COVID-19: Desperate times call for desperate measures
Under normal circumstances, economic agents are theoretically able to logically and rationally infer future economic states. These often linear projections, which simply extrapolate past trends or experience, sit within a structured universe of representations and beliefs that anchor economic expectations. An irrational element remains, however, born of the spontaneous need to act summed up by John Maynard Keynes in his famous reference to “animal spirits”*. In any event, trust remains the foundation for all key decisions necessary to the smooth running of the economy and market stability.However, when an extraordinary shock at the limits of probability occurs, prevailing beliefs and conventions abruptly collapse, trust evaporates and we are plunged into a world where the irrational becomes the new rational, while anxiety and fear rule amid crippling uncertainty. The coronavirus crisis is just this kind of moment, bringing an unprecedented global triple shock to public health, the economy and the financial system. It is first and foremost a shock to public health, unleashing a lethal pandemic upon a globalised, interconnected world where the virus can circulate quickly, putting health systems under pressure. Second, on the economic front, drastic lockdowns – the only effective defence against the spread of the virus – are bringing economic activity to an abrupt standstill, with combined demand and supply shocks propagating across national borders by jamming up international trade. Lastly, on the financial front, with economies paralysed indefinitely, markets are anticipating a global recession and the accompanying wave of corporate defaults in a world already overburdened with debt, to the point where fears of disorderly unwinding are plunging the economy and the financial world into a depressive vicious circle. The fact that market hubris had driven asset valuations up to excessive levels means the correction is all the more abrupt and severe. Over the past few days, this financial pendulum swing has triggered an abrupt decline on stock markets, a sharp rise in risk premiums and high levels of volatility, with investors swept up in an across-the-board, every-man-for-himself stampede into the safest and most liquid high-quality assets. This sought-after and supposedly plentiful liquidity has evaporated in risky market segments, with wave after wave of distress sales of assets failing to find buyers even at knock-down prices. In the face of this multidimensional crisis, there is an urgent need to meet the challenges of liquidity and solvency to prevent this temporary shock from having lasting consequences. On the liquidity front, central banks are manoeuvring to keep the financial wheels oiled and prevent both bank and market funding mechanisms from seizing up. Each has its own preferred approach: in a still highly intermediated economy, the European Central Bank is, as one would expect, offering banks unlimited liquidity at subsidised prices to stop funding channels drying up and thus prevent a credit crunch. Meanwhile, the Federal Reserve is providing liquidity to market segments hurt by the crisis in an effort to keep the system moving and help price formation. Both are bending over backwards to prevent financing conditions from tightening and thus ensure that monetary policy is properly transmitted to the economy, acting as buyers of last resort of government and corporate securities and constantly re-evaluating their firepower. This deluge of funds – measured in the billions – will help irrigate the financial system and lower stress levels. The challenge is also to convince markets of their unlimited firepower in order to stabilise expectations and restore the trust needed to guarantee market integrity. The same banks that found themselves in the dock during the 2008 crisis are being called to the rescue and summoned to lend unlimited amounts to save viable businesses lacking liquidity, particularly in the hardest-hit sectors. With their renewed financial strength, banks can serve as a bulwark against cascading defaults at a time when the liquidity crisis could easily degenerate into a solvency crisis, even if that means loosening the regulatory straitjacket to help them in their mission. Keeping the core of the system working protects us from systemic chains of events with damaging consequences. This is the big difference from the 2008 crisis! Not to be outdone, governments are taking tough fiscal action to supplement and reinforce the effectiveness of monetary policy. Countries are obviously spending as much as it takes to help their health systems fight the pandemic. They also need to save businesses which, beyond the immediate difficulties, will remain at the forefront of preparations to kick-start the economy once the crisis is over. Social security contributions and tax payments have been deferred and government guarantees put in place to secure new bank lending to prepare the path toward this new post-crisis world. To avoid delayed effects once the crisis is over, jobs, income and overall demand must be protected as far as possible, notably by financing the kind of short-time work arrangements that proved effective during the Great Recession. Governments also have a duty to take targeted action to help the most vulnerable. The bill for all this is clearly going to be big, further inflating public deficits and debts already swollen after the last crisis, all under the benevolent gaze of central banks ready to play their part as lenders of last resort. While Europe-wide efforts at coordination have struggled to come up with a financial solution of sufficient scope, they have managed to activate the general escape clause suspending fiscal rules until further notice.Necessity knows no law, and no effort must be spared to halt the crisis in all its many dimensions. A tomorrow will dawn in which the global economy is ever more laden with debt, interest rates are ever lower and financial markets seeking returns remain prone to fresh excesses. Moreover, given markets’ inclination to punish their rescuers, questions over the sustainability of public debt and the health of fragile banking sectors may well come back to haunt us once the crisis is over… * “A large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits – of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” (John Maynard Keynes, The General Theory of Employment, Interest and Money, 1936). For more information, read or reread Tania Sollogoub’s article “The power of ‘animal spirits’”. Isabelle Job-Bazille - firstname.lastname@example.org
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China is slowing down in the short, medium and long term
In the very short term, the coronavirus epidemic that has been ravaging China is likely to result in a sharp drop in economic activity in the first quarter, as was the case during the SARS (Severe Acute Respiratory Syndrome) outbreak in 2003. The timing and magnitude of the recovery will then depend on the extent and duration of the epidemic currently paralysing the country; in the best case, China will make a rapid recovery spurred by catch-up effects followed by a return to economic normality.This sudden brake on growth comes at a time when the economy is already weakened by the effects of the US/China trade war. These tensions have had a direct impact due not only to the drop in trade with the US but also their knock-on effects on global value chains in which China is a key link. Even so, some corporations have skirted US trade tariffs by having goods manufactured in China transit through an intermediate country not subject to extra tariffs (thus masking the source country) – a short-term avoidance strategy that does nothing to address the issue of how supply chains might be reorganised should the conflict persist. Furthermore, these strategic questions about the global value chain could proliferate following the coronavirus crisis, which has highlighted the vulnerability of global logistics centred on China. This has encouraged the Chinese authorities to pursue their strategy of upscaling Chinese manufacturing and encouraging consolidation in industry with the aim of increasing locally generated added value, and redirecting growth towards consumption, which is less dependent on global ups and downs. Growing uncertainty against a backdrop of mounting trade tensions has also hampered both foreign and domestic investment in China.Beyond these ups and downs, there are deeper reasons underlying China’s slowdown. Firstly, efforts to reduce debt, or rather to manage growth in debt, including tighter control over the shadow banking system, have had an impact on the economy’s financing capacity, and thus on investment and growth. The shadow banking system has grown, fuelled by the inability of the highly regulated traditional banking sector to finance SMEs and high-risk sectors in a rapidly growing economy, hence the Chinese authorities’ initial benevolent stance. Following the 2008 stimulus plan, local authorities also had to turn to non-bank borrowing via dedicated financing vehicles in order to continue with their investment strategies. Meanwhile, state-owned banks continued to supply state-owned enterprises with credit, overwhelmingly driven by the race for volume without regard for the credit quality of these government-backed corporations. All of this resulted in overaccumulation, with overcapacity in heavy industry and the indiscriminate development of infrastructure and urban development projects that were as unprofitable as they were useless. Having loosened the reins due to the health crisis, the authorities are likely to make debt reduction a priority again to safeguard against financial risks and stabilise the foundations for growth at a time when China is embarking on a new phase in its development.Indeed, China is faced with a declining trend in total factor productivity. During the period when the economy was taking off, growth was both extensive, with a combination of fast-paced growth in production factors (labour and capital), and intensive, with high productivity gains stemming from technological catch-up effects and the massive shift in the workforce from farming to the more productive manufacturing sector. As capital accumulation and job creation slow, Chinese growth is becoming relatively more intensive and thus more dependent on productivity gains. Yet productivity gains in the manufacturing sector have traditionally tended to lose steam once the catch-up phase is over. While the "Made in China 2025" plan advocates an industrial policy focused on cutting-edge sectors of the economy, it is still far easier to approach the technological frontier by adopting, copying and then incrementally improving existing innovations than it is to push back that frontier through disruptive innovation. Furthermore, the current rebalancing of growth in favour of consumption and services should enable the Chinese economy to reap the benefits of a middle class with growing purchasing power and to gain independence thanks to more self-sustaining growth. This shift towards a more service-based economy will see jobs migrate towards service businesses, particularly in local services, which are less dynamic in productivity terms – a structural bias that goes hand in hand with structurally weaker growth. nIsabelle Job-Bazille - email@example.com Loans by trust companies, intercompany loans, peer-to-peer platforms, structured wealth management products...
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