03/03/2020

Coronavirus: Preparing for the Pandemic

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Senior Fellow - Economy

The SARS-CoV-2 coronavirus epidemic has become a pandemic. While it appears to be stagnating in China, it is spreading rapidly in Japan, Iran, Italy and elsewhere in Europe, including Germany and France. In the United States, the Center for Disease Control and Prevention (CDCP) warned the authorities that the country would not be spared, which led to a sharp fall in the financial markets. The question of the economic cost of the measures to be taken to curb the epidemic has, since then, entered the political debate. In this regard, although the information from China is not fully transparent, it should not be ignored: procrastination is the worst policy and the high economic cost of the radical measures needed to contain the epidemic should not deter the authorities. At the same time, thinking that economic boosters such as fiscal or monetary stimulus could erase the shock is an illusion.

Dr. Li's death caused a 180-degree turn by the Chinese authorities...

By December 2019, the first cases of infection with a new variant of coronavirus had been detected in the town of Wuhan, but the authorities were quick to impose a blackout, including by ordering the destruction of samples from sick people for fear of a panic reaction from the population or, more likely, for fear of displeasing high ranking officials. The death of Dr. Li, one of the first physician to warn about the threat while devoting himself to treating the first patients but who was then arrested by the militia, immediately inflamed Chinese social networks. The very powerful digital censorship had to go as far as banning the first verse of the Chinese national anthem "Stand Up! People don't want to be slaves anymore!" which was used on the internet as a reference to the man who had become a national hero in a matter of days. As the epidemic in Hubei province was also developing rapidly, Chinese leaders reversed course in mid-January, recognizing the seriousness of the situation, mobilizing their state-of-the-art research teams in virology and epidemiology and, most importantly, placing the population of many cities under house arrest.

The cost of containment could cost China up to 5 points of GDP

The economic cost of such a radical quarantine policy is huge. It is very likely that China's GDP contracted in the first quarter: car production and sales virtually stopped, coal-fired power production fell by 25% to 30% according to the Carbon Project. Transport, whether by air, rail or road, is virtually paralyzed, and shops are largely deserted. At this stage, a 5% drop in GDP compared to the last quarter of 2019 seems a conservative assumption. This is what the drop in the PMI index, from 50 in January (corresponding to an annual production rate of 6%) to 35.7 in February, suggests. And even if Chinese leaders are now encouraging a cautious resumption of economic activity, it is likely that the recovery, driven by unmet and latent demand, will only really accelerate in the second half of the year.

While the short-term economic cost of containing the epidemic might be comparable to that of a severe economic recession, it is far less than the cost of political delays and half-hearted decisions taken late in the process.

Under these conditions, it is possible that Chinese growth, already in structural slowdown but which still reached 6% last year, could fall to 1% this year - a loss of five growth points - before accelerating sharply again in 2021. Even if the epidemic had remained confined to China, the global impact would be considerable given the importance of the Chinese market for exporting countries and the importance of Chinese industry in global value chains. The China effect alone could cut global growth by a good percentage point, bringing it down between 2% and 1% in 2020, a pace generally described as recessionary. For the record, world growth had fallen to -0.1% in 2009.

Should the pandemic spread uncontrollably to the rest of the world, as the situation in some countries such as South Korea and Iran suggests, the impact in terms of human lives and economic cost could be much higher, as we indicated in our note of 20 February, but would depend heavily on the strategies implemented by the authorities, as the OECD has just pointed out.

If the virus is much more virulent than influenza, strict containment measures are justified.

While the short-term economic cost of containing the epidemic might be comparable to that of a severe economic recession, such as 2008-2009, it is far less than the cost of political delays and half-hearted decisions taken late in the process, which would result in a heavy toll in terms of human lives as well as increased unemployment. The economist Jérôme Adda had shown from historical data that containment measures such as school or public transport closures entail significant costs for the economy, including in the long run (school closures reduce future human capital, for example), but that they are justified if the fatality rate of a new virus is two to three times higher than that of seasonal influenza (Economic activity and the spread of viral diseases : evidence from high frequency data, Quarterly Journal of Economics, 2016). It is clearly the case with the new coronavirus since its mortality rate is over 2%, compared to about 0.1% for seasonal influenza. Adda adds in a video from Bocconi University on February 27, that containing the spread of the virus through vigorous measures is all the more justified if it appears to be seasonal.

Don't surrender to lobbies in an attempt to avoid panic

It is often rightly argued that a wave of panic among an ill-informed population would cause serious economic damage, thus it is a good reason to scrupulously inform the population of the development of the epidemic and it must certainly not be used as a pretext to give in to the pressures - unavoidable and understandable - of economic agents, worried about the repercussions, for example, of a quarantine policy.

Stimulating demand would be a big mistake...

Can economic policy diminish the shock of a large-scale disease containment policy? To the extent that the shock is primarily a supply shock - the unused production capacity is unused because people cannot work or cannot work under normal conditions - neither fiscal policy nor monetary policy is appropriate, since they are primarily demand-driven. Stimulating demand when production is constrained is obviously futile.

...but we have to limit the damage for the supply...

This does not mean that nothing can be done on the economic policy side. On the one hand, the fall in production and consumption inevitably leads to a fall in tax revenues and thus to an increase in the budget deficit. Trying to counteract this would be like shooting both the messenger and the ambulance.

If central banks cannot produce medicines, it is up to them to ensure that liquidity does not run out.

Governments should therefore allow fiscal stabilisers to play freely, and not hesitate spending resources to implement an active policy of prevention, containment and care. The Italian authorities have already made a request to the European Commission to this end, and they are right to do so. Secondly, company closures, even temporary ones, can quickly lead to bankruptcy, triggering a vicious circle through the deterioration of the banks' balance sheets. If central banks cannot produce medicines, it is up to them to ensure that liquidity does not run out, while bank supervisors may temporarily allow an increase in risk on bank balance sheets. It is also justified for governments to come to the rescue of companies in difficulty as a result of their trade links with China or as a result of local containment measures, through credit facilities for example, since bankruptcies caused by an external shock and not by a lack of competitiveness would cause lasting damage to the country's economic potential. This is the path that Germany has decided to take. However, it must be anticipated that supply-side support measures of this kind can also have undesirable long-term consequences if, for example, they allow unprofitable companies to stay afloat. In any general measure, no matter how justified, there are windfall and side effects, but this is not a reason for not undertaking them.

Should we fear that a financial crash will add to the damage caused by the epidemic?

Until February 24, global financial markets had not reacted significantly to the news from China. Implicitly, investors believed that as long as the epidemic remained essentially a Chinese affair the world economy would not be too badly affected and that central banks would come to the rescue anyway, starting with the US Federal Reserve, which the interest rate futures markets had begun to price in. The dramatic increase in the number of cases in Italy, and especially the CDCP's statement that the epidemic was in all likelihood going to turn into a pandemic and affect the United States changed the situation radically. Since then, stock markets have lost between 10% (CAC 40) and 15% (DAX 30), with the US market (S&P 500) losing 12% before recovering somewhat on Monday 2 March. A severe correction, certainly, but without signs of panic: trading volumes have increased, albeit reasonably. In reality, and so far, financial markets are following the news flow, reacting to the unexpected (Italy) rather than pricing the worst-case scenarios. For example, while sovereign bonds that were considered safe havens were rising in value - the 10-year yield on German Federal Government bonds fell by about 0.25 percentage points, the 10-year yield on Italian Republic bonds rose by the same amount, implying a symmetric loss of value.

The markets seem to have integrated a kind of mid-range scenario, where corporate profits would fall significantly in 2020, at least compared to previous forecasts, before recovering in 2021, without the world economy being caught in an uncontrolled downward spiral.

If the epidemic continues to spread as rapidly as it has in recent days, the authorities should not hesitate to take severe containment measures, without being deterred by the short-term economic cost, and without giving in to economic lobbies.

In a way, the markets are counting on government interventions to limit the damage by temporarily relaxing credit rules, as mentioned above.

That the impact of the coronavirus is recessive is already in the prices, one is tempted to say. What is not however, would be an ineffective response by the authorities, either to contain the epidemic, or to limit the consequences on companies’ solvency. In other words, bad news regarding the management of the crisis could cause a relapse in the markets for risky assets, shares or bonds of risky companies and countries. Conversely, as happened in 2009, the markets will be quick to recover as soon as the probability of a worst-case scenario appears to diminish.

Let us not forget that markets are by definition speculative, i.e. buyers and sellers of financial assets try as far as possible to anticipate what the future of the companies or entities issuing these assets will be worth. This necessarily includes an estimate of the probabilities that can be assigned to the various possible scenarios. But as time passes, probabilities give way to realities, which inevitably lead to price adjustments. It is therefore expected that markets will become more volatile during the pandemic’s expansion, followed by a return to calm once the reality is better understood, and even a rebound in the markets once the crisis has passed its peak.

One can only hope, of course, that the epidemic now developing in Europe will be stopped as quickly as possible. It is even possible that an early spring may prove to be the best barrier to the coronavirus. But if the epidemic continues to spread as rapidly as it has in recent days, particularly in Italy, the authorities should not hesitate to take severe containment measures, without being deterred by the short-term economic cost, and without giving in to economic lobbies.

Copyright : Philip FONG / AFP