The Coronavirus disease, also known as COVID-19, which was first reported in Wuhan, China in December 2019, has spread rapidly worldwide evolving into a full-blown pandemic. In order to curb the spread of the virus, authorities around the world have implemented lockdowns which have brought much of global economic activity to a halt.
Social distancing, quarantining citizens, restrictions to traveling and social gatherings; and businesses’ shut downs have partially helped contain the spread of this very contagious virus while, unfortunately, they have also brought a number of world economies to their knees. In fact, many companies have been hardly hit by the aftermath of the COVID-19 pandemic due to severe disruptions to global supply chains; global trade operations, and due to tough restrictions to people’s mobility.
The countries that have immediately adopted bold approaches to contain the rapid spread of the virus, through contact tracing, testing and treating patients, and encouraging the use of face masks, seem to have had so far a better response to the healthcare crisis such as stabilizing the Intensive Care Unit admissions in the hospitals or containing new coronavirus flare-ups at an early stage.
Yet, today, it is still very difficult to determine how long this pandemic disease will last; if new stringent lockdowns might be required in the future, or what will be the long-term effects of this health crisis on humanity; the health systems; the financial markets; the real economy, and the sustainability of our social contract.
Some experts argue that this pandemic outbreak could potentially turn into the second most severe health crisis after The Spanish flu pandemic of 1918.
As indicated here below in figure 1, about 17,3 million cases of COVID-19 have been reported worldwide including about 673.000 deaths as of July 312020 (ecdc.europa.eu, 2020).
Figure 1- Geographic distribution of 14-day cumulative number of reported COVID-19 cases per 100 000 population, worldwide, as of 31 July 2020
Source: ecdc.europa.eu. (European Centre for Disease Prevention and Control).
The U.S. economy suffered its worst period ever in the second quarter 2020 with GDP falling a historic 32.9% amid virus-induced shutdown (figure 2) (Cox, 2020).
Figure 2- US Economic Booms and Busts
Source: (Cox, 2020) CNBC Economy.
Germany’s GDP also contracted sharply in the second quarter 2020 (-10.1 percent), its largest decline since 1970, while Mexico’s economy contracted 17.3 percent in the same period, its fifth fall in a row. Furthermore, in the first half of 2020 UK car manufacturing fell to the lowest level since 1954.
International institutions and multilateral organizations have lately revised their economic outlook for the year 2020, forecasting a tough recession for most countries worldwide, but they have also predicted a likely quick recovery (V-shaped) for the subsequent two years (2021 and 2022), although new flare-ups in coronavirus cases across many parts of the world are raising concerns of a rockier recovery (IMF, 2020).
The International Monetary Fund (IMF) predicts for the year 2020 a very sharp slump in the global economy real global GDP which is expected to fall at -4.9%. The unique magnitude of this shock is confirmed by a marked difference between the current recession and the one following the Global Financial Crisis, which reached only a – 0.8% fall in real GDP in 2009 (IMF, 2010).
The looming sovereign debt crisis
Another element of difference with the GFC of 2008 and of great concern regarding the current sharp recession is represented by the global average cumulative debt levels on the onset of the COVID-19 crisis. In fact, as indicated below in figure 3, the global debt (financial, sovereign, and private non-financial) at the beginning of the coronavirus crisis reached a record level of over $250 trillion in 2019, led by a surge in borrowings in the U.S. and China, whereas the same figure in 2009 was approximately $200 trillion (Srivastava, 2020).
Furthermore, in mature economies total debt at the end of 2019 was $180 trillion or 383% of these countries’ combined GDP, while in emerging markets it was double what it was in 2010 at $72 trillion, driven mainly by a $20 trillion surge in corporate debt (Jones, 2020).
Of course, due to the damage of the COVID-19 pandemic the average cumulative debt levels of the post-COVID-19 era are expected to be even higher than those reported in 2019.
After the Global Financial crisis of 2008, emerging markets have boosted debt-driven growth strategies, in particular in the private non-financial sector. Much of this debt has been denominated in ‘hard foreign currencies’ such as, $US and euro (figure 4) (Jones, 2020).
China’s debt in 2019 was approaching 310% of its GDP — one of the highest in emerging markets. Despite the country’s attempts in the past years to push for deleveraging to avoid potential risky asset bubbles, on the onset of the COVID-19 pandemic crisis, household debt, government debt and corporate debt surged again (Jones, 2020).
Figure 3- Global Debt in $ Trillion
Source: (Srivastava, 2020)
Figure 4- Emerging Markets’ FX Debt in $ Trillion
Source: (Srivastava, 2020)
These figures alone give a clue on the magnitude of this unprecedented shock to the global trade, economy, and financial markets and provide clear warning signs about a potential gloomy scenario for the poorer and more fragile emerging and developing economies, the ones more likely to be hit by a looming sovereign-debt crisis.
In April 2020, analysts of the World Bank have predicted that the COVID-19 pandemic will probably have a lasting impact on poorer and more vulnerable emerging and developing economies. They have argued that the pandemic crisis will cause a sharp increase in global poverty pushing about 40-60 million people into extreme poverty. The covid-19 pandemic, however, has caused millions to lose their jobs or rely on government furlough schemes even in the advanced economies (Gerszon Mahler, et al., 2020).
Governments, central banks, health organizations, and multilateral institutions (i.e. IMF, World Bank, UN, WHO) have ensured important rescue measures to help shield national and global communities from the health and humanitarian crises since the unveiling of the virus outbreak. Yet, it is hard to determine today if their rescue plans will be sufficient to weather the looming “perfect storm” on these economies.
On a positive note, it is worth mentioning that since the beginning of the COVID-19 pandemic crisis (March 2020), emerging and developing economies’ liquidity crunch issues and deep market sell-offs have been alleviated by the massive financial intervention of the US Fed, which as mentioned by former Fed economist Nathan Sheets, “has vigorously embraced its role as a global lender of last resort.”
In fact, the Federal Reserve warned that potential shock may impact international financial markets, such as the international shortage of dollars, therefore, has decided to provide emergency swap liquidity lines with some central banks and temporary repurchase agreement facilities to international monetary authorities (and not only in the emerging and developing markets). By stabilizing overseas markets, the Fed’s actions helped avert higher disruptions to overseas economies and to world markets; to assure a proper functioning of the monetary markets, and to avoid that traders would sell Treasurys and different dollar-denominated assets to lift money (Ng and Timiraos, 2020).
The Fed has dollar swap lines with the Central banks of Australia, Brazil, South Korea, Mexico, Singapore, Sweden, Denmark, Norway and New Zealand and also permanent standing swap line arrangements with key central banks such as the ECB, the Bank of Japan, the Bank of England and the Bank of Canada (Politi and Smith, 2020).
Role of central banks
Central banks have also undertaken exceptional measures to support domestic economic recovery and financial stability offering all-time low interest rates, purchasing massive quantities of government debt, mortgage-backed securities, corporate bonds, ETFs (i.e. US Fed), and offering low-cost loans to business.
In case of a prolonged and more stressed adverse scenario, central banks might even take bolder unconventional measures to rescue their economies such as, introducing negative rates; yield curve controls; or buying equities; relying on debt monetization, helicopter money, digital currencies (i.e. recession insurance bonds and Fed-backed digital currency), and so on in order to mitigate potential systemic risks.
In many countries, even the fiscal policy response has been quite rapid and aggressive in order to offset the immediate economic fallout and to sustain employment, and consumer spending. In fact, a number of governments have provided exceptional fiscal stimuli such as, government-backed credit facilities and loan guarantees, moratorium on debt repayments, temporary nationalizations of firms; subsidies for bank recapitalizations; government guarantees on bank risk, unemployment insurance benefits, and even forgivable loans to small firms that would not lay off workers.
The EU insights
In Europe, the European Union leaders have agreed in July 2020 to €750 billion (circa $860 billion) recovery fund (Next Generation EU) to guarantee the survival of the European Union project; to help weaker European economies recover from a very deep recession and a severe health crisis, and to help them close the persistent economic gap vis-à-vis more developed and competitive European countries. This event might set a turning point for the European Union since it is the first time, due to the pandemic crisis, that EU countries seem committed to issue a sort of “EU-bond” (debt mutualization) on the market to finance the EU recovery fund and to offer to weaker economies worst hit by the COVID-19 crisis, a mix of grants and loans.
The EU is rated as a triple A issuer by Fitch and Moody’s, and double A by Standard & Poor’s. Thus, the recourse to the EU Recovery Fund is also a ‘breakthrough’ for the creditworthiness of member states and the sustainability of their sovereign debt ratings (Stubbington, 2020).
The EU Recovery Fund might take the bloc closer to potentially becoming a “fully fledged fiscal union” and could bolster the euro’s status as a reserve currency by creating a new set of large liquid bonds for central banks to buy (Stubbington, 2020).
The announcement of the EU Recover Fund has had a positive effect on the southern European sovereign bond yields and has reduced the threat of a potential downgrade by the credit rating agencies for the most vulnerable European economies that remains just one notches above “junk” borrower status (Stubbington, 2020).
The EU leaders have also temporarily suspended some of the EU’s economic governance rules (i.e. The Stability and Growth Pact and State Aid rules) and they have offered the European Stability Mechanism (ESM) funds with “light” conditionalities (ESM is eurozone’s bailout fund) and the SURE fund (a European instrument for temporary support to mitigate unemployment risks in an emergency). However, in exchange for the access to the EU Recovery Fund, the European countries receiving the grants and loans are obliged to undertake the long-awaited structural reforms.
Of course, some challenges still persist for the formalization of the EU Recovery Fund since the EU treaties require that the agreement must be ratified by national parliaments of the EU member states. The EU is also planning to soften the Mifid II regulation and other regulatory requirements (i.e. loosened loan-loss provisioning requirements in an effort to keep credit flowing) in order to boost the region’s economic recovery and to facilitate access to funding for small companies, although, some analysts have warned against assuming that the economy will automatically bounce back as a result of government relief efforts.
Staring at a recession?
Several economies, which have been more successful with their emergency containment strategies of the COVID-19 pandemic, are more likely to avert a prolonged recession and to achieve a faster recovery if they manage to curb the new waves of coronavirus without imposing stringent and prolonged lockdowns. In fact, stringent lockdowns represent one of the biggest potential downward risk to economic recovery.
Due to the exceptional mobilization of global medical resources dedicated to the COVID-19 vaccine, however, it is easy to understand the great hopes and expectations people have in a soon-to-come discovery of a safe, effective and accessible vaccine against the coronavirus. There are, in fact, promising progress on vaccine research and testing from Pfizer, BioNTech, Moderna, AstraZeneca, CureVac, Johnson & Johnson, Sanofi, Jenner Institute of Oxford University, IRBM-Advent, and others which raise positive expectations. The results of the vaccine’s testing seem so far to be very encouraging in providing strong antibody production with tolerable side effects. Yet, currently there is no assurance from experts that the vaccine’s protections will build permanent immunity to the virus (Imbert and Fitzgerald,2020) (Feuer, W., 2020) (Jee, 2020) (Patel, 2020).
As lockdown measures begin to relax in a number of countries and people are starting to interact more, it is likely to expect that the chances for a second wave of infections will increase. Since it is not yet available an effective therapy or vaccine, the reopenings are intended to take place safely while maintaining social distancing, and masking and hand-washing but some people relaxed these infection prevention efforts, in fact, cellphone data are showing decreased social distancing. Of course, mass testing and contact tracing may mitigate the impact of a potential a second wave, but such measures are not easily enforceable in all countries.
Empirical evidence seems to indicate that the first wave of the epidemic resulted in a level of immunity well below herd immunity levels. According to the experts of the Johns Hopkins University, about 70 percent of the population needs to be immune to this coronavirus before herd immunity can work. Thus, the pandemic is still evolving. There are pockets of a population in which the virus not only survives but continues to spread. The World Health Organization (WHO) has warned about a resurgence of COVID-19 in the coming months. Of course, one of the key priorities for the world community and its institutions in the post-COVID-19 era, is to reduce the risk of future epidemics (Kleczkowski, 2020) (Lockerd Maragakis, 2020).
Analysts and savvy investors are fully aware of the fact that record-high market valuations cannot be sustainable for long without a robust economic recovery; a strong corporate earnings season; pre-COVID-19 consumer confidence and spending levels; robust disposable incomes, and low rates of unemployment.
A speedy rebound from the COVID-19 crisis in Q3 and Q4 of 2020, as well as, in the following quarters 2021, will be essential to avoid a potential correction in the equities market. Governments are doing all they can, in tandem with central banks, health authorities, IMF, and biotech firms researching and testing COVID-19 vaccines, in order to win the race against time to avoid a “Big Reset” in debt, credit and securities’ markets and an even worse health crisis and economic fallout (figure 5).
Figure 5- Stock Market’s Wild 2020 Ride (S&P 500)
Source: (Imbert, Fitzgerald, 2020)
The prolonged and sharp economic fallout following the COVID-19 pandemic crisis will probably have a lasting impact for years which will affect job creation, firm’s insolvencies, and countries’ and corporate debt hangovers.
Regarding the risks of over-indebtedness, it seems that debt-for-equity swaps have emerged in recent times as the preferred method to clean up bad loans and reduce leverage in the economy in some emerging markets. Debt rescheduling and debt restructuring are also critical measures to the resolution of severe debt crisis.
Among the casualties of COVID-19 pandemic, there is also the wave of corporate insolvencies and of companies filing for Chapter 11 bankruptcy due to the prolonged lockdown and subdued consumer demand; due to disrupted supply chains, and due to the global economic slowdown and a sharp contraction of global trade. Notable companies include: Thomas Cook, Cirque du Soleil, Hertz, Advantage, Chesapeake, JCPenney, Neiman Marcus, Brooks Brothers, J Crew, and Virgin Atlantic Airways Ltd. (Rennison; Fontanella-Khan, 2020)(CB Insights, 2020).
According to Euler Hermes (figure 6)(figure 7), in the second quarter of 2020, close to 150 large companies with turnover above €50 Million went insolvent, representing an increase by +70 cases compared to Q1 2020 (Lemerle, 2020).
Euler Hermes warned that the Covid-19 pandemic is an insolvency time bomb. They expect a stronger risk of domino effects, notably on fragile providers along supply chains (Lemerle, 2020).
Figure 6- Number of major insolvencies* by quarter and size of turnover in EUR million
(*) Companies with a turnover exceeding EUR50million. Sources: Euler Hermes, Allianz Research
Figure 7- Number of major insolvencies* in H1 2020 by sector and size of turnover in EUR million
(*) Companies with a turnover exceeding EUR50million. Sources: Euler Hermes, Allianz Research
Easing insolvency laws
In several countries, insolvencies have been delayed since governments have temporarily suspended their insolvency law, allowing companies to put off declaring bankruptcy for a few months. However, as time goes by and new potential waves of viral shedding may increase, the scenario may become much more challenging for all stakeholders, also affected by a massive increase of additional savings of the consumers during the strict lockdowns. Thus, in a worst-case scenario, since fiscal funds are not unlimited, it is possible that firms would increase their layoffs due to overcapacity and a sharp contraction in revenues, liquidity, and earnings.
Continued ultra-expansionary monetary policies of central banks, temporary suspension of insolvency laws, and massive fiscal stimuli and subsidies of the governments may probably allow to weather the perfect storm for a while, but adverse markets conditions and additional severe waves of the COVID-19 pandemic may severely complicate the picture in a worst-case scenario since after the GFC of 2008 there has been a spike of Non-financial corporate debt and low-quality corporate debt in the U.S (figure 8) (figure 9).
Figure 8- US Corporate Debt has Climbed to an All-Time High in the Decade Since the Financial Crisis
Source: (US Global Investors, 2020)
Figure 9- US Non-Financial Corporate Debt Rated BBB has Exploded in Recent Years
Source: (US Global Investors, 2020)
The EU’s banking watchdog, the European Banking Authority, expects banks might suffer a capital loss of up to €380 billion as a result of the economic disruption from coronavirus (Corbishley, 2020).
As reported by Euler Hermes’ Economists, Ozyurt and Utermöhl, public loan guarantee schemes are likely to be extended to 2021 in most Eurozone countries; meanwhile the ECB is likely to boost its support to the banking sector raising the tiering multiple (to shield more of banks’ liquidity), further sweetening the terms on Targeted Longer-Term Refinancing Operations, (TLTRO) loans and/or including bonds that have lost their investment grade status, in its asset purchase programs. If the scenario, will eventually, further deteriorate and a protracted crisis will materialize with the Eurozone NPL ratio rising to around 20%, then the creation of a European bad bank might be the solution (Ozyurt and Utermöhl, 2020).
A TARP-style bad debt fund would issue bonds that commercial banks would buy in exchange for NPL portfolios. These bonds in turn would be eligible to be posted as collateral with the ECB to attain more funding (Ozyurt and Utermöhl, 2020).
The ECB, however, would need other institutions such as the European Stability Mechanism (ESM) to enter the scene to act as guarantors. The ESM is already able to recapitalize banks, and with a treaty change might gain the right to purchase NPLs. Yet, to raise the level of competitiveness of European banks, it is critical to tackle the long overdue structural weaknesses of the sector in Europe with incentives to embrace efficiency and digitalization and progress with the sector’s consolidation process (Ozyurt and Utermöhl, 2020).
According to NYU’s Professor, Edward Altman, and creator of the Z-score, a stressed credit cycle with a deep recession is a potential “perfect storm”. The catalyst for the next market crisis could be a major stock market correction or a significant decline in economic growth in a systemically important country or region — say, the United States or China (Altman, 2019).
For a decade since the Global Financial Crisis of 2008, central banks have injected massive amounts of liquidity at record-low interest rates into financial markets, much of which has been used by corporations to boost billions of debt-driven buybacks of equities in order to push asset prices higher.
Based on his well-known models for predicting corporate insolvencies he has warned U.S. credit investors in July 2020 of the start of a wave of mega bankruptcies. He reported that more than 30 American companies with liabilities exceeding $1 billion have already filed for Chapter 11 since the start of January 2020 (Wee, 2020).
He stated that while the stimulus-fueled rally in U.S. credit markets since March 2020 has helped borrowers stay afloat during the coronavirus crisis, he believes that many companies are just delaying an inevitable reckoning. According to Prof. Altman, companies are doing the opposite of what they should be doing, which is to de-leverage as the banks did after the global financial crisis of 2008 instead of increasing debt, which eventually increases risk of default (Wee, 2020).
Excluding other stringent lockdowns, it is possible to envision a more optimistic and promising outlook with safe reopenings and a gradual return to economic growth driven by environmentally-friendly investments, improving consumer confidence and discovery of effective COVID-19 vaccines or treatments.
The COVID-19 pandemic, like other previous crises, will certainly leave lasting economic scars around the world in the years to come, but, hopefully, it will also become the catalyst of a brighter and more sustainable future, thanks to the acceleration of industries’ transformation, digitalization, consolidation, reconfiguration of supply chains, productivity enhancements, and the invention of new business models.