How to Manage the Economic Fallout of the Coronavirus

By Kavaljit Singh | Briefing Paper # 33 | March 19, 2020

The novel coronavirus (Covid-19) is rapidly spreading around the world. The first case of coronavirus was reported in the Chinese city of Wuhan in December 2019, but now it has spread to every continent except Antarctica. As of 18 March, 211,200 people have been infected, and at least 8,822 have died across six continents.[1]

At the time of writing, there are no signs of coronavirus abating outside China. The virus, recognized as a pandemic by the World Health Organization on 11 March 2020, has caused considerable human suffering within a short period of three months. Globally, the death toll from the coronavirus outbreak is rising despite the enforcement of strict lockdown and social distancing measures across the world. In the near term, it is challenging to predict when the spread of coronavirus would be fully contained. Most health experts believe that it may take 12 to 18 months to develop a vaccine for the novel coronavirus.

Along with the human cost, the economic costs of the global epidemic are also mounting. The virus has caused massive economic disruption. The result is a widespread contraction in economic activity. There are fears that it could lead to a severe worldwide economic downturn depending on how long the coronavirus outbreak lasts and how governments manage the economic fallout. Undoubtedly, the pandemic will have a significant adverse effect on the global economy, not seen since the 2008 global financial crisis.

A Triple Crisis

The real economy is simultaneously hit by a supply shock and a demand shock by the spread of coronavirus. Such a twin shock is a rare phenomenon in recent economic history.

On the supply side, it has lowered the capacity to produce goods and services due to the freezing of economic activity in China (during February-early March) and currently in Europe and the US. Available indicators point out a dramatic output contraction in China with a significant drop in fixed-asset investments during the first two months of 2020.

Given the importance of China in the regional and global supply chains as a producer of intermediate goods, the virus outbreak has disrupted production in other economies (such as Japan and Australia) that are closely integrated into supply chains. Even a country like India, relatively insulated from the regional and global value chains, is also experiencing supply-side contagion shocks because of its dependence on China for imports of chemicals and pharmaceutical inputs.

On the demand side, consumer spending on air travel, transportation, tourism, and restaurants has been severely hit due to nationwide lockdowns, social distancing, and quarantine measures aimed at reducing the spread of infection.

Since February, global financial markets have been on edge. The coronavirus and the oil price war have unleashed chaos in financial markets. Massive selloffs in equity markets have been witnessed despite the imposition of circuit breakers to halt the trading activity temporarily. On March 16, the S&P 500 declined 12 percent — its biggest one-day fall since “Black Monday” in 1987. Attempts by central banks from the developed world to cut interest rates and to relaunch quantitative-easing programs have, so far, failed to inspire market confidence.

Consequently, the world is facing a triple crisis — a combination of a health crisis, an economic crisis affecting both production and consumption, and, increasingly, a financial crisis. The interplay of the three interconnected crises has further complicated the policy response. That is why policy actions implemented recently by central bankers appear ineffective because a cut in interest rates cannot stop the virus infection from spreading nor can it open shuttered factories.

The policy tools used by the monetary authorities during the 2008 global financial crisis are impotent to tackle the ongoing triple crisis because the spread of coronavirus has led to a shutdown of economic activities and which, in turn, has triggered a corporate credit crunch. Unlike the 2008 crisis, leveraged banks and exotic financial instruments are not the problems this time. There is no playbook to deal with the potent economic threats posed by the coronavirus. Instead of isolated measures, immediate and coordinated actions by health authorities, market regulators, fiscal authorities, and central banks are needed to prevent the spread of the virus and to manage the emerging financial risks.

A Virus-induced Global Recession

The coronavirus outbreak came at the worst possible moment as the global growth prospects are uncertain. The global economy is facing several downside risks including rising cross-border trade and investment tensions, increased geo-political risks in the Middle East, and uncertainty over the future UK-EU trade agreement. The sharp drop in crude oil prices due to the oil war between Saudi Arabia and Russia has further added uncertainty.

A coronavirus-induced recession now looks a certainty, given the sudden stop in the economic activity around the world followed by a rout in global financial markets in recent weeks. Economists at JPMorgan Chase & Co. project that the recession will hit the US and European economies by July 2020.

According to the OECD estimates, annual global GDP growth is projected to drop to 2.4 percent in 2020 as a whole, from an already weak 2.9 percent in 2019, with growth possibly even being negative in the first quarter of 2020.[2] While economists at the Institute of International Finance estimate that global growth may touch 1 percent this year, the lowest since the 2008 crisis.[3]

The number of job losses due to virus-induced recession could be far-reaching and possibly as severe as during the 2008 financial crisis. Shutdowns in business activities are pushing millions of people into unemployment and underemployment. In its initial assessment, the International Labour Organization has estimated that the economic fallout from coronavirus could cause the loss of up to 25 million jobs globally.[4]

Even if a worldwide recession is averted this year, the global economy still faces its biggest economic shock since the 2008 global financial crisis.

A Looming Global Corporate Credit Crunch

The sharp tightening in global financial conditions in the wake of the coronavirus outbreak has raised the risks of a corporate debt crisis. While the 2008 crisis started with the subprime mortgage markets, the world is now readying up for a corporate credit crunch followed by a wave of corporate debt defaults and bankruptcies.

The rapid growth in the debt of non-financial corporations poses an immediate risk to the financial stability. Taking advantage of low-interest rates in the aftermath of the 2008 crisis, non-financial companies from advanced and emerging economies raised substantial funds through bonds and loans. According to the Institute of International Finance, corporate debt among non-financial companies reached $75 trillion in 2019, up from $48 trillion in 2009. Many corporations used cheap debt not to expand their businesses, but to issue dividends or buy back shares.

Apart from the quantity, the deterioration in the quality of corporate debt is equally worrisome. According to Fitch, BBB-rated bonds — a notch above junk — make over half of all new investment-grade corporate bonds issued globally in 2019.

Since the coronavirus outbreak has forced non-financial corporations to shut down their businesses, corporations that have borrowed heavily (particularly in the electronics, hospitality, retail, energy, and auto sectors) would find it difficult to meet their debt repayments due to sudden stop in their cash flows, thereby triggering a wave of defaults and bankruptcies.

Faced with an economic slump, corporations would have no option but to slash costs, lay off workers and shut down businesses which, in turn, would further worsen the economic downturn. In such circumstances, current BBB-rated bonds could be downgraded to junk overnight, thereby forcing some bondholders (such as pension funds and insurance companies) to sell these bonds because of their investment mandates barring them to invest in junk bonds.

The panic over the coronavirus outbreak has already caused a dramatic rout in the global stock markets as investors flee to haven assets such as gold and long-term US treasury bonds. At times of market turbulence, rating downgrades are frequent in bond markets. A wave of rating downgrades and defaults in the corporate debt segments can further depress the markets and has the potential to exacerbate systemic risks through financial contagion.

The stress in the corporate funding markets is evident across the world and will exacerbate cash-flow problems for non-financial corporates. In particular, BBB-rated corporates, small and medium companies, and emerging market companies with heavy reliance on foreign exchange debt are the most vulnerable. Hence, financial regulators should remain extra vigilant about the potential systemic risks emanating from the corporate credit crunch.

What Shall be Done?

The coronavirus pandemic is more than a public health crisis, as it is affecting every sector of the economy and every section of society. It has the potential to cause a much bigger economic havoc than the 2008 global financial crisis if the governments fail to adopt a quick multi-pronged response to the virus threat. Time is of the essence.

The following are some concrete policy proposals to respond both to the public health crisis and the corresponding economic fallout of the coronavirus pandemic.

Strengthen the Public Health System

First and foremost, it is the primary duty of all governments to protect the health and well-being of their citizens. After all, health is a global public good. The governments should strengthen the public health system on a war footing as the pandemic has exposed the poor public health infrastructure not only in the developing countries (such as India) but also in several developed countries (such as Italy and the US).

If the choice is between spending public money on health care or physical infrastructure, health care should receive the priority. Spending money on health care is far more essential for the well-being of people than building highways.

The governments should undertake massive investments in providing public health services by constructing makeshift hospitals, hiring more medical personnel and sourcing of supplies to treat all those who could become infected. In this regard, there is plenty to learn from Hong Kong, Taiwan, South Korea, and Singapore, which scaled up their health facilities to deal with the virus threat. China built two new makeshift emergency hospitals in 12 days to treat patients infected with the coronavirus.

Special attention should be given to protect the poor and low-income households that cannot afford private health care and for whom social distancing solutions are impractical.

Apart from public investments, regulatory measures in the form of a price cap on drugs and medical devices should be imposed to curb any undue profiteering by drug companies.

Further, the poor and developing countries should be immediately offered grants and concessional loans by international aid agencies and financial institutions to beef up their public health system. In early March, the IMF made available $50 billion through its emergency financing facility to the poor and developing world hit by coronavirus but given the enormity of the health crisis, more concessional loans should be made available by other regional and international financial institutions.

The Limitations of Monetary Policy

To improve liquidity in financial markets, central banks of the developed world unveiled measures ranging from interest rate cuts to quantitative-easing programs to swap lines. On March 15, for instance, the US Federal Reserve reduced policy interest rates to near zero and announced a $700 billion asset purchase program. Still, these measures did not inspire market confidence. Instead, these measures have revealed the inherent limitations of using monetary policy in the present crisis because zero interest rates are not going to offset supply shocks driven by the spreading coronavirus.

Further, there is a legitimate concern that easy monetary policies pursued by the developed world could channel much of money into the financial sector (rather than into the real economy) and a significant portion of that money could finally end up in higher-yielding emerging markets securities.

The Importance of Fiscal Spending

Huge fiscal spending is needed to fight the economic downturn triggered by the virus outbreak. The governments should enact large fiscal stimulus measures to get the real economy back on its feet.

A wide range of fiscal measures could be undertaken by the governments. These may include direct income support via cash handouts (“helicopter money”), food aid, and unemployment assistance; wage subsidies; guarantees to cover virus-related health costs; expansion of social safety nets; increased spending for social care; cheaper loans and loan guarantees to small and medium enterprises; public procurement of goods and services; and short-term tax relief.

Several countries affected by the endemic have announced or undertaken some of these above-listed fiscal measures. Hong Kong, for instance, offered a cash handout of HK$10,000 to its permanent residents aged 18 and above.

It is equally important that fiscal measures must be targeted at those individuals, households, and businesses who are experiencing economic hardship due to the coronavirus outbreak. As the poor and low-income households may suffer disproportionately by the virus outbreak, special measures should be undertaken to provide them economic security.

Of late, some developed countries such as the US, France, and the UK have proposed rescue packages for airlines, hospitality and leisure companies that have been severely affected by the epidemic. But such direct financial support should be strictly monitored by the authorities and made conditional on retaining their workers and caps on executive compensation.

Ban Short Selling

In addition to fiscal policy response, a slew of regulatory measures should be implemented to ensure the orderly functioning of financial markets and overall financial stability.

To begin with, financial regulators should consider imposing a ban on short selling in the equities markets in the near term.

Short selling is a risky trading strategy that speculates on the decline in a share’s price. Traders indulge in short selling by selling the shares that they do not own but borrow from a broker. If the share price drops after selling, they repurchase it at a lower price and return it to the broker. Short selling can potentially set off a vicious cycle wherein falling prices trigger a panic reaction that encourages more investors to sell their shares, which in turn, pushes down prices further. Usually, hedge funds indulge in short selling as they seek to profit both ways: from rising and falling markets. What is good for hedge funds may not be good for market stability.

Financial regulators often ban short selling to arrest the deep sell-off that could disturb the orderly functioning of stock markets. During the 2008 financial crisis, the US temporarily banned short selling of stocks to reduce market volatility. During the peak of the 2010-11 European sovereign debt crisis, Italy and Spain also imposed a ban on short selling when other regulatory measures failed.

On February 2, China announced a ban on short selling of stocks even before the markets opened after the Lunar New Year holiday.[5] On March 13, South Korea’s financial regulator announced a ban on short selling for six months.[6] On March 18, financial regulators in France, Italy, and Belgium also banned short selling to curb volatility amid a massive sell-off of equities.[7] The ban on short selling in Italy will remain for three months while the ban in France and Belgium will run for a month each. According to media reports, India is currently considering a similar ban on short selling in equity markets.[8]

Preserve Financial Stability and Manage Capital Outflows

In addition to a ban on short selling, other regulatory and supervisory measures such as mandatory delivery-based trading in derivatives markets; higher margin requirements; a financial transaction tax;  restricting the entry of traders in specific market segments; circuit breakers; speed bumps (to slow down high-technology trading);, and increased surveillance of algorithmic trading and high-frequency trading  (HFTs) should be proactively deployed by financial regulators to curb extreme market volatility.

In the case of emerging markets, the fears over the coronavirus outbreak have sent shockwaves to foreign exchange markets as investors are fleeing in record numbers and piling into the US dollar. Several EMEs are experiencing a sudden stop in capital flows in the wake of coronavirus pandemic. The Institute of International Finance has noted that fund outflows from EMEs since late January “are already twice as large as in the global financial crisis and dwarf stress events such as the China devaluation scare of 2015 and the taper tantrum in 2014.”[9] In particular, the sudden stop in capital flows has put the economies of Turkey and South Africa at high risk because of their large external financing needs.

As expected, the reduction in dollar liquidity due to record-high outflows of funds from emerging markets has put downward pressures on the currencies of India, Indonesia, Brazil, Turkey, South Africa, and Mexico. In the case of India, the rupee fell to 74.50 per dollar, an all-time low. In the second week of March, foreign investors pulled out close to $2bn from the Indian markets. Although India’s foreign exchange reserves remain comfortable at $487bn to meet any exigency, the Reserve Bank of India has decided to undertake a $2bn US dollar-rupee swap deal to address the dollar shortages in the market.

In response to the sudden in capital flows, financial regulators of EMEs should not hesitate to deploy capital controls on outflows and other foreign exchange restrictions, as imposed by Malaysia (1998), Iceland (2008), and Ukraine (2008) during crisis episodes.[10]

Currency Swaps Agreements: Pros and Cons

On March 15, the US Federal Reserve, Bank of Canada, European Central Bank, Bank of England, Bank of Japan and Swiss National Bank announced a coordinated action to enhance dollar liquidity with cheaper rates and longer maturities via the US dollar swap line arrangements. This move is intended to provide easy access to US dollar funding.

A bilateral currency swap is an agreement between two countries to exchange currencies with predetermined terms and conditions. The bilateral currency swap agreements are undertaken to address short-term foreign exchange liquidity requirements or to maintain adequate foreign currency reserves to avoid balance of payments crisis.

Following the 2008 crisis, central banks around the world have entered into bilateral swap agreements with one another to overcome foreign exchange shortages. For instance, central banks from 14 countries[11] (including South Korea, Mexico, and Brazil) signed currency swap agreements with the US Federal Reserve to overcome their dollar funding scarcity during the 2008 crisis, with a swap amount of up to $850bn. These currency swap agreements expired in 2010 and were not renewed as the dollar funding pressures eased. It is widely anticipated that South Korea and Mexico may reestablish currency swap lines with the US Federal Reserve as a precautionary measure to overcome dollar funding pressures in the coming weeks.

Nevertheless, it has been observed that the US Federal Reserve has been very cautious in extending dollar-swap lines to developing countries, often its decision is influenced by non-economic factors (including geopolitical considerations) to achieve foreign policy ends. Hence, such arrangements are not consistent with transparency and stability principles.

Besides, there are some larger implications too. The currency swaps lines among Western central banks help in maintaining the US dollar’s status as the world’s de facto reserve currency and preserving the US-dominated international financial system. By undermining any potential to challenge the dollar hegemony in international trade and investment transactions by other currencies, it reinforces the world’s dependence on the US dollar-dominated financial system. Consequently, the agenda for the reform of the international financial system loses impetus.

Indeed, the US dollar-centric swap agreements act as an impediment to push a wide range of global financial governance reforms, including the quota reforms of the IMF. Therefore, even if more developing countries join the swap network, the US dollar-centric currency swap agreements should not be considered as a substitute for multilateral cooperation to foster monetary and financial stability.

Multilateral Cooperation

The coronavirus has demonstrated that viruses do not respect national borders. Hence, there is a need to strengthen multilateral cooperation. One would expect the UN to initiate a multilateral policy dialogue on collective actions to address the myriad challenges posed by the coronavirus pandemic.

A coordinated multilateral strategy would be far more effective than each country acting by itself. Another advantage of a multilateral strategy would be the active participation of poor and developing countries that have weaker fiscal and external debt positions to tackle the global pandemic.

In the present times, however, the prospects of multilateral cooperation appear bleak with the rise of unilateralism, right-wing populism, and ultra-nationalism across the world, but the challenge is to stand together in a time of adversity and find ways to collaborate.

What is shameful is that not a single member country of the European Union responded to Italy’s urgent request for help with face masks, lung ventilators, and other medical supplies. There is no other European country suffering as severely as Italy, with 2,978 deaths and 35,713 confirmed cases of coronavirus, as of March 18, 2020.[12] Finally, China stepped in to help Italy in the absence of European solidarity. In times like this, the EU member states need to stand together and care for one other. Much better is expected from the EU because solidarity is one of its guiding principles right from the beginning. Otherwise, what is the purpose of having a union?

At present, there is no need to create a new supranational agency to contain the coronavirus outbreak and to manage its wider economic fallout. Existing international institutions (such as the UN, WHO, IMF, World Bank) can collectively meet the myriad challenges posed by the virus, provided they follow the spirit of solidarity. Indeed, this is the right time to test the relevance and capacity of such institutions.

What about G20?

While the G20 has struggled to maintain its influence in recent years, many expect this bloc could play a lead role in the global efforts to manage the economic fallout of the coronavirus, as it coordinated macroeconomic policies among member-countries during the 2008 global financial crisis.

The G20 finance ministers and central bank governors recently issued a joint statement calling for monitoring of the coronavirus pandemic and underscoring “the need for cooperation to mitigate risks to the global economy from unexpected shocks.”[13] The statement further noted: “We are ready to take further actions, including fiscal and monetary measures, as appropriate, to aid in the response to the virus, support the economy during this phase and maintain the resilience of the financial system.”[14]

Although the joint statement strikes the right tone, the proposed cooperation and collective actions are yet to be seen on the ground. Needless to add, there are definite gains from economic policy coordination that can generate positive spillover effects for every member-country of the G20.

Can the G20 rise to the occasion? Can it prove to the world that it is still relevant in today’s increasingly polarized world? Or is it far-fetched to expect the high-level policy coordination from the G20 as achieved during 2008-09? These are some of the big questions being raised in the context of ongoing coronavirus outbreak.

In case G20 members are unable to develop a quick collective policy response to tackle the coronavirus pandemic in the next few weeks, it would further strengthen the critics’ demand for disbanding the G20 altogether.

From what we have seen so far, the global human community deserves better and well-coordinated policy actions to contain the coronavirus and to offset its economic impact.

 

Endnotes

[1] Coronavirus Map: Tracking the Global Outbreak, The New York Times, Updated on March 18, 2020, available at: https://www.nytimes.com/interactive/2020/world/coronavirus-maps.html?action=click&module=Top%20Stories&pgtype=Homepage&action=click&module=Spotlight&pgtype=Homepage.

[2] Coronavirus: The World Economy at Risk, OECD Interim Economic Assessment, OECD, March 2, 2020. Available at: http://www.oecd.org/berlin/publikationen/Interim-Economic-Assessment-2-March-2020.pdf.

[3] Sergi Lanau and Jonathan Fortun, “The Covid-19 Shock to EM Flows,” Economic Views, Institute of International Finance, March 17, 2020.

[4] “Almost 25 million jobs could be lost worldwide as a result of COVID-19, says ILO,” Press Release, ILO, March 18, 2020. Available at: https://www.ilo.org/global/about-the-ilo/newsroom/news/WCMS_738742/lang–en/index.htm.

[5] Zhang Yan and Ryan Woo, “China moves to limit short selling as virus looms over market reopening,” Reuters, February 2, 2020. Available at: https://www.reuters.com/article/us-health-china-shortselling/china-moves-to-limit-short-selling-as-virus-looms-over-market-reopening-idUSKBN1ZW0P2.

[6] Yonhap, “S. Korea temporarily bans stock short selling for 6 months,” The Korea Herald, March 13, 2020. Available at:  http://www.koreaherald.com/view.php?ud=20200313000701.

[7] Chiara Remondini and Alan Katz, “Italy, France, Belgium Ban Short Selling Amid Coronavirus,” Bloomberg, March 18, 2020. Available at: https://www.bloomberg.com/news/articles/2020-03-17/italy-bans-short-selling-for-three-months-amid-coronavirus-rout.

[8] Samie Modak & Shrimi Choudhary, “Sebi considers short selling ban, trading curbs to reduce market volatility,” Business Standard, March 16, 2020. Available at: https://www.business-standard.com/article/markets/sebi-considers-short-selling-ban-trading-curbs-to-reduce-market-volatility-120031500915_1.html.

[9] Sergi Lanau and Jonathan Fortun, “The Covid-19 Shock to EM Flows,” Economic Views, Institute of International Finance, March 17, 2020.

[10] For more information on capital controls, see Kavaljit Singh, “Recent Experiences with Capital Controls,” Madhyam Policy Brief No.4, April 2019, Available at: https://www.madhyam.org.in/recent-experiences-with-capital-controls/.

[11] These 14 central banks are Reserve Bank of Australia, Central Bank of Brazil, Bank of Canada, Danish National Bank, Bank of England, European Central Bank, Bank of Japan, Bank of Korea, BANCO DE MEXICO, New Zealand Reserve Bank, Norwegian Central Bank, Monetary Authority of Singapore, Sveriges Riksbank (Sweden), and Switzerland National Bank.

[12] Coronavirus Map: Tracking the Global Outbreak, The New York Times, Updated on March 18, 2020, available at: https://www.nytimes.com/interactive/2020/world/coronavirus-maps.html?action=click&module=Top%20Stories&pgtype=Homepage&action=click&module=Spotlight&pgtype=Homepage.

[13] Statement on COVID-19, G20 Finance Ministers and Central Bank Governors, March 6, 2020. Available at: https://g20.org/en/media/Documents/G20%20Statement%20on%20COVID-19%20-%20English.pdf.

[14] Ibid.

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