Dollar Outlook – GDP Lifts Dollar Despite Storm Impact

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6 ways in which a falling dollar-rupee will impact the Indian economy

Hareesh V of Geojit Financial Services said the rupee turned strongly bearish versus the dollar since March as the US and China started imposing tariffs on each other

Geojit Financial Services

The Indian economy has posted the fastest growth among all other major economies since the beginning of this year. A sense of confidence in the economy among investors has reflected in the stock market too, with the benchmark Nifty rallying about 9 percent since January.

However, despite a strong growth rate, the rupee has plunged to record lows, shedding more than 12 percent during the year. At present, the rupee is the worst performing Asian currency.

A strong greenback, coupled with a collapse in emerging market currencies and escalation in the global trade war, affected the Indian currency.

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The dollar has risen more than 7 percent since the country started imposing tariffs on imports, pressurising other global currencies. The economic crisis in Turkey and Argentina too worsened sentiment.

The impact of the trade standoff between the world’s top two economies and its implications on the Indian economy are still unclear, but it has evidently hit the domestic currency.

The rupee started the year at a two-and-half year high of Rs 63.28 versus the dollar, but thereon it traded with a mild negative bias. However, the trend had turned strongly bearish since March as US and China started imposing tariffs on each other.

Since then, the rupee has weakened more than 11 percent so far. Investors sought safety in the dollar and pulled out of emerging market currencies ahead of a worsening global trade war.

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A weak currency impacts an economy in multiple ways:

Higher landing cost for commodities

Currency weakness leads to higher landed cost for commodities imported into the country. Crude oil and gold are instances of such commodities which are traded higher in the domestic market in comparison with their international counterparts.

Impact on current account deficit

A weak currency is likely to widen India’s current account deficit further (CAD). A falling rupee versus the dollar increases the cost of imports and increases export revenues in rupee terms.

The current weakness in the rupee is mostly attributed to widening CAD, which is higher due to the crude oil import bill.

As per government data, India’s oil import bill rose over 50 percent in the first four months of this fiscal as against the same period last year. Since India imports more than 80 percent of its crude requirement, it is resulting in huge dollar outflows.

Impact on flows

Foreign capital inflows help in bridging the gap between imports and exports. Since our imports are more than exports, there is potential for an increase in the trade deficit.

Adds to inflationary pressure

Currency weakness is likely to result in inflationary pressure as well. Higher costs of commodities would exert pressure on overall economic activity and may force the central bank to tweak its monetary policy to tackle inflation.

Impact on GDP

Higher inflation is likely to hit short term growth prospect of the economy as well. Increased input cost due to weak currency may impact the profit margin of companies.

Rise in interest costs for India Inc

Corporates may also face an additional burden on interest costs when the central bank lifts rates. This may impact sentiment of foreign investors in the stock market.

However, a weak rupee versus the dollar usually benefits exporters and people who are remitting currency into the country.

Weekly global economic update March 2020

What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.

Week of Mar 30, 2020

US Congress enacts massive expansion in spending

The US Congress has passed a bill to spend US$2 trillion to help the economy with the fallout from the coronavirus crisis. It will provide the following:

  • US$340 billion of emergency appropriations, 80 percent of which go to states/localities
  • A US$150 billion relief fund for state and local governments
  • A US$500 billion Economic Stabilization Fund for loans, loan guarantees, and liquidity to businesses, states, and municipalities. The funds can be leveraged to provide far more assistance to businesses. The fund will include money for airlines.
  • US$349 billion for small business loan guarantees and grants
  • US$500 billion of direct payments to individuals and other tax provisions for individuals and businesses, including a new employee retention tax credit
  • Enhanced and extended unemployment insurance benefits, including an additional US$600 per person per week for four months
  • Penalty-free withdrawals from tax-deferred retirement plans
  • Mortgage payment forbearance and protection from foreclosure and eviction
  • Deferral of student loan payments

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What impact will this legislation have? First, it is important to note what it will not do. Although it has been labelled a stimulus in the popular press, it is not likely to stimulate the economy. Indeed, Senate Majority Leader McConnell said, “The Senate will act to help the people of this country weather this storm. Nobody thinks legislation can end this. We cannot outlaw this virus. This is not even a stimulus package. It is emergency relief.” Indeed, the legislation will help protect households and businesses from being seriously hurt by the slowdown that must take place in order to quell the spread of the virus. That is, there are effectively two contradictory policies: one policy is to stifle economic activity in order to stop the virus from spreading; the other policy is to give people and businesses money. In other words, if properly written and implemented, the legislation should help people obtain food, housing, and credit. In addition, it should help small businesses stay in business. Many are already close to insolvency. Finally, the bill should help fund the large levels of medical care that will be required in some parts of the country, such as New York.

The economy will likely only be significantly stimulated when large numbers of people and businesses become confident that the virus is no longer a big problem. Even when that happens, there will remain the risk that the virus will come back again. And that raises the question as to whether the Congress may be called upon again to spend vast sums of money. If the economy is shut down again, such expenditure would likely be necessary. That said, if the virus goes away before the summer as temperatures rise, governments will get time to prepare for the next wave that might come in the autumn. Preparation might entail having adequate testing and tracking capabilities, similar to what took place in South Korea. In such a case, it might not be necessary to shut down the economy. Rather, there might simply be a renewed emphasis on modest social distancing. That would surely please those who worry that the stifling of economic activity is imposing too high a cost on society.

High frequency data tells us about the state of the US economy

Mike Wolf, a global economist with Deloitte, provides an analysis of high frequency economic data that reveals the scope of the US downturn.

Economic indicators are necessarily reported with a lag. It takes considerable effort and time to go from collecting data to aggregating and disseminating it. Unfortunately, that means most of the US data coming out now captures economic activity that predates the most stringent measures put in place to prevent the spread of coronavirus. Perhaps more than ever before, we need more timely data to better understand the magnitude of economic losses and any turning points in the economy in this rapidly changing economic environment.

Only a few of the more common economic statistics are reported at a high frequency. For example, the Bureau of Labor Statistics reports jobless claims on a weekly basis, and we already know that the number of people who filed for unemployment surged to 3.28 million the week ending March 21. Meanwhile, same-store retail sales jumped 9.1 percent from a year earlier during the same week as Americans stockpiled goods ahead of shutdowns. However, some of the increase in same-store sales may also be due to the ability of big box stores with grocery offerings to be deemed essential services. This may allow them to grab market share from less fortunate retailers. If this is the case, the rise in same-store sales, which focuses on large chain stores, may not adequately capture the losses for other smaller retailers. Indeed, other types of goods consumption are plummeting. US auto sales fell 22 percent year over year the week of March 22, with losses nearly twice that for some West Coast cities.

Apart from those indicators, most of the major economic data is not provided more frequently than on a monthly basis. Because of this, we are monitoring some unconventional data sources. For example, there have been no bookings for any restaurant that allows reservations through OpenTable since March 21. Similarly, the US box office recorded its first-ever zero revenue reading earlier this week. In addition, travel restrictions have decimated transportation demand. TSA traveler throughput, a proxy for air travel, was 89.5 percent lower than a year earlier as of March 25. Usage of the Transit app, a proxy for public transportation demand, was down 71 percent year over year on March 25. Although leisure and hospitality, along with air and ground transportation, account for only about 5 percent of the US economy, their losses will have an outsized effect on US GDP. Plus, any gains in these metrics will help to identify an inflection point in the current downturn.

While governments have understandably clamped down on the movement of people, the movement of goods within the United States is also struggling. The Association of American Railroads reported that rail traffic was down 8.6 percent the week of March 21 compared with the same week last year, while intermodal volume was down 11.4 percent over the same period. Changes in rail traffic may help identify losses in industrial production and the health of the manufacturing industry. The huge fall in oil prices has already weakened investment in the energy industry with US oil rigs falling 24 percent year over year as of March 20. The drop in rig counts suggests business investment is falling along with consumer spending.

After a slight recovery at the end of last year, residential investment is poised for a substantial decline. Last week, mortgage applications for purchase, an indicator of housing demand, fell 11 percent from a year earlier. Applications for mortgage refinancing remain much higher than a year ago, but they plummeted 34 percent from the week before, highlighting the weakening demand for some financial services. The one small silver lining is that financial markets are beginning to respond to stimulus measures. In addition, risk metrics like the spread between corporate bonds and treasury yields have come down some, though remain considerably higher than they were just a few weeks prior.

ECB supports fiscal policy in the Eurozone

In recent years, one of the hottest tickets on Broadway was the musical “Hamilton,” which implausibly became a hit by examining the life of America’s first treasury secretary. Alexander Hamilton himself was probably best known for having the new Federal government assume the debts that had been incurred by the states during the War of Independence. This set the stage for the creation of a strong Federal government. As indicated in a new study by the Peterson Institute, what Hamilton did is relevant to Europe today. In the United States, redeeming the debts of individual states was imperative because the country had fought a war. In Europe today, there is a war against a virus that member states are fighting, in part, by taking on massive debts. And now the European Central Bank (ECB) is effectively assuming some of that debt by engaging in massive bond purchases.

ECB President Lagarde said, “The coronavirus pandemic is a collective public health emergency unprecedented in recent history …. Unlike in 2008-09, the shock we are facing is universal: it is common both across countries and across all sections of society. Everyone has to scale back their daily activities, and therefore their spending, for as long as the containment measures last. … Public policies must help them.” She created the Pandemic Emergency Purchase Program (PEPP) that, unlike vehicles created during the debt crisis in 2020, provides unlimited and unconditional support to member states. Thus, the ECB is supporting Italy’s massive borrowing without conditions, thereby avoiding political turmoil, which could have set the stage for an Italian exit from the Eurozone. Indeed, yields on Italian government bonds have fallen sharply since the PEPP was announced. This was after having initially risen sharply as the crisis unfolded. Thus, what the ECB is doing is comparable to having a central fiscal authority take responsibility for government debt.

Although the Eurozone does not have a central fiscal authority and does not issue Eurozone bonds, the actions of the ECB replicate the impact of such a situation. The European Union has already suspended all fiscal rules applied to member states and there is increasing talk of using the European Stability Mechanism (often referred to as the ESM), which was created during the last crisis, to channel funds to member states. As the Peterson study says, “ECB purchases and bond holdings become the expression of a euro area fiscal solidarity, a shared fight against a common enemy, that the ECB and European political leaders could not otherwise have contemplated out of fear of overstepping national sovereignty of member states.” Thus, Christine Lagarde might be a modern-day Alexander Hamilton. Moreover, once the crisis is over, the experience of centralized fiscal behavior might change the way European leaders think about how the Eurozone should operate.

Purchasing managers’ indices point to sharp global downturn

We now have the first monthly data that demonstrates the slowdown of the major developed economies in March. Specifically, IHS Markit released its preliminary, or flash, purchasing managers’ indices (PMIs) for the United States, Eurozone, United Kingdom, and Japan for March. The PMIs are forward-looking indicators meant to signal the direction of activity in the broad manufacturing and services sectors. They are based on sub-indices such as output, new orders, export orders, employment, pricing, inventories, pipelines, and sentiment. A reading above 50 indicates growing activity; the higher the number, the faster the growth, and vice versa. The latest PMIs indicate that the broad services sectors in the United States, Eurozone, United Kingdom, and Japan all experienced a stunning drop in activity in March. The PMIs for manufacturing were not quite as bad but were bad nonetheless. This means that factory activity was weakened, but not as severely as services. Services includes most non-manufacturing and non-construction activities. These include finance, retail and wholesale, transportation and distribution, telecoms, professional and business services, hospitality, utilities, education, and healthcare. The near shutdown of public life in many places, both voluntarily and by government fiat, has meant a sharp decline in such activities as air and rail transportation, shopping at stores, hotel stays, entertainment, and restaurant meals, among others. Here are the numbers by region.

In the Eurozone, the services PMI fell from 52.6 in February to 28.4 in March, the lowest number since records began in 1958, indicating activity in the services industry fell at an extraordinary pace. The separate PMI for manufacturing declined from 48.7 in February to 39.5 in March, the lowest in 11 years. Among sub-indices, the news was also stunning. For both services and manufacturing, new orders fell at the sharpest rate on record. Export orders fell to a record low due to a near collapse in cross-border movement of goods and services. The sub-index for employment declined very sharply, indicating that many businesses dismissed large numbers of workers. The data on pipelines indicates that supply chains were severely disrupted. However, this did not result in price increases. Rather, prices declined sharply due to a near collapse in demand. Business sentiment also fell sharply. Markit published data for France and Germany, both of which experienced record declines in their services PMIs and sharp declines in the manufacturing PMI. However, Markit also said that other Eurozone countries had even worse performance than Germany and France. Certainly, the restrictive policies in Italy and Spain can explain this. Markit said that the Eurozone PMIs for March are consistent with an annualized decline in real GDP of 8 percent. It expects this to continue, saying that “clearly there is scope for the downturn to intensify further as even more draconian policies to deal with the virus are potentially implemented in coming months.”

In the United Kingdom, the news was similarly bleak. The services PMI declined from 53.2 in February to 35.7 in March, a record low. The manufacturing PMI fell from 51.7 in February to 48.0 in March. Compared to everything else going on, this number doesn’t seem so bad. Evidently British manufacturers were not as disrupted as those on the continent—at least not yet. Also, the British numbers were not as poor as those in the Eurozone partly because the government was late to impose strict restrictions on human activity. The UK government only ordered the closure of pubs and restaurants last week while such measures were taken much earlier on the continent. Still, the combined effect of the two PMIs is already greater than at the height of the 2008–09 financial crisis. Markit says that the two PMIs are consistent with an annualized decline in GDP of between 6 and 8 percent. Markit said that in March, “any growth was confined to small pockets of the economy such as food manufacturing, pharmaceuticals and healthcare. Demand elsewhere has collapsed, both for goods and services, as increasing numbers of households and businesses at home and abroad close their doors.” Markit also expects worse to come, saying that “this decline will likely be the tip of the iceberg and dwarfed by what we will see in the second quarter as further virus containment measures take their toll.”

In the United States, the numbers were bad, but not as bad as in the Eurozone. That likely reflects the fact that restrictions on activity in the United States have been undertaken by individual states, not the Federal government. The Wall Street Journal reports that the states that have imposed severe restrictions account for roughly 40 percent of GDP. Markit reports that the services PMI declined from 49.4 in February to 39.1 in March, a record low, reflecting the fact that “consumer-facing industries such as restaurants, bars and hotels [bore] the brunt of the social distancing measures, while travel and tourism has been decimated.” The manufacturing PMI declined from 50.7 in February to 49.2, a 10-year low. Markit said that this was “linked to either weak client demand, lost exports or supply shortages.” The sub-indices for output, new orders, export orders, and employment all fell sharply. There was also a record decline in selling prices, which suggests that there could soon be a sharp decline in overall inflation in the economy. Survey results reveal that supply chains were significantly disrupted. Interestingly, business sentiment was relatively optimistic, with many respondents saying that they expect things to improve in the coming year. Still, overall sentiment was low. Finally, Markit said that the two PMIs were consistent with an annualized decline in GDP of 5 percent. It expects the second quarter to be worse due to “the increasing number of virus-fighting lockdowns and closures.”

Japan’s coronavirus outbreak has not been as bad as North America’s or Europe’s. Still, Japan’s economy has suffered from the consequences. The services PMI declined from 46.8 in February to 32.7 in March, a record low. The manufacturing PMI declined from 47.8 in February to 44.8 in March, an 11-year low. The weak numbers reflected poor domestic and export demand as well as supply disruption. Japan’s economy is clearly in a deep recession. It was already likely in a recession before this crisis began, with real GDP having declined at an annualized rate of 7.1 percent in the fourth quarter of 2020.

Week of Mar 23, 2020

The challenge of a century

In the aftermath of September 2001, the cover of the Economist magazine posed the question “Will anything ever be the same?” One might ask that same question now. As last week closed, it was apparent that the world has changed enormously in a short period of time. The number of COVID-19 cases continues to increase outside of China and may remain so in the coming weeks. The result has been a different global economy. Economic activity is declining rapidly. Consumers are staying at home and businesses are shutting their doors. Unemployment is rising sharply, key industries face massive disruption and likely bankruptcies, and central banks have cut interest rates and injected liquidity on a scale rarely seen before. Asset and commodity prices have fallen sharply. Risk spreads have increased, threatening to cause credit markets to seize up. Investors first fled to the safety of bonds and then to the safety of cash. And, because monetary policy is limited in its impact, governments in Europe and North America are planning or contemplating vast increases in fiscal expenditures. They have closed or restricted borders and, in some cases, restricted internal movement of people.

The bottom line is that, in North America and Europe, we are likely already in a very deep recession. Real GDP will probably fall in the second quarter at a rate not seen since the 1930s. The rate of unemployment will rise commensurately. And uncertainty will grip businesses, leading them to shy away from new investments. Rather, they will hunker down, attempting to salvage their enterprises amidst an unprecedented threat. This situation is expected to last until the virus is contained. And even then, it will take time to recover. We see that happening in China, a place that should now offer hope. China closed down and, in the process, stifled the spread of the virus. Economic activity likely fell sharply in the first quarter but is starting to recover slowly as people and authorities move with caution, as they should. The hope is that something similar will happen in the West. It is simply too early to say whether or not that will be the case.

Evidence of a US recession

Meanwhile, although it appears a US recession is already under way, last week we got the first clear indication that the US economy is faltering. The government published data on new claims for unemployment insurance for the previous week. There were 281,000 new claims, up from 211,000 the week before. That is the highest level in two years. Still, it is a relatively low number compared to recent history. Recall that, during the last recession, the weekly number of new claims approached 700,000. That said, the dramatic increase is unusual. Moreover, based on data seen early last week for some US states, we can reasonably predict that the number of new claims last week (which will be published this coming Thursday), will be dramatically higher than the number released last week. We know that, in several key industries, a large number of workers have been or will soon be dismissed. This includes hotels, casinos, restaurants, bars, airlines, and manufacturing. Here is what we know: in Pennsylvania, 121,000 people filed for unemployment insurance on Monday of last week alone. That is 10 times what transpired in the entire previous week. In Ohio, there were 78,000 new claims in the first three days of last week compared to 5,400 for the entire previous week. Based on these anecdotes alone, it appears that a tsunami might be coming.

If unemployment rises substantially in the weeks to come, this will mean that a large number of households will face difficulty in servicing debts including mortgages, credit card debt, automotive loans, and student debt. The financial services industry is bracing for this. It is reported that some banks are providing easier repayment terms for their customers. Still, it seems likely that many will face significant losses. Even before this crisis, debt levels were historically high, although debt servicing costs as a share of income remained much lower than prior to the last recession. Many households could face a significant decline in their credit ratings, making it more difficult to obtain credit in the future once the crisis is over. In fact, it is reported that the White House and members of Congress have been talking to credit-scoring companies about what can be done to protect consumers.

The US policy response

Talks continue in Washington about undertaking a massive fiscal stimulus that will likely entail cash payments to households, subsidies for troubled industries and households, expenditures on medical equipment and care, and help for state and local governments among other things. Referring to the financial crisis in 2008-09, former US Treasury Secretary Lawrence Summers said, “Then, we had to encourage people to go out and shop and buy and boost economic activity. Today the job is to put the economy in a coma without doing harm to people so as to keep people apart. It is arguably an even bigger challenge.”

Meanwhile, the US Federal Reserve has been quite busy. It cut the benchmark interest rate by 100 basis points, pledged US$700 billion in new asset purchases, injected US$1.5 trillion in new liquidity, and set up a US$500 billion fund to purchase commercial paper. Then, it announced that it will allow dealers in government debt to borrow against holdings of equity and debt. The idea is to further boost liquidity in financial markets and guarantee that dealers can create markets. The Fed said that this tool would “allow primary dealers to support smooth market functioning and facilitate the availability of credit to businesses and households.” The Fed last did this during the financial crisis in 2008-09. Its actions appear to reflect its concern that the COVID-19 crisis could lead to even worse trouble for financial markets. For example, the decline in oil prices could reduce the ability of energy companies to service debts. The decline in travel has already created trouble for airlines and hotels. The decline in consumer movement could lead to a rash of small business bankruptcies and failures, creating a negative impact on the banking sector. The Fed hopes that by injecting more liquidity and allowing banks to borrow more cheaply, it could head off a greater rupture in financial market activity. Still, the Fed alone cannot stop the downturn in economic activity. That is why fiscal stimulus is seen as so important.

Equity prices and oil prices continued to fall sharply last week, despite the Fed’s actions. In fact, the price of oil hit a 17-year low. Yet normally when equity prices fall, bond yields fall as bond prices rise. That is what has happened in recent weeks as investors engaged in a classic flight to safety. However, bond yields around the world rose sharply late last week (which means that bond prices fell). How can we interpret this? It appears that, rather than engaging in a flight to safety, investors are engaged in a flight to cash. Businesses and the banks that fund them want to be as liquid as possible. Evidently, they’re worried that the measures taken by the Federal Reserve and other central banks to boost liquidity are inadequate. It is also likely that investors were worried because the US Congress had not yet passed a major stimulus package.

Evidence of China’s Q1 weakness

When the coronavirus hit China, it was widely expected that the strict government measures aimed at limiting human interaction and thereby stifling the spread of the virus would have a negative impact on the economy. There have been limited bits of data to confirm the extent of the damage. These include reports of declining automotive sales as well as the plummeting Purchasing Managers’ Indices (PMIs) that are based on survey data. Yet there have been varying predictions about the degree to which the economy would suffer.

However, we now have real data that indicates just how bad things have been. Specifically, in January and February combined, fixed asset investment fell 24.5 percent from a year earlier, an unprecedented number. The decline was across the board, encompassing all sectors and both public and private sector investment. This compares to the 5.4 percent increase in fixed asset investment in 2020, which itself was a historically poor performance. Also, industrial production fell 13.5 percent in the first two months of 2020 versus a year earlier. This was the first decline since 1990. There were big declines in such sectors as transport equipment (down 28.2 percent), machinery (down 24.7 percent), and textiles (down 27.2 percent). In addition, industrial exports were down 19.1 percent from a year earlier. The latter figure is consistent with reports of disruption of global supply chains in manufacturing. Finally, Chinese retail sales were down 20.5 percent in the first two months of 2020 versus a year earlier. This compares to an increase of 8.0 percent in December. The partial lockdown of many cities as well as the complete lockdown in Hubei Province prevented Chinese households from engaging in much discretionary shopping outside the home. There were especially sharp declines in spending on automobiles (down 37 percent), clothing (down 30.9 percent), jewelry (down 41.1 percent), home appliances (down 30.0 percent), furniture (down 33.5 percent), and building materials (down 30.5 percent). It is reported that visits to shopping centers, restaurants, and movie theaters were down substantially.

This data gives us a strong hint of what Q1 GDP numbers will be when they are published. It also gives us a sense of what we might expect in Europe and the United States starting in the second half of March. Already, we are seeing a sharp reduction in the movement of people, the closure of stores and other public venues, and government restrictions as well. This is meant to stifle the spread of the virus as was the case in China. Yet it will likely lead to a sharp reduction in economic activity, which explains the significant losses we have been seeing in financial markets.

What next for China

This week Xu Sitao, Chief Economist of Deloitte China, provides an analysis of China’s policy options.

Last week saw zero new infections for a second day in Wuhan, but China’s newly confirmed cases of Covid-19 mostly came from overseas visitors. This has cast a cloud over the government’s top priority of resuming business. So, how to strike a balance between not wasting previous efforts and jump-starting the economy is indeed a difficult task. The good news is that China has developed a playbook of early testing and subsequently pooling medical resources during its war on coronavirus. As such, we expect local governments to boost medical resources and to bring back badly needed workers. Despite China’s huge capacity for generating domestic demand, export markets remain important for the economy. Anecdotal evidence suggests that some factories could see reduced export orders simply because of COVID-19 containment measures, such as lockdowns in other countries. How should China react to external uncertainties?

First, drastic moves by major central banks within a week raises the question of whether the People’s Bank of China should be more aggressive. The answer to this question is not straightforward. There is no downside for cutting rates but what policymakers have been trying to do is channel funds into the real economy and especially into SMEs. Successful containment of COVID-19 has taken a toll on the economy as evidenced by almost all major economic data in January and February. How to help SMEs and sectors (retail, restaurants, and transportation-related sectors) that have been battered by stalled economic activity ought to be the priority as business resumption gathers pace. From this perspective, the decision taken by the Chinese government to cap the cost of capital at 1.6 percent for significantly affected industries is sensible. This decision was announced by the Ministry of Finance on March 3 in the press conference of the Joint Prevention and Control Mechanism of the State Council. Unlike the United States, China’s domestic stock market has gone through several episodes of de-leveraging campaigns since 2020. We could see sporadic financial sector stress (e.g., among regional banks, smaller property developers, or offshore corporate bonds when the US dollar is going from strength to strength) but systemic risks are unlikely. So, the situation for China is about an elevated role of fiscal policy. Therefore, the issue now is how to get targeted fiscal expansion implemented.

Second, should China take a page from the West with a strong dose of fiscal relief? In China, cash payments are unlikely because fiscal structures were not set up in such way. So, to boost consumption, a number of local governments—led by Nanjing—have rolled out consumption coupons or the equivalent, which have been replicated in many cities quickly. The bigger issue is how to boost consumption in the medium term and to avoid major layoffs in the short run. On the latest development, the government has predicted that suspension of social security contributions for firms, which will be extended to June, will provide relief of an estimated amount of RMB500 billion. This was announced by the Ministry of Human Resources and Social Security of PRC in its March 19 press conference.

Third, should China adjust its 2020 growth target? In our view, the answer is yes. As the economy is undergoing structural changes (more consumption and services), large infrastructure investment projects could boost GDP growth but may not create as many jobs as in the past when labor costs were lower and overcapacity was less acute. In practice, China could comfortably have a fiscal deficit/GDP ratio at 5 percent even though the debate is whether the ceiling of 3 percent could be exceeded in special situations. COVID-19 will change the balance between local governments and Beijing, meaning the former is expected to do more. That is why the National Development and Reform Commission or NDRC gave the green light for local government debt issuance last month. However, if China wants to avoid a “flood irrigation” type of stimulus and to focus on investment in health care or wellness in general, then a lower GDP growth target will be prudent. In China, the growth target is normally announced at Two Sessions that could be delayed to late April or early May, according to overseas media (Singapore’s Lianhezaobao). Last week, Premier Li Keqiang highlighted the importance of preventing layoffs, a subtle signal of de-emphasizing the GDP growth target. So what would be the likely growth trajectory for the Chinese economy assuming COVID-19 could be contained in the United States and Europe before Q3? It is safe to say that Q1 will be an outright contraction while Q2 could see flat growth because it will take some time for local governments to strike a balance between resuming business and containing the virus. In all likelihood, recovery in H2 will be vigorous and those economies (e.g., Hong Kong and South Korea) that have been affected more severely by COVID-19 could see a strong rebound. In short, the best policy responses are to: 1) lower the growth target; 2) accelerate business resumption with greater fiscal relief; and 3) avoid a “flood irrigation” type of stimulus.

Bond yields in Europe

Italy’s bond yields rose dramatically early last week, reflecting fears about the impact of the crisis on the government’s ability to service its large debts. Meanwhile, the yields on the bonds of Spain, Portugal, and Greece rose sharply as well. This was sort of a contagion effect of what happened in Italy. In the case of Spain, it likely reflected concern that the Spanish economy will decline sharply due to a near complete shutdown of public life. Bond yields in these countries remain far below the levels seen during the debt crisis in 2020, but it is the same group of countries that were at risk during that crisis. Still, the rise in yields meant that the troubled governments of weak economies could have greater difficulty rolling over their large debts. If the virus crisis lasts for a while, this could be problematic and might set the stage for another credit crisis. Recall that during the last crisis, then European Central Bank (ECB) President Draghi reassured investors when he said that he would do “whatever it takes” to save the euro. Investors interpreted this to mean that he would engage in targeted purchases of the bonds of troubled countries. He did not do this. Rather, his words made all the difference and bond yields fell sharply, providing financial relief to troubled countries, thereby ending the crisis.

Meanwhile, after major European governments announced various fiscal stimulus measures which, combined amount to about EUR1 trillion of stimulus, the ECB followed suit and, late last week, announced a program of bond purchases that will amount to EUR750 billion. Specifically, over the course of this year, the ECB will purchase a combination of sovereign debt and corporate bonds. The program will continue until the COVID-19 crisis is over. ECB President Lagarde said, “There are no limits to our commitment to the euro. We are determined to use the full potential of our tools, within our mandate.” The decision to do this came after bond yields in Italy, Spain, Portugal, and Greece had risen sharply. However, there was opposition within the ranks of ECB officials. The representatives of Germany and the Netherlands are said to have opposed the move. The ECB has a self-imposed rule against buying more than one third of the debt of any member country. This is meant to prevent the ECB from violating the European Union rule against financing the deficits of member countries. Yet the ECB is now close to hitting the limit of its self-imposed rule. As such, there is now talk of repealing the rule, something Germany and the Netherlands evidently oppose. In order to assist a country like Italy, which will likely borrow massively this year because of a deep recession, the ECB will surely have to repeal its rule. Failure to do so could mean a further spike in Italian bond yields. Meanwhile, Italian, French, Spanish, Portuguese, and Greek bond yields fell sharply following the ECB announcement. German and Dutch bond yields, however, were up as investors moved to riskier assets.

Week of Mar 16, 2020

European response to the virus

Italy’s government has imposed a lockdown on the entire country. This unprecedented measure comes as the country faces what the prime minister called its “darkest hour,” invoking Winston Churchill’s description of Britain during World War II. The lockdown means that all 60 million people in Italy will effectively be under quarantine. They’re being told to only leave their homes for health or work reasons. All schools and universities will be closed. All public events will be cancelled, including much-beloved sporting events. Even private events, such as weddings and funerals, will be banned. People will be allowed to travel only for work, shopping, and health reasons. Restaurants and bars will be required to close by 6:00 PM. All citizens will be required to carry documents explaining their movements. Police will be able to stop people and question their movements. Anyone judged to be breaking the rules could face fines or even imprisonment. Prime Minister Conte said, “Our habits must change now. We all must give up something for the sake of Italy.”

The Italian government is using a strategy that apparently worked in China. The Chinese government imposed a strict quarantine on the people of Hubei Province, which is where the outbreak began. The number of new cases in Hubei has dropped to a low level and there is now hope of containing the outbreak. Yet this was done at an enormous economic cost. For now, Italy will face a big economic cost as well. Regardless, the country’s leaders know that they face a tradeoff—either stifle the virus and stifle economic growth or risk a wider spread of the virus with untold future consequences.

Meanwhile, Italy keeps increasing the size of its fiscal stimulus. Last week, it announced that it will spend EUR25 billion on measures to alleviate the pain from the crisis. In the last two weeks, it has successively boosted the stimulus from EUR3.6 billion to EUR7.5 billion to EUR10 billion and now to EUR25 billion. This is a substantial amount of money and might help to limit the economic damage.

In Germany, where there has been a big increase in the number of infections, Chancellor Merkel predicted that as much as 70 percent of the country’s population could become infected. She said, “Once the virus has arrived in Germany and we do not have immunity in the population at all to this virus, and yet there is no option for either vaccination or treatment, a high percentage of experts say 60 to 70 percent of the population will become infected.”

Meanwhile, Merkel appears to have changed her view on fiscal policy. Even before the COVID-19 crisis, her government had been under pressure to boost spending even at the risk of eliminating the fiscal surplus. With the crisis, many analysts see fiscal expenditure as the best means of offsetting the negative economic consequences of the outbreak. The government was initially reluctant to increase spending. Yet last week, Merkel said, “We will not ask ourselves every day what this means for our deficit. This is an extraordinary situation. We will do whatever is necessary.” She initiated considerable aid to troubled businesses.

The Bank of England (BOE) announced an emergency reduction in its benchmark interest rate from 0.75 percent to 0.25 percent. In addition, it introduced cheap loans to banks to ensure that they continue to lend during the crisis. This is meant to help small- and medium-sized businesses that are hurt by the virus outbreak. Also, the BOE introduced new, lower capital buffer requirements for banks. This, too, is meant to stimulate more bank lending. Finally, the BOE said that commercial banks may not use the added funding to boost their dividends for shareholders. These actions come as the government reports a continued and deep decline in manufacturing output, partly the result of uncertainty about how Brexit will unfold in the coming year.

In Spain, there is now a complete lockdown in which restaurants and bars are closed and citizens are ordered to stay home, and can venture out only to shop for food and drugs as well as to go to work or for medical emergencies. Spain joins Italy in implementing strict measures to contain the spread of the virus. In France, the government ordered that bars, restaurants, movie theatres, and the Eiffel Tower be closed. President Macron said that the country faces the greatest public health crisis in a century.

Chinese economic data reveals impact of COVID-19

When COVID-19 hit China, it was widely expected that the government measures aimed at limiting human interaction and thereby stifling the spread of the virus would have a negative impact on the economy. There have been limited bits of data to confirm the extent of the damage. These include reports of declining automotive sales as well as the purchasing managers’ indices (PMIs) that are based on survey data. Yet there have been varying predictions about the degree to which the economy would suffer.

However, for the first time, we now have real data that indicates just how bad things have been. Specifically, in January and February combined, fixed asset investment fell 24.5 percent from a year earlier, an unprecedented number. The decline was across the board, encompassing all sectors and both public and private sector investment. This compares to the 5.4 percent increase in fixed asset investment in 2020, which itself was a historically poor performance. Also, industrial production fell 13.5 percent in the first two months of 2020 versus a year earlier. This was the first decline since 1990. There were big declines in such sectors as transport equipment (down 28.2 percent), machinery (down 24.7 percent), and textiles (down 27.2 percent). In addition, industrial exports were down 19.1 percent from a year earlier, consistent with reports of disruption of global supply chains in manufacturing. Finally, Chinese retail sales were down 20.5 percent in the first two months of 2020 versus a year earlier. This compares to an increase of 8.0 percent in December. The partial lockdown of many cities, as well as the complete lockdown in Hubei Province, prevented Chinese households from engaging in much discretionary shopping. There were especially sharp declines in spending on automobiles (down 37 percent), clothing (down 30.9 percent), jewelry (down 41.1 percent), home appliances (down 30.0 percent), furniture (down 33.5 percent), and building materials (down 30.5 percent). It is reported that visits to shopping centers, restaurants, and movie theaters were down substantially.

This data gives us a hint of what first quarter GDP numbers may be when they are published. The data also gives us a sense of what we might expect in Europe and the United States starting in the second half of March. Already, we are seeing a sharp reduction in the movement of people, the closure of stores and other public venues, and government restrictions. All this is meant to stifle the spread of the virus as was the case in China. Yet it will likely lead to a sharp reduction in economic activity, which explains the significant declines we’ve been seeing in financial markets.

The COVID-19 crisis has had a significant negative impact on Chinese trade. The government reports that in January and February combined, exports evaluated in US dollars were down 17.2 percent from a year earlier. This follows growth of 7.9 percent in December. China normally combines trade data for January and February because the timing of the Lunar New Year holiday can distort the data for each individual month. The decline in exports was across the board and, unlike previous episodes, was not principally due to trade restrictions or weakness in demand. Rather, it reflected the fact that fewer people in China were working, factories were producing less, transportation was disrupted, and there were restrictions on movement. In addition, imports into China were down 4 percent in January and February versus a year earlier. This largely reflected the downturn in Chinese factory production and the consequent reduction in the demand for components. When the crisis is over, trade should bounce back. It is not clear how long this will take to happen.

Financial market mayhem and central bank responses

Last week was a time of unusual mayhem in global financial markets. In the United States, equity prices were hugely volatile and were down substantially for the week. Last Thursday, prices fell by the largest percent since the crash of 1987. It was the sixth-largest percentage decline in US history. In Europe, equity prices fell in the 9–11 percent range, the worst-ever single day. Shares in airlines, cruise ships, and related industries fell especially low. In addition, oil prices and bond yields fell. US equity prices are now no higher than at the start of the current administration. What explains the carnage in equity markets?

Investors were likely alarmed by the rapid spread of the virus, especially in Europe. The number of infections increased rapidly each day in the past week. Yet in China, there were few new cases. Instead, there was a big increase in the number of cases in Europe and Iran. In Italy, the government intensified its quarantine, ordering the closure of all retail establishments other than those selling food and drugs. Likewise, Spain imposed a nearly complete lockdown of the country, ordering people to stay home and avoid going out except for critical reasons. In the United States and Europe, there was a steady stream of news about cancelled events; closed schools, universities, and museums; and businesses telling employees to work at home.

In addition to volatility in asset markets, financial markets exhibited increased stress. Credit default swap prices are up substantially. The price of insuring against default on high yield bonds hit the highest level in eight years. The cost of insuring high-quality debt also hit a nearly eight-year high. This rapid increase reflects concern that, during the coming economic downturn, many debtors will face difficulty in servicing their debts. In line with the rise in the price of CDS there has been a sharp rise in the spreads between high yield bonds and safe Treasury bonds. Again, this reflects a perception of increasing risk. These trends could weaken credit market activity. The recent efforts by central banks to boost liquidity are meant to counter these trends.

Even the market for mortgages has been affected by the crisis. Recall that, in 2008, the global financial crisis began with a seizing up of the market for mortgage-backed securities (MBS) in the United States. Now that market is again under stress. The sharp decline in interest rates engineered by the Federal Reserve, followed by the unprecedented decline in bond yields, led to historically low mortgage interest rates. This, in turn, caused a surge in refinancing activity. As such, there was a sudden jump in the supply of mortgage backed securities in the market. Yet banks, which are intermediaries in this market, found it difficult to sell the MBS, in part because of the uncertainty associated with the virus crisis. The result was a sharp increase in mortgage interest rates, with the spread between the rate on 30-year mortgages and the 10-year Treasury bond soaring to the highest level since the financial crisis. The rate on 30-year mortgages increased by about 70 basis points in a matter of days, hitting the highest level since mid-2020.

The Fed responds

On Sunday, the Federal Reserve announced that it was cutting its benchmark interest rate by 100 basis points and that it would engage in US$700 billion in asset purchases (quantitative easing). Even after that, equity prices continued to fall sharply and there was considerable volatility in financial markets.

One might ask why investors kept selling after the Fed took such demonstrative action. The answer likely is that investors don’t expect an easing of monetary policy to change the trajectory of consumer and business spending. After all, lower interest rates will not get consumers on an airplane or into a movie theater. Rather, the decline in spending is related to fear about the virus as well as government efforts to keep people away from public places. That is not to say, however, that the Fed action was without merit. Although the interest rate reduction got the biggest headlines, the most important thing the Fed has done in recent days was to boost liquidity and, it is hoped, prevent a seizure of credit markets. Last week the Fed offered US$1.5 trillion in cheap short-term loans to banks in order to assure liquidity in the market for Treasury securities. Then, it announced massive purchases of bonds and mortgage backed securities in order to provide liquidity to the banking system and to housing finance. Moreover, it sent a clear signal that it is willing to do whatever is necessary to keep markets functioning. This is important given that several sectors of the economy now face the threat of distress. This includes such sectors as airlines, hotels, energy, non-food retailing, automotive, and small business. Moreover, if the crisis is prolonged, the banking sector could face stress as well. In any event, the increase in the prices of credit default swaps and the rise in risk spreads is evidence that investors are concerned about potential trouble.

The ECB responds

Meanwhile, the European Central Bank (ECB) initiated measures meant to respond to the crisis. Specifically, ECB President Lagarde announced that the bank will boost bond purchases (quantitative easing) by EUR120 billion for all of 2020 as well as make cheap loans available to commercial banks. However, the ECB chose not to reduce its benchmark interest rate, leaving it at -0.5 percent. However, Lagarde noted the limits of monetary policy and called for more fiscal action. Specifically, she said, “An ambitious and coordinated fiscal policy response is required to support businesses and workers at risk.” The ECB decision comes on the day when the European Union reported that, in January, industrial production in the Eurozone fell 1.9 percent from a year earlier, the fifteenth consecutive month of declining annual output. At the same time, output was up 2.3 percent from the prior month. This suggests that, just prior to the COVID-19 crisis, Europe was starting to see a potential recovery. Yet with the near shutdown of the Italian economy, industrial production for the Eurozone overall is likely to fall further in the coming months. Moreover, economic stress in other European economies will also contribute to a downturn in output. Europe is clearly on the verge of recession if not already there.

China responds

China pumped money into its economy by cutting the required reserve ratio for certain types of banks. The result will be an additional US$78 billion in funds available for lending. China’s central bank thus joins the world’s other major central banks in easing monetary policy this week. Meanwhile, the International Monetary Fund says it is receiving inquiries from countries worried about a downturn. It says it is prepared to provide financial assistance to emerging countries that face financial difficulties as a result of the global slowdown.

Week of Mar 9, 2020

Investors were unimpressed by a strong US jobs report

In ordinary times, when the US government releases a strong employment report, bond yields rise because the data confirms the view that the economy is strong and that there might be an acceleration in inflation. But these are not ordinary times. Last week, the US government did indeed release an unusually strong jobs report. Yet bond yields promptly fell to historic lows while equity prices continued to fall sharply. Oil prices plummeted. The surprising reaction of financial markets was related to the COVID-19 outbreak. The outbreak continues to worry investors, especially given the already significant disruption of a wide range of global industries including manufacturing, automobiles, technology, pharma, apparel, transportation, retailing, and tourism. Although the number of new cases in China has declined, the damage to the Chinese economy persists and may take time to repair. Moreover, the virus continues to spread outside of China, creating uncertainty about the potential for economic dislocation. As of this writing, the number of infections in Europe has reached a fairly high level and the number in the United States has started to rise rapidly. Investors hate uncertainty and they are reacting commensurately.

As for the employment report, the US government releases two reports: One based on a survey of establishments, the other on a survey of households. The establishment survey reveals that, in February, there were 273,000 new jobs—the same as in January. The last time there were two back-to-back reports of such strength was in early 2020. Breaking this down by industry, there was a strong 42,000 gain in construction, likely due to the rebound in the US housing market. In addition, there were 15,000 new jobs in the manufacturing sector, despite the fact that the industry began to be disrupted by supply chain dislocation in China. There was even a strong increase in employment in the automotive sector. In services, there were actually declines in employment in retailing, wholesaling, and transportation and distribution. But there were big increases in employment in professional and business services, health care, hospitality, and government. Going forward, if the US economy weakens due to the COVID-19 outbreak, it is likely that job growth will decelerate if not reverse. The Purchasing Managers’ Indices (commonly known as PMIs) for February suggested that the economy was already decelerating, but it usually takes time for this to affect the job market. The household survey revealed that the unemployment rate fell again to a 50-year low of 3.5 percent. Participation in the labor market remained steady. Finally, wages accelerated modestly in February.

Investors were unimpressed when the Fed cut interest rates

At the start of last week, US and global equity prices rose sharply on expectations that the world’s leading central banks would soon take action to mitigate the economic impact of the COVID-19 outbreak. Based on the interest rate futures market, US investors evidently had expected that the US Federal Reserve would cut the benchmark federal funds rate by 50 basis points at its next meeting two weeks from now. Their expectations turned out to have been correct. Last Tuesday, the Fed surprised investors by cutting rates ahead of the next meeting. For the first time since the financial crisis in 2008, it took action outside of its usual meeting schedule, cutting the benchmark federal funds rate by 50 basis points. As a general rule changes in monetary policy work best when they are least expected. This was not expected, at least so early, so it is more likely to be impactful than otherwise. However, investors apparently were not entirely surprised because equity prices initially went nowhere after the Fed’s action, and then dropped very sharply for the remainder of the week.

The challenge is that monetary policy does not necessarily address the factors that are causing an economic problem. Monetary policy, by easing credit market conditions, is generally aimed at boosting credit activity amidst weak demand. Yet the virus is mainly a supply-side problem. It has caused disruption to manufacturing output and supply chains because workers in China have not returned to work in sufficient numbers. On the demand side, to the extent that consumer and business demand has weakened, it is not due to inadequate income or high borrowing costs. It is due to fear and restrictions on activity. In the United States, for example, businesses are cancelling travel and meetings, having a negative impact on the transportation and hospitality industries. The Fed’s action will not change this. At the same time, one impact of the virus uncertainty has been a decline in issuance of corporate bonds. By cutting borrowing costs, the Fed action might help to modestly boost activity.

Meanwhile, bond yields fell sharply last week as investors continued to downwardly revise their expectations for economic growth and inflation.

Perhaps a more expansive fiscal policy would help to offset some of the negative impact. In Washington, there is discussion about a temporary tax cut. However, if consumers simply save the added money, it would make no immediate difference. That is why some analysts are suggesting an increase in government spending on infrastructure or other public-sector investments. In any event, investors are clearly betting that the Federal Reserve will soon cut interest rates again and do so emphatically.

Then again, there could be a temporary spike in consumer spending in countries that are at risk. It is reported that, in the United States, Italy, and Japan, there has been a surge in shopping for household essentials. Consumers are evidently stocking up on things like water, food, medicine, and household products in anticipation of a more restrictive environment. Retailers report having to work with vendors to guarantee an adequate supply of such goods. In Japan, sales of toilet paper have increased tenfold from normal levels due to rumors of shortages from China.

Finally, the Fed’s action, which was meant to calm markets, did no such thing, given the sharp decline in equity prices and bond yields. Many investors evidently do not expect that the trajectory of economic activity will be affected by what the Fed did. Or, they might be disappointed by what Fed Chairman Powell said. He brushed off suggestions that the Fed should have cut rates even further, saying that “we like our current policy stance.” Perhaps some investors saw the Fed’s action as panicky, as a signal that the Fed leadership has less confidence in the economy than previously believed. If so, investors might have sold equities because of increased pessimism. In any case, to some extent last week’s events demonstrate the limits of monetary policy in this kind of situation. It is a lesson that other central banks will, hopefully, learn.

On the day the Fed acted, the central banks of Australia and Malaysia cut rates while the Bank of Japan boosted liquidity. Canada soon followed. The Bank of England said it stands ready to support the British economy, with Governor Mark Carney saying that the global economic impact from the virus “could be large.” Bond yields have fallen in most other markets. This reflects rising pessimism about growth and inflation as well as expectations that central banks will further ease monetary policy. In most countries in Western Europe, the yield on the 10-year government bond is now below zero. The major exceptions are Spain, Italy, and Greece. In Italy, the yield has actually increased modestly since the start of the crisis. This reflects concern that a rapid weakening of the Italian economy will hurt the government’s ability to service its debts. Finally, the G7 group of industrial nations released a statement pledging to take action on the virus, but without saying what that action will entail. But investors were clearly not impressed.

One positive impact of the Fed action has been that mortgage interest rates are pushed down to historic lows. This will likely lead to a surge in refinancing activity, thereby boosting household disposable income. If people spend that money, it will help to offset the negative impact of the virus. If, however, they save the extra funds, it will make no difference. Also, lower mortgage rates should lead to an increase in home buying. However, some analysts are concerned that the virus situation may cause consumers to defer the process of house hunting.

Of OPEC, Russia, oil prices, and financial markets

In the market for oil, a sudden and large movement in the price is usually due to either a shock to demand or a shock to supply, but not both. Currently, both are happening. The demand shock is clear: The COVID-19 disruption to the Chinese economy has already led to a sharp decline in demand for crude. This is likely to persist until the Chinese economy can get back on its feet. Plus, a shock to demand in other countries is possible as the coronavirus spreads. The supply disruption is a bit more complicated. Initially, Saudi Arabia-led OPEC and Russia collaborated in January in reducing supply in response to the demand shock. The idea was to stabilize the price. But the shock to demand turned out to be much greater than previously anticipated. Consequently, last week, Saudi Arabia sought Russian approval for a further cut in production. Russia said no, and the price fell sharply at the end of last week. But that was not the end of the story.

Over the weekend, the Saudis announced that they would boost production and offer their crude at a discounted price. The result was that, in a matter of minutes, the price of crude initially fell about 30 percent before settling at a loss of about 20 percent, the largest one-off decline in modern times. The price fell to a level not seen in four years, with Brent crude hitting US$36 per barrel. It was reported that the Saudi decision was aimed at punishing Russia for its unwillingness to cooperate. When the price had been in the high 40s last week, it was seen as sufficient to allow Russia to maintain fiscal probity. Yet a price of US$36 is a different story. It is possible that Saudi Arabia is hoping that the Russians will change their mind before long, thus enabling them to reach an accommodation and, consequently, a higher price. However, in the interim, global financial markets have been shocked.

Following Saudi Arabia’s action, the yield on the US government’s 10-year bond fell sharply again, down from 0.74 on Friday to as low as 0.31 percent before bouncing back to 0.54 percent as of this writing. This is, by far, the lowest rate ever. A measure of expected inflation in the United State fell to the lowest level since early 2020. European bond yields also fell sharply; Italy, however, was an exception—the yields continue to rise on fears about the country’s economic downturn. Global equity prices were down so sharply that the New York Stock Exchange temporarily halted trading when prices fell more than 7 percent, which triggered a circuit-breaker. European equities were down commensurately. Meanwhile, the dividend yield on US stocks is above the yield on the US Treasury 10-year bond for the first time since 2008. The value of the US dollar fell sharply against the Japanese yen and the euro as investors fled the low yields on US assets. Normally, the value of the dollar and oil prices move inversely. In contrast, currencies of oil-producing countries, such as Canada, Mexico, and Russia, fell. What happened over the weekend was a supply shock that followed a demand shock, leading to a shocking price reduction.

What happens next? Who will blink first? Russia lacks the financial reserves of Saudi Arabia but has a more diversified economy. The Saudis lack economic diversity but have plenty of cash to weather this storm. They also have plenty of oil underground and can easily boost production even further if they choose. Thus, they appear to hold the best cards. The last time Russia endured a sharp decline in prices, its currency nearly collapsed, forcing its central bank to raise interest rates and stifle economic growth. Indeed, the ruble has already fallen sharply in the last week. Meanwhile, other oil producing nations will struggle to deal with a much-diminished price, especially those other than affluent Gulf nations. Iran, in particular—now facing a serious COVID-19 crisis and the imposition of severe US sanctions—will be challenged. Likewise, such countries as Nigeria, Venezuela, Indonesia, and Mexico could face trouble. Even the United States, which has a large and vibrant oil industry, will feel the impact. The rise of US shale producers played a role in driving OPEC and Russia into each other’s arms in 2020.

Week of Mar 02, 2020

A Chinese perspective on coronavirus

This week we get a perspective on the COVID-19 virus from Deloitte China chief economist Xu Sitao who offers his thoughts on what is happening in China as a result of the virus:

The business resumption rate, which now tops China’s policy agenda, is likely to rise from around 30 percent to 50 percent by early March. Of course, this number varies by sector and region. For example, Zhejiang, one of the most economically developed provinces, is seeing a resumption rate of 90 percent. Based on a survey from the American Chamber of Commerce (Beijing), nearly half of respondents expect 2020 China revenues to decrease if business cannot return to normal before April 30; nearly 20 percent say 2020 revenues will decline more than 50 percent if the epidemic extends through August 30. The China Association of Automobile Manufacturers (CAAM) reports a business resumption rate of nearly 75 percent in the auto industry. Also, according to CAAM, car sales could drop 10 percent in the first half and by about 5 percent for the full year, given a rigorous recovery in the second half.

The auto industry has been a headline-grabber in recent days for several reasons. First, unlike in developed countries, the auto market in China remains a growth market despite disappointing sales in the past two years. Second, the auto sector in China has become a lynchpin for the global market from a supply chain perspective in recent years. For example, Hyundai has four plants that are closed due to disruption of the auto part supply chain. Third, precisely because auto is not a mature sector in China, the ability of the Chinese government to mitigate supply chain disruptions and attract additional investment will be sorely tested. Interestingly, on February 27, the European Union Chamber of Commerce in China called for fiscal support but also advocated more market access. It said that “balancing the need to contain any further spread of the virus with the need to get the economy back online is no easy task.” MNCs are likely to lobby harder to ease the foreign equity ceiling in certain industries as a part of a commitment embedded in the US-China “phase one” trade deal.

On the policy front, continued fiscal relief is likely this week. For example, the government will waive certain fees and taxes for travel agencies that have seen business losses this year. The People’s Bank of China (PBOC) has raised the quota of special loans to small and medium-sized enterprises (SMEs) by RMB500bn, in addition to the increase of RMB300bn in early February. It is certain that China will have a much higher fiscal deficit/GDP this year than previously. In theory and in practice, the central government has much leeway in undertaking a more potent expansionary fiscal policy. With global interest rates staying low (even in the absence of virus fears) this year, China could have a fiscal deficit/GDP ratio as high as 5 percent in 2020.

Small and medium-sized businesses in China

The lifeblood of the Chinese economy is SMEs. They employ 233 million workers and generate more than two-thirds of the revenue of all business enterprises in China. They account for about 60 percent of China’s GDP. Notably, they are being especially disrupted by the coronavirus. Many rely on migrant workers that have not yet been able to return to their work locations after visiting relatives during the Lunar New Year holiday. The result is that many SMEs are not generating sufficient cash to remain viable. A survey jointly conducted by Tsinghua University and Peking University estimates that 85 percent of SMEs will run out of cash within three months and two-thirds will run out of money in two months if the crisis does not abate. A spate of business failures could lead to a sharp increase in unemployment. Although the government has implemented interest rate cuts and fiscal stimulus, these measures will do little for businesses that are not generating revenue. It is possible that the government will provide direct subsidies to businesses that are at risk. But this would involve a sharp increase in government borrowing. Thus, unless the crisis abates soon, the economic consequences could become far more onerous.

Chinese manufacturing implodes

China’s National Bureau of Statistics reported that its purchasing manager’s index (PMI) for manufacturing fell sharply in February. The PMI is a forward-looking indicator meant to signal the direction of activity in the manufacturing sector. It is based on sub-indices such as output, new orders, export orders, employment, pricing, and inventories. A reading above 50 indicates growing activity; the higher the number, the faster the growth and vice versa. The latest report says that the PMI slipped from 50.0 in January to 35.7 in February, a record low. This is an even deeper decline in activity than the one that took place during the global financial crisis in 2008-09. At that time, the index fell to 38.8. In February, the sub-index for export orders fell to 28.7, indicating that trade nearly dried up and that global supply chains were disrupted to a degree unprecedented.

The virus hits Italy

A growth in the number of Coronavirus detections has prompted Italy to launch a “quarantine.” The word quarantine has its roots in the 17th century Italian dialect and means 40 days. In the 17th century, the so-called “black death” was threatening to overwhelm Europe. Consequently, ships delivering goods to Venice and other Italian ports were required to wait for 40 days before entering ports in order to stifle the pandemic. Thus, it is somewhat ironic that Italy has now launched a quarantine of 10 cities in order to stop the spread of the coronavirus.

The virus has suddenly accelerated in Italy which went from three cases two weeks ago to over 400 as of this writing, the most of any country other than China or South Korea. In response, officials closed schools in Milan, cancelled the Venice Carnival, cancelled most other public events, closed museums, and placed soldiers on the periphery of 10 towns southeast of Milan to prevent people from leaving.

One problem for Europe is that, because Italy is a member of the Schengen Agreement which allows free movement of people between most European countries, Italy and its neighbors have no permanent border controls. Thus, there is concern that the coronavirus could spread rapidly across Europe if it is not contained in Italy. Imposition of border controls would be hugely disruptive to the European economy. Switzerland and Austria have taken steps to limit rail travel from Italy. Meanwhile, authorities are so far unable to determine how and why the virus suddenly spread so quickly in Italy. Without this information, fighting the outbreak will be more difficult. The sudden spread of the virus far from China demonstrates the potential for global ramifications.

Italy had already faced economic headwinds before the coronavirus reared its ugly head. Real GDP fell in the fourth quarter and a decline in the first quarter of this year now seems likely. This would mean a fourth recession in a decade. The economy has benefitted from tourist traffic as well as exports of fashion goods. With much of the country shut down, these activities will be damaged. Even as bond yields fell in other countries, yields on Italian government bonds rose on fears about fiscal probity.

Global trade at risk

In 2020, global trade contracted due to the trade war between the United States and China. Overall trade volume was down 0.4 percent from 2020. This followed a period of steady and strong growth in global trade in the years since the financial crisis. However, by the end of 2020, it appears that trade was modestly rebounding. CPB World Trade Monitor, a report from the Netherlands Bureau of Economic Analysis, found that the volume of global trade was up 0.5 percent in December versus a year earlier. This was the first month in which trade volume had increased since May and the strongest growth since February of last year. Yet with the coronavirus already disrupting supply chains of global companies, it seems likely that the December figure will turn out to be a high point for global trade. Most analysts now expect a sharp decline in early 2020. Moreover, the extent to which trade declines will depend on how long it takes to resolve the coronavirus crisis. The sharp decline in asset prices this week suggests that investors are upwardly revising their expectations for the length and depth of the crisis.

Meanwhile, it was reported that about 50 percent of scheduled shipping lines between Europe and Asia have been cancelled. The problem is that trade drives much economic activity. When trade fell in 2020, it led to a drop in industrial production in multiple countries and a deceleration in business investment. These were the principal factors behind the slowdown in global economic growth. Now, with coronavirus threatening to undermine trade, another round of economic deceleration seems likely. Plus, the virus is also disrupting consumer spending and travel in East Asia.

Financial markets react to the virus

In the past two weeks, equity prices, bond yields, and oil prices have fallen sharply. US equity prices are down enough in the past week to wipe out all gains since October. The yield on the US government 10-year bond fell to a record low of 1.16 percent. Recall that, previously, the record low had been 1.32 percent and that, as recently as one year ago, the yield had been close to 2.8 percent. Also, the price of oil fell 5 percent today after having fallen sharply in the past week. Finally, risk spreads have increased, with the gap between yields on junk bonds and high-quality bonds rising. Investors are avoiding risky assets.

What is happening? Evidently investors are increasingly worried about the disruptive impact on the global economy stemming from the COVID-19 virus. This is despite the fact that the number of new cases in China each day has been declining. What worries investors is the possibility of a further outbreak around the world. The virus is now present in 46 countries and the World Health Organization (WHO) has boosted its risk assessment from “high” to “very high.”

Meanwhile, the decline in US bond yields partly reflects investor belief that the US Federal Reserve will cut interest rates this year. Indeed, one top Fed official said that a cut in rates is a possibility. Moreover, it is not clear that an easing of monetary policy will make any difference. That is because the expected weakening of the economy is not related to financial conditions. Rather, it is related to a disruption of supply as well as a weakening of external demand. Besides, if the virus becomes a problem in the United States, that would like lead to a drop in domestic demand. The US Centers for Disease Control and Prevention (CDC) says that it is likely that this will ultimately happen.

As for Europe, the intensification of the civil war in Syria has boosted the likelihood of a flood of refugees from the Middle East to Europe. There is concern that, given the surge in cases in Iran (now more than 500), and given the unsanitary conditions that refugees face, the risk that the virus could spread from the Middle East to Europe has likely increased.

Also, there is one point of view that now is a good time to purchase equities. The assumption is that, ultimately, the virus will be contained and that the economic damage will have been temporary. Absent the virus, the global economy will bounce back quickly. This implies that the correction in equity prices is temporary and will be reversed. Yet buying now would surely be bold. It would assume that the worst is over and that the rebound is imminent. The reality is that we don’t know. If the virus spreads in the United States or Europe, it might be more difficult for authorities in democratic nations to impose the kind of draconian restrictions on movement that have taken place in China. Absent such restrictions, it might be difficult to contain the virus. Moreover, if the virus spreads to poorer countries, containment might be difficult as well.

Meanwhile, one might ask if the world’s investors are overreacting to the COVID-19 virus? The European director for the World Health Organization (WHO) suggested as much. He said that “there is indeed no need for panic. Bear in mind that four out of five patients have mild symptoms and recover.” In addition, the director-general of the WHO said that “using the word pandemic carelessly has no tangible benefit, but it does have significant risk in terms of amplifying unnecessary and unjustified fear and stigma, and paralyzing systems. It may also signal that we can no longer contain the virus, which is not true. We are in a fight that can be won if we do the right things.” He went on to say that “for the moment, we are not witnessing sustained and intensive community transmission of this virus, and we are not witnessing large-scale severe disease or death. China has fewer than 80,000 cases in a population of 1.4bn people. In the rest of the world, there are 2,790 cases in a population of 6.3bn.” In contrast, economist Nouriel Roubini, widely known as Dr. Doom for his prescient writings in anticipation of the last global financial crisis, said that “investors are deluding themselves about how severe the coronavirus outbreak will be. Despite this week’s big sell-off in equity markets, the worst is yet to come.” He suggested that a recession is not unlikely.

In any event, regardless of whether or not health officials are able to suppress the virus, it is the reaction of individuals and businesses that creates an economic impact. Moreover, official efforts to stem the spread of the virus by restricting transportation of people have a negative economic impact. It is highly likely that the WHO officials are correct in saying that this can easily be resolved. The problem, then, is the temporary shock to the global economy.

Gross domestic product (GDP)

Gross domestic product (GDP) is the standard measure of the value added created through the production of goods and services in a country during a certain period. As such, it also measures the income earned from that production, or the total amount spent on final goods and services (less imports). While GDP is the single most important indicator to capture economic activity, it falls short of providing a suitable measure of people’s material well-being for which alternative indicators may be more appropriate. This indicator is based on nominal GDP (also called GDP at current prices or GDP in value) and is available in different measures: US dollars and US dollars per capita (current PPPs). All OECD countries compile their data according to the 2008 System of National Accounts (SNA). This indicator is less suited for comparisons over time, as developments are not only caused by real growth, but also by changes in prices and PPPs.

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Gross domestic product (GDP) Source: Aggregate National Accounts, SNA 2008 (or SNA 1993): Gross domestic product

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Definition of
Gross domestic product (GDP)

Gross domestic product (GDP) is the standard measure of the value added created through the production of goods and services in a country during a certain period. As such, it also measures the income earned from that production, or the total amount spent on final goods and services (less imports). While GDP is the single most important indicator to capture economic activity, it falls short of providing a suitable measure of people’s material well-being for which alternative indicators may be more appropriate. This indicator is based on nominal GDP (also called GDP at current prices or GDP in value) and is available in different measures: US dollars and US dollars per capita (current PPPs). All OECD countries compile their data according to the 2008 System of National Accounts (SNA). This indicator is less suited for comparisons over time, as developments are not only caused by real growth, but also by changes in prices and PPPs.

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