COVID-19 economic update – May 7, 2020

EU economy - GDP decreased by 3.5% in the European Union (3.8% in the euro area) in the first quarter of 2020 compared to the previous quarter (q-o-q). At the country level, France's GDP dropped by 5.8% q-o-q, Spain's GDP by 5.2% and Italy's by 4.7%, These are the most significant quarterly falls since the GDP series collection began. Expectations for the second quarter remain gloomy. This is confirmed by the EIB economic department's coincident indicators, the flash purchasing managers' index (PMI) indicators and the European Commission's Business and Consumer sentiment indicators in Europe: these indicators all deteriorated in April, with a significant worsening of the expectation component for the next three months. More than 20 million European workers from Germany, France, Italy, Spain and the United Kingdom, about a fifth of all workers, are currently on temporary work schemes. All in all, a U-shape recovery seems a likely outcome.

Although rating activity was somewhat lower lately, Fitch downgraded Italy to BBB- on 28 April on account of the severe economic impact of COVID-19 on the economy and the associated worsening of the debt sustainability outlook. The market reaction was muted. S&P confirmed Italy's BBB rating on 24 April.As the crisis persists and the impact on public finances and economic performance continues to worsen, more downgrades, including for the European Union, can be expected during the coming weeks.

Euro area banks report higher demand for credit from enterprises and future easing of credit standards. This reflects higher liquidity appetite by corporates and the numerous policy measures introduced by governments and regulators to help alleviate credit standards. This situation is likely to persist in the second quarter, according to the April Bank Lending Surveyby the European Central Bank (ECB). That said, country heterogeneity is quite evident. We observe a dichotomy in funding conditions for corporates. While there are some early signs of gradual improvement of funding conditions for larger corporates, which can also benefit from the ECB's bond purchase program, smaller enterprises with no access to market finance still encounter major difficulties, in particular in certain sectors.

Emerging Markets - Turning to emerging markets, market sentiment remains weak, albeit with slight improvements compared to the past couple of weeks. Some early signs of stabilisation were mainly driven by the generally positive news about the evolution of the COVID-19 pandemic in major advanced economies, along with announcements of a gradual unwinding of containment measures and additional policy interventions. That said, emerging markets' vulnerability to the economic fallout of the pandemic and their capacity to respond remain a cause for concern, in particular with regard to debt sustainability.

Policy responses, focus on the European Union - Policymakers across the European Union have taken swift action to mitigate the impact of the pandemic. The focus has been on the short term, including measures to contain the spread of the virus, support medical care and maintain economic structures. On top of national measures, EU leaders agreed on a common response package amounting to a total of EUR 540 bn to fight the consequences of the pandemic, including a) a pandemic crisis support instrument managed by the European Stability Mechanism (ESM), b) support via the European instrument for temporary support to mitigate unemployment risks in an emergency (SURE), helping to boost member states' efforts to protect employment and c) a EUR25 bn guarantee fund at the EIB to support European companies, particularly SMEs, with up to EUR 200 bn. Moreover, the Commission was tasked to prepare plans for a recovery fund in the context of a revision of the multiannual financial framework. The discussion is still very open in terms of recovery strategies and policy priorities looking ahead.

The authors of this note are: Simon Savsek, Joana Conde, Andrea Brasili, Matteo Ferrazzi, Aron Gereben, Laurent Maurin, Ricardo Santos and Patricia Wruuck. Reviewed by Barbara Marchitto and Pedro de Lima. Responsible Director: Debora Revoltella.

The European economy is on its way toward a deep recession. GDP decreased by 3.5% in the European Union (3.8% in the euro area) in the first quarter of 2020 compared to the previous quarter (Figure 1). In annualised growth terms, the fall is -14.4%, three times as large as in the United States (-4.8%) reported on 30 April. At the country level, France's GDP dropped by 5.8% q-o-q, Spain’s GDP by 5.2% and Italy’s by -4.7%, all largest falls since the GDP series collection began. Our coincident indicators¹ (intended to summarise short-term dynamics) for April also shows a definite worsening at the beginning of the second quarter  for all the four countries (Figure 3). The decline is particularly steep for Italy, where the index in April is well below the (relative) minimum reached during the 2012 recession. Moreover, the two-month cumulative drop between February and April is as big as the drop between June and December 2008, the seven months that marked the beginning of the global financial crisis in the second half of 2008. For Germany, the monthly decline in April is second only to the ones recorded in November and December 2008. The dataset is still mainly populated by survey results (PMIs and European Commission surveys) even though some hard data has been included: car registration, retail sales and exports. Turning to the European Commission surveys, the Economic Sentiment Index (ESI) plunged in the Netherlands (−32.6), Spain (−26.0), Germany (−19.9), and France (−16.3), while no data was collected in Italy due to difficulties linked with the confinement measures. Industrial confidence fell dramatically (−19.2), but remained above the record low of March 2009, while for services the indicator dropped (-32.7) to its lowest level on record driven by record-breaking deteriorations in expected demand.

Sovereigns

The COVID-19 crisis is hitting sovereign creditworthiness across the world. As a result, the three main credit rating agencies downgraded numerous countries, and their activity is well above the 2019 average (Figure 6). On on 29 April, Fitch downgraded Italy to BBB- from BBB on account of the severe economic impact of COVID-19 on the economy and associated worsening of the debt sustainability outlook (the market reaction was, however, muted). On 24 April, S&P confirmed Italy's sovereign rating at BBB, arguing that although public debt is set to reach 153% of GDP by end-2020, the ECB provides an efficient backstop for the required additional borrowing. Although no other EU country was downgraded (the UK was downgraded to AA- with negative outlook by Fitch in March), nine had their outlook lowered in March and April by at least one of the agencies (Belgium, Bulgaria, Croatia, Cyprus, Greece, Latvia, Malta, Portugal and Romania). It is worth recalling that the ECB introduced measures to mitigate the effect of rating downgrades on collateral availability and eligibility for the asset purchase programmes, and thus ECB monetary policy transmission, to prevent potential pro-cyclical dynamics. More specifically, the ECB announced on 18 March that Greek government bonds would be included in the new public sector asset purchase program (PEPP), despite their lower rating. More recently, on 22 April, the ECB announced that it would ease the minimum rating requirements for collateral from BBB- to BB at least until September 2021².

Policymakers across the European Union have taken swift action to mitigate the impact of the pandemic. The focus has been on the short-term, including measures to contain the spread of the pandemic, support medical care and maintain economic structures. The discussion is still open in terms of recovery strategies and policy priorities looking ahead.

EU leaders agreed on a common response package amounting to a total of EUR 540 bn to fight the consequences of the pandemic. On 23 April the European Council endorsed a set of instruments to mitigate the pandemic shock. Three safety nets for sovereigns, workers and firms will be put in place. These operate through i) a pandemic crisis support instrument managed by the ESM, ii) support via SURE, helping to boost member states' efforts to protect employment and iii.) a EUR25 bn guarantee fund managed by EIB to support European companies, particularly SMEs, with up to EUR 200 bn. In the concluding statement by the President, Members of the European Council have called for the package to be operational by 1 June 2020. Additionally, the Commission is reportedly working on a recovery fund of sufficient magnitude to provide targeted sectoral and geographic support to the parts of Europe particularly affected. In the following section we take stock of the size and the areas of policy measures that EU countries have put forward, both at national and EU level. First, we discuss policies that addressed the acute – health and economic – emergencies; then we focus on what remains to be done to support the post-crisis recovery.

At the Governing Council meeting held on 30 April, the ECB announced new measures, re-calibrated some of the previous measures and re-iterated the commitment to increase the size of the PEPP and adjust its composition by as much as necessary and for as long as needed³. More specifically: (i) the conditions on the targeted longer-term refinancing operations (TLTRO III) have been further eased, (ii) a new series of non-targeted pandemic emergency longer-term refinancing operations (PELTROs) will be conducted to support liquidity conditions in the euro area financial system and contribute to preserving the smooth functioning of money markets by providing an effective liquidity backstop, (iii) operations under the new pandemic emergency purchase programme (PEPP), which has an overall envelope of EUR 750 billion, will continue to be conducted in a flexible manner over time, across asset classes and among jurisdictions at least by the end year, (iv) net purchases under the asset purchase programme (APP) will continue at a monthly pace of EUR 20 billion, together with the purchases under the additional EUR 120 billion temporary envelope until the end of the year, (iv) reinvestments of the principal payments from maturing securities purchased under the APP will continue in full according to the specified conditions, (v) the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will remain unchanged at 0.00%, 0.25% and -0.50% respectively.

Short-term priority: emergency response

With COVID-19 as a symmetric shock, member states – supported by EU-level instruments - have deployed rather similar policy mixes (but different sizes of intervention) to mitigate the short-term social and economic consequences of the pandemic. Member States have rapidly deployed targeted fiscal measures and liquidity schemes over the last weeks. Policy responses focus on common themes such as boosting capacities in the health sector, supporting companies through loans and guarantee programs and tax measures, maintaining employment and mitigating social hardship for citizens, as well as measures supporting the financial system. In the European Union, support packages vary in size and design but also in the current status of implementation⁴. European responses tend to rely more heavily on guarantee instruments than other major economies such as Japan or the United States.

Health and containment measures. Health measures to contain the spread of the virus, improve monitoring and support treatment form the first line of defence against the pandemic, and show the potential for complementarities between national and EU actions. Most member states diverted additional spending to healthcare over the last weeks to shore up resources, regardless of their respective healthcare system capacities and fiscal space. This includes increased spending on immediate measures to fight the pandemic, ramping up health supplies and purchasing equipment such as testing kits or ventilators, additional compensation for health workers, financial support for hospitals and funds to develop medicines and vaccines.

At the EU level, health measures are supported through the Coronavirus Response Investment Initiative, which allows rechanneling unused resources from the structural and cohesion funds to first-line defence, among other objectives. The EU Solidarity for Health Initiative was launched to support member states' healthcare systems with approximately EUR 6bn. Furthermore, the European Union supports member states' health and containment efforts through administrative measures and coordination. These include joint public procurement mechanisms for medical equipment, setting up coronavirus testing guidelines, establishing an EU "clearinghouse" for medical equipment, restrictions on exporting medical supplies outside the European Union, lifting customs duties on imports of crucial supplies, and coordination of cross-border healthcare cooperation, including the facilitation of the transfer of patients from one member state to another.

Measures targeting firms. All countries have put in place financial support to firms affected by the demand shock and measures to help preserve employment and incomes. Support to firms comprises both loan and guarantee schemes to address liquidity needs and tax measures, including tax deferrals or reduced tax rates for particularly hard-hit sectors. Almost all member states implemented public loan and guarantee support schemes focusing on working capital and the availability of the support for both SMEs and larger corporates. The vast majority of countries has also put in place support measures for self-employed. Some countries, such as France and Germany, also implemented programmes dedicated to start-ups and innovative companies. This is also one area where EU-level action has been applied to reinforce and broaden national efforts, such as the setting up of a EUR 25bn guarantee proposed by the EIB.

Besides loans and guarantees, a majority of member states also provides support in the form of grants to corporates, often with a focus on smaller firms and the self-employed. In addition, tax measures are used to ease corporates' liquidity  and support particularly hard-hit sectors such as tourism, through tax holidays, deferrals or reduced taxation rates. Other support measures include credit moratoria and automatic rollover existing working capital loans.

Support to employment and social policy. A crucial component of the enacted policy responses are measures aimed at supporting employment, notably through the use of short-term work schemes that help firms to adjust working hours while preserving jobs. Public income support permits employers to hold on to staff and restart production quickly once activities can resume. Short-term work (STW) schemes can be an effective way to mitigate the economic and social costs of a major economic crisis, notably if the drop in demand is expected to be temporary. First indications show that while STW schemes are being used extensively, their use has most likely not peaked yet. To that extent, the EU-supported program SURE acts as a second line of defence, helping member states to address the sudden increase in expenditure as a result of STW scheme use.

Maintaining employment can also mitigate the further deepening of inequalities as a result of the pandemic shock. However, it should be noted that while most member states operate STW schemes, institutional differences remain in the way costs are shared between governments, firms and workers and in conditions for participation. When it comes to specific social measures, most member states have taken actions to support vulnerable persons, including income support for quarantined workers who cannot work from home, and help to deal with unforeseen care needs or special income support for sick workers and families. In some member states, credit moratoria or payment deferrals of rent or energy bills are used to support households' liquidity needs. From an EU-wide perspective, there is considerable heterogeneity across the range of implemented social measures, reflecting the diversity of, existing social systems and social policy approaches. Altogether, the aim, choice of key support instruments – loans, guarantees, tax measures and STW – and measures taken, indicate a joint understanding of short-term needs to fight the pandemic, to support corporates and to maintain employment, with EU measures complementing member states' efforts.

Financial system and monetary policy. Financial and monetary measures substantially support the common response within the Eurozone, with policies in non-Eurozone member states broadly aligned. The functioning of the system of financial intermediation is critical during the crisis and for the subsequent recovery. First, the financial sector acts as an intermediary for many of the measures targeting corporates and individuals. Second, a spillover of the crisis into the banking system would amplify its negative impacts. Third, a functioning banking system is necessary to support the post-crisis recovery through financing investment needs.

Ensuring ample liquidity and capital in the banking system has been a priority since the beginning of the crisis. Since the previous crisis originated from the banking sector and policy measures have been taken in response, the EU banking system is now better prepared, both in terms of balance sheet health, and when it comes to safety nets. To ensure adequate liquidity in the banking system, the ECB introduced a range of new measures (see above).  

EU central banks outside the Eurozone implemented similar measures (targeted long-term refinancing, bond purchase programmes, easing of collateral regulations). In some countries, such as Poland, Czech Republic, Romania or Sweden, these measures were complemented with interest rate cuts. However, some Central and Eastern European countries have been already facing capital outflows, and their currencies weakened since the beginning of the outbreak⁵. In such circumstances, central bank liquidity injections and monetary policy easing can amplify the pressure on the exchange rate. Thus, if capital outflows strengthen, it may pose a dilemma for monetary policy in these countries and countries may have to navigate between the conflicting goals of liquidity provision and exchange rate stability.

On the capital side, measures by the Single Supervisory Mechanism and national supervisors have been adopted to preserve the strong capital position of the EU banking system and the flexible use of existing buffers. These include dividend and share buyback freezes, the relaxation of macro-prudential buffers, the flexible use of the various capital buffers. Furthermore, regulators have initiated actions to ensure that measures targeting the corporate sector do not put an unnecessary excess burden on banks.

The ECB has agreed to swap line arrangements with some EU central banks to provide euro liquidity and is assessing further requests for euro-providing swap lines. This is part of a coordinated action of major central banks (i.e. ECB, FED, Bank of Canada, the Bank of England, the Bank of Japan, and the Swiss National Bank) to enhance the provision of US dollar and euro liquidity. On 15 April, the ECB agreed to provide a EUR 2bn currency swap line to the Croatian central bank for additional liquidity, with maximum maturity for each drawdown of three months. A similar agreement was concluded with Bulgaria on 22 April. Earlier in March the ECB reactivated its pre-existing swap line with the Danish central bank, and increased the maximum amount to be borrowed by the Danish central bank from EUR 12 bn to EUR 24 bn. The swap lines will remain in place at least until end-2020 or as long as it is needed.

At this point, the implementation speed of policy responses is crucial. The implementation speed of the emergency measures is critical, not only to support health systems' still under strain, but also to address firms' urgent liquidity needs. While EU countries show similarities in the type of measures, the speed at which the measures have been announced and implemented show significant differences. Although it is difficult to make a complete assessment at this stage, the differences are evident. For instance, Bpifrance reported that by mid-April 150,000 enterprises had received pre-approval for emergency financing, for a total of EUR 22bn, while the Hungarian Development Bank announced the details of its guarantee and loan programmes only during the second half of April.  

Long-term agenda: supporting a robust recovery

Looking beyond measures to tackle the acute phase of the crisis, plans for the recovery are yet to be streamlined. The European Council tasked the Commission to establish a recovery fund of a sufficient magnitude, targeting the most affected sectors and geographical parts of Europe.

Policy priorities for a recovery agenda are difficult to pinpoint at this stage, but early preparation is vital. We believe the following elements are essential to support a rapid and robust rebound of the EU economies in the aftermath of the pandemic.

• Combine policy focus with the need for 'smart' and 'green'. Public investment can be a crucial element of a fiscal stimulus package, and one that can be implemented at the EU level. Both public investment and broader economic policy needs to keep the focus on the long-term structural challenges faced by the EU economies, such as sdigitalisation and climate change mitigation. Maintaining momentum for Europe's existing pre-pandemic long-term political and economic priorities will be paramount in the post-COVID-19 recovery. Notwithstanding the current emergency, these areas are the foundations of the long-term competitiveness and growth potential of the EU economies. The EU recovery plan must take that into account, and public spending should foster these objectives beneath general demand support. It is also important to highlight that the COVID-19 crisis further amplifies the social and labour market challenges and transformation needs associated with sdigitalisation and climate change; therefore, active policies mitigating the labour market and social impacts of the digital and climate transition must be reinforced and accelerated. Given its role in supporting innovation and transformation, and because of its substantial long-term benefits, education is also one of the areas with room for further support.
• Fixing the labour market. The shutdown of economic activity and its spillover effects are causing severe disruptions on the labour market. Even with mitigating policies in place, many jobs will be lost, and a disproportional impact of the pandemic shock stands to impact more vulnerable groups in the labour market. It is imperative to implement measures that speed up matching in the labour market in the aftermath of the crisis. Hiring (and training) subsidies for firms may provide a valuable incentive to absorb the unemployed back to the job market. Training programmes and other active labour market policies would help to address mismatches between labour demand and supply.
• Preventing deterioration of balance sheets now and repair them as a matter of priority later on. Most of the policy response now is aiming at injecting liquidity in the system, preventing major deteriorations in credit quality and keeping the credit flows going, by providing state guarantees for companies and banks. But past crises show that a protracted crisis will lead to increased bankruptcies and non-performing loans. Lessons from past crises have shown that the speed of recovery depends heavily on the speed of clearing balance sheets and debt overhangs, both for corporates and banks. Bank supervision and regulation will thus have to encourage the recognition and resolution of non-performing loans through strengthened insolvency frameworks and development of markets for distressed debt.
• Pre-define exit strategies, to take place in due time, to protect the single market. While targeted emergency measures are essential during the crisis phase, their timely and orderly phase-out is equally important. First, the scale-back can free up fiscal space for a broader stimulus. Second, explicit exit strategies can limit the moral hazard associated with some of these measures, such as low-cost blanket guarantees and payment moratoria. Third, measures that allow flexibility in providing state aid may provide incentives for governments to support national companies at the  expense of similar firms in other member states, which would bring distortions to the single market.
• Reacting to shifts in preferences. While supporting the recovery, public policy must take into account the impact of the crisis on social preferences. The pandemic and its consequences will leave their mark on habits, social norms, the world of work and production, and more. For instance, telework and videoconferencing are likely to be more widespread than before. Such shifts are difficult to predict, but they need to be accommodated when designing public policy.

Fiscal space will be even more constraining for the recovery phase. While fiscal sustainability issues became naturally less visible under the current circumstances, they will resurface forcibly during the recovery. Substantial differences in fiscal room and deficit accumulation among EU countries will matter when it comes to supporting the post-crisis recovery. Countries with a lower initial debt position will be able to provide ample support to kick-start their economies, while those who entered in the crisis with already high levels of public debt will have minimal options to support aggregate demand, and will be more likely to face a protracted recovery.

This calls for joint EU-level action in the form of a recovery fund. The rationale for joint action goes beyond solidarity. The high level of economic integration in goods and services markets, value chains, capital markets and labour flows all add to EU-wide welfare. Both negative and positive spillovers from individual member states are impacting on the European Union as a whole. Without a common mechanism, the recovery in the Union will take longer and will be uneven. An uneven recovery would contribute to further divergence across member states, weakening the various components of the single market. Also, it could aggravate imbalances in the fiscal-monetary policy mix. An uneven recovery would also slow down the long-term structural transformations (digitalisation, climate change mitigation) that are key to the long-term competitiveness of the EU economy. Furthermore, it would amplify the existing social inequalities. A lengthy and uneven recovery with insufficient EU-level support could erode the social and political support for the European Union impose some additional hardship on the European project.

3. For more details and exact wording  see https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.mp200430~1eaa128265.en.html

4. For further discussion, see for instance IMF Fiscal Monitor April 2020.

5. Since the beginning of the year, the Hungarian forint depreciated by 7.3%, the Czech koruna by 6.7%and the Polish zloty by 6.4% relative to the euro.