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Stress Testing under COVID? Follow the Money

Who had stress tested Shanghai, Paris or New York turning into ghost towns in 2020? Who modeled energy prices down 70% within a few days? Surely enough, all sectors of all developed countries grinding to a halt in a matter of weeks, were overlooked scenarios.

Remotely comparable situations involve the Great Recession of the 30’s, or more recently the Asian crisis of 1997-98. In those days, governments initially compounded the crisis with tighter fiscal or monetary policies, then eventually resorted to Keynesian economics, with the help of the IMF in the latter case. Ever since, every major tail event (every 10 years or so) is addressed with liquidity injections to net out the impact of the stall and of its aftershocks.

This time will be no exception and the 3 main economic powers, China, the Eurozone (EU19) and the US, have all vowed to a “whatever it takes” moment. The liquidity injection will be like the world has never seen. Solving the equation for “how much” and “how to spend it ” helps outlining what our future might look like.

This document will compare the stimuli packages brought forward by the 3 main economic powers and discuss the key risk indicators (KRIs) that can be monitored to assess their effectiveness and help revisiting the 2020-21 stress tests. 

How much is “Whatever it Takes”?

The table below compares the economic packages pledged by the 3 main economies, in US$, relatively to their 2019 GDP updated for the latest 2020 GDP estimations (probably still optimistic). The US and China expect their 2020 growth rates to be reduced to 1.14% and 6% respectively. The ECB anticipates a recession, though by a mild 0.1% at this stage.

The first observation is that the ECB and the US Congress have estimated that some 8% to 9% of 2020 GDP will be necessary to shore up their economies. Assuming a support of 30% of output, this reveals that the EU and the US expect the crisis to last some 3 to 4 months respectively. Based on the Chinese and Korean curves of COVID infection spread, this would assume a noticeable flattening rather sooner than later. If we were still in exponential growth within a month from now, those previsions could be mostly irrelevant and the corresponding packages would be insufficient.

In addition to the risks associated with the evolution of the virus and its total impact on the economy, the mechanisms by which governments can channel hundreds of billions of funds in a matter of weeks or months to whom need them most are a critical element to monitor. In other words, how do fiscal and monetary policies meet up? 

How to spend a trillion or two?

1-    The US

The Fed’s balance sheet knows no bound, at least in principle. From helicopter money to repurchases of commercial paper, government bonds and mortgage backed securities, it can move very fast to enable the government spending plans, target a particular sector or supply chain. What can shrink the wiggle room are near-zero interest rates and the yawning public deficit which was already expected to exceed US$ 1tn in 2020 before COVID stroke. Spending an additional $1.8tn (Republicans) to $2.5tn (Democrats) could send the budget deficit to 2009 levels (10% to 12%). 

While some of the 2009 injections were temporary, such as the TARP funds which were loans later repaid, 3 rounds of QE took place between November 2008 and October 2014, inflating the US monetary base from $800bn to $4.9tn throughout that period of time. If we compare the magnitude of both shocks, the forthcoming QE could be a multiple of the previous one, but it will now start up from a monetary base $3.45tn.

If it all works as expected and the pandemic is contained within 3 to 4 months, the recovery will build on historically low energy prices and interest rates.  Explosive consumer and factory demand will compensate for the slack and fiscal revenue will start reducing the deficit. The Fed though, whose assets had ballooned from US$1tn to $4.5tn between 2008 and 2015, will have to put the current FOMC balance sheet normalization program on ice and navigate unchartered seas. Prices will find a perfect storm of high demand, low cost, abundant to excessive liquidity.

2-    China

With centralized institutions and deep pockets China has both its fiscal and monetary policies in a single hand. As the country is hopefully getting through the toughest phases of the sanitary crisis, it can truly focus on its recovery. With a pledge of 2.65% of a GDP growing 6% in 2020, China obviously anticipates to mop up the damages and move on. 

One of the key unknowns is whether having half of the Western world at a standstill will boost or strain orders. This should be quickly reflected by the purchasing manager index (PMI) which plunged 30% in the last 2 months, to levels lower than in 2008.

As the stall also impacts other export driven Asian countries, and as we can expect the US to maintain tariffs to support most needed fiscal revenue, competitiveness could be an issue. The development of domestic demand is somehow limited by private debt levels and the inflation rate having already doubled to 5.3% from September 2019 to March 2020. Initially explained as a surge in pork price ahead of the Lunar New Year festival, the rate unexpectedly stayed at 8 year high in February. If it does not recede quickly, then it would be an indicator that the response to COVID is having an inflationary effect, definitely a KRI to monitor.

3-    EU19

The fate of the Eurozone is much more uncertain. Unlike the US and China who were going through a period of economic growth when COVID appeared, the EU19 has struggled with a lingering structural recession ever since GFC. The overall budget deficit of the EU19, a mere 0.5% of GDP, would suggest that there is plenty of room for easing, but that would be ignoring the public spending and indebtedness limits imposed by the Maastricht Treaty of 1993. 

The second issue is the effectiveness of QE in Europe. Despite spending US$ 3tn from 2015 to 2018, the ECB did not bring growth and inflation rates to the expected targets and had to resume QE in September 2019. As of March 2020, we can estimate that new stimulus has reached US$ 300bn, to which Mrs Lagarde’s adds a new pledge of Eur 750bn (US$ 820bn). Overall the package exceeds a trillion, but she will face the same problem than her predecessor: No matter how much money the ECB adds to the system, it needs someone to spend it; and as long as the EU19 sticks to the Maastricht rules, it’s hard to see how. 

Under the current system, the ECB provides QE via the banking network, not directly into the economy. This helped banks to lend to the economy (though discretionarily) but it pushed entire yield curves into negative territory, which in turn weakens the profitability of banks and is a risk to financial stability. Meanwhile budgets across the EU19 are solely managed by the members’ governments within the bounds of the treaty, a profound disconnect between fiscal and monetary policies.

The final question mark will be the financing of the 2021 EU28 budget, with the UK out of the union and Italy likely incapacitated.

One essential KRI is therefore not quantitative but observing political developments that would enable the EU governments to rapidly shore up their economies with ECB money. In a worst-case scenario, the failure to reach the capillaries of the economy with the new liquidity can result in the creation of alternative, local currencies.

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