and equipment, manufacture of leather and related products and production of motor vehicles, trailers and semi-trailers were the worst hit.


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Table 1: Real GDP forecasts and post COVID-19 revisions (annual % change)

 

 

2020

2021

Region

Source

before

COVID-19

post

COVID-19 

 

before COVID-19 

 

 

post

COVID-19 

World

IMF

3.3

 

 

 

Goldman Sachs

1.9

1.3

 

 

Moody’s

2.6

1.9

 

 

his

2.5

-2.8

 

3.3

S&P

-

1 to 1.5

 

 

Deutsche

3.3

2.0

3.5

3.9

IIF

2.6

-4.1

 

 

BNP

2.8

0.5

                 3.2

4.4

Natixis

 

-2.9

 

2.8

Euro Area1)

IMF

1.3

 

 

 

Goldman Sachs

1.0

-9.0

1.3

7.8

ECB

1.1

0.8

1.4

1.3

Moody’s

1.3

-2.2

 

2.0

IHS

0.0

-4.5

 

1.2

S&P

1.0

-0.5 to -1.0

1.2

1.5

Deutsche

1.0

-6.9

1.2

4.8

IIF

1.2

-5.9

 

 

BNP

0.8

-4.7

1.3

6.4

Continuum Economics

 

-0.3

 

1.1

The Economist

 

-5.0 to -10.0

 

 

Natixis

 

-5.9

 

4.4

Memorandum items: real GDP growth

 

2009

 

EU

-4.2

 

Notes: 1) From these institutions/banks/agencies, no forecasts are available for the EU yet.

Sources and dates of revised forecasts: IMF WEO (January), GS (March 17th (World) and 27th), ECB (March 12th), Moody’s (March 20th and March 26th), IHS (March 27th), S&P (March 3rd and March 17th), Deutsche Bank (March 18th (World), March 30th), IIF (March 23 and 25th), BNP (March 20th), Continuum Economics (March 21st) and Natixis (April 1st).


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The performance of emerging markets has remained weak and capital outflows are reaching record levels. Emerging market stocks and currencies continued their slide during the week. The stimulus packages put forward by central banks and governments across the globe did not deter international investors from fleeing emerging market assets. Since the beginning of the year, a record USD 83.3bn have flown out emerging market equity and debt markets, according to the Institute of International Finance (IIF). This is a considerably sharper outflow than those seen during the 2008 financial crisis, the “taper tantrum” in 2013 and the 2015 Chinese yuan devaluation scare (chart below), implying a sudden stop in emerging markets due to the combination of uncertainty around the spread of coronavirus and large oil price and financial shocks (Figure 6).


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To gauge the resilience of emerging markets’ external balances, some indicators of external liabilities and reserves for nine systemically important emerging markets are presented below. According to the data, among the selected countries, Turkey, Brazil and Mexico have the highest external indebtedness relative to their national income (Figure 7, A). Excluding FDI stocks, reserve assets of all selected countries are high enough to cover net liabilities (Figure 7, B). . However, no countries except for Russia and Thailand would be able to cover a sudden reversal in portfolio flows with its own reserves (Figure 7, C). That said, Thailand’s economy has proved to be quite resilient so far, but it will likely suffer from the COVID-19 crisis on the back of shrinking tourism revenues. As for Russia, the extreme volatility in its financial indicators is related to the heavy dependence of the country on oil revenues for both fiscal revenues and external accounts.


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Funding markets for banks are showing some signs of distress, but the current situation is different from what was experienced in the global financial crisis. In 2008/2009, banks faced real liquidity constraints that are now almost residual: central banks have been more proactive in providing liquidity than in 2008/09. The ECB is now offering long term unlimited funding through different instruments. Money market spreads, usually a measure of liquidity risks, show no signs of stress in the euro area (Figure 9). Further, while there are still some signs of stress in the United States, with the biggest increase in spreads since the 2008-2009 financial crisis, current spread levels are still far from the levels registered back then. Moreover, these spikes can largely be attributed to the increasing demand for US dollars, the global funding currency.


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European financial institutions’ credit risk increased somewhat as measured by financial market indicators such as the Itraxx indexes (which are a measure of credit risk represented by an average of CDS spreads of the main European banks for senior and subordinated debt). These indexes have been increasing substantially since late February but registered a relative decline in the past week (Figure 10). The picture is relatively common across some of the main European banks. Still, banks show a different credit risk depending on the country where they concentrate their operations and on their or idiosyncratic issues (Figure 11).


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2) This time is different: the crisis is a global health crisis hitting the real economy hard, but it did not originate in the banking sector. Yet, spillovers could be severe.

The current crisis had its origin in the real side of the economy. In contrast, the 2008 global financial crisis started in the financial sector and therefore led to significant losses through exposure to financial markets. Hence, it is plausible to assume that losses could be more contained. Yet, given the potential severity of the recession, banks may still face significant strains, both through a deterioration in financial markets and credit asset quality (NPLs).

Following the 2008 crisis, European banks experienced further losses through their exposure to sovereigns. A repetition of this “doom loop” cannot be entirely excluded at this stage, as shown by the increase in sovereign bond yields in the first weeks of March. Nevertheless, the prompt policy intervention of the ECB and the policy packages put in place by national authorities have so far provided much-needed support to both banks and sovereigns (See Section 2 of weekly briefings).

Non-performing loans are expected to increase at a faster pace than in past crisis episodes given that the expected fall in GDP could be much bigger, concentrated in time and broad based (households, micro, small and medium enterprises and corporates are all taking a hit and many economic sectors are going to be affected simultaneously). Non-performing loans tends to lag GDP growth by 12-18 months, but this time the reaction function could be steeper as entire economies across Europe (and the world) come to a (almost) sudden stop. Still, this increase is likely to be more concentrated in some sectors and could potentially be reversed, if GDP growth recovers in 2021. This seems the most likely scenario if containment measures are effective at eventually halting the virus spread and policy support measures are swiftly implemented to mitigate the economic fallout.

3) Policy matters: measures proactively implemented by central banks and financial regulators can go a long way in strengthening banks’ resilience to the crisis. But more is needed to support the real economy.

Several policy measures have been implemented already at EU level and by MS to help mitigate the impact of the crisis on the capital position of European banks (See also Section 2):

Dividend freezes - The ECB updated its recommendation to banks on dividend distributions. To boost banks’ capacity to absorb losses and preserve their capita position, they should not pay dividends for the financial years 2019 and 2020 until at least 1 October 2020. Banks should also refrain from share buy-backs aimed at remunerating shareholders. Some national regulators also introduced similar measures.

Credit guarantees - An unprecedented broadening of credit guarantee instruments have been announced by various MS, as well as by EU institutions, including the ECB. Such guarantees can help to take some of the increased credit risk off the balance sheet of the banking system and provide capital relief at the same time. The ECB announced that loans that become non-performing and are under public guarantees would benefit from preferential prudential treatment in terms of supervisory expectations about loss provisioning.

Treatment of compulsory loan repayment moratoria - The European Banking Authority stated that generalised payment delays due to legislative initiatives and addressed to all borrowers should not lead to any automatic classification as default, forborne or unlikeness to pay. Individual assessments of the likelihood to pay should be prioritised.

Flexible use of existing capital buffers - Capital and liquidity buffers have been designed to allow banks to withstand stressed situations like the current one. The European banking sector has built up a significant amount of buffers since the last crisis, but various measures were now allowed1. Relaxation of the capital buffers does not improve the capital position of the banks per se. However, flexibility by the regulators limits the potential stigma associated with using these buffers, and the possible negative market reactions.

Limiting pro-cyclical assumptions in loan loss provisioning - To avoid excessive pro-cyclicality in the regulatory capital and published financial statements, the ECB recommends that all banks avoid pro-cyclical assumptions in their models to determine provisions.

To summarise, we argue that while the current economic shock poses significant risks for banks, a number of factors could mitigate the negative impact. In comparison to the 2008-2009 financial crisis, we note that: (a) the initial shock will most likely be shorter if the policy response remains strong, timely and well-targeted, (b) the crisis is not originating in the banking sector, (c) banks have sounder capital and liquidity positions than in 2008 on the back of the policy and regulatory measures undertaken following the financial crisis. On the other hand, the contraction in GDP may be more significant than during the global financial crisis and could trigger a more immediate impact on non-performing loans, as entire economies are being shut down. All in all, we expect European banks to remain resilient. Yet, uncertainty remains huge, and a prolonged or sharper recession would not leave banks unscathed.


1) For example, it allows them to operate temporarily below the level of capital defined by the Pillar 2 Guidance (P2G), the capital conservation buffer (CCB) and the liquidity coverage ratio (LCR). These measures are enhanced by the relaxation of the countercyclical capital buffer (CCyB) by the various national macro-prudential authorities. In addition, banks will also be allowed to partially use capital instruments that do not qualify as Common Equity Tier 1 (CET1) capital, such as additional Tier 1 or Tier 2 instruments, to meet the Pillar 2 Requirements (P2R).