Our Economics department keeps track of all the important developments in the financial markets in both advanced economies and emerging markets. We are publishing periodic briefings with analytical assessments of the current macroeconomic and financial market situation. Find out more about the EIB Group's response to the crisis
Part I. Recent economic developments
The real economy – Incoming monthly data (purchasing mangers’ indexes, EU business and consumer confidence indicators) and the EIB Economics Department’s coincidence indicators for May show some mild improvement month on month, but still point to a severe economic recession, with GDP levels below pre-COVID-19 levels.
The new European Central Bank (ECB) forecasts expect the euro area economy to contract by 8.7% in 2020 and expand by 5.2% in 2021 and 3.3%, in 2022, confirming a U-shaped recovery. Inflation is expected to slow substantially, falling to 0.3% this year before increasing to 0.8% in 2021 and 1.3% in 2022. The ECB also expects the unemployment rate to peak at 10.1% in 2021, and average general government debt for countries in the euro area to reach 101% in 2020.
Financial markets and access to credit – European stock markets strengthened in recent weeks. The stock prices of non-financial corporations have continued to rise from the lows of late March. Share prices have recovered about half of losses recorded since the beginning of the year. Conversely, banks’ stock prices have remained almost flat, 40% below December 2019 levels. Credit risk (measured in the spreads of credit default swaps) has continued to decline for banks, but remains higher before the COVID-19 pandemic. Turning to emerging markets, stock prices climbed to their highest level in almost three months at the beginning of June, curbing losses from since the beginning of the year to about 14%. In line with the higher risk appetite, the spreads on emerging market sovereign bonds also declined, while emerging market currencies strengthened.
Part II. Special topic: Corporate investment, debt and policy response
Corporate financing and corporate investment outlook – Our special feature below, “From liquidity shortfalls to increased indebtedness, a bleak outlook for EU corporate investment”, focuses the outlook for corporate finance and investment. Extending the analysis presented in a previous edition (15 April) of this bi-weekly series, we consider the impact of the prolongation of the crisis on EU corporate liquidity and medium-term strategies and estimate the impact of two different deconfinement scenarios, lasting three and six months, respectively. The crisis and the subsequent recovery process might lead to a cumulative reduction in net corporate revenues of €1.9 trillion and €3.4 trillion (13% to 24% of EU gross domestic product, or GDP). To compensate for this decline, firms will have to change their mid-term strategies, facing a hard trade-off between medium to long term business prospects (requiring more investment) or financial sustainability (implying lower leverage). They can either try to preserve investment, at the cost of higher leverage, potentially exposing themselves to solvency issues, or prevent substantial leverage increases, by substantially cutting investment.
In the less adverse scenario, EU corporate indebtedness rises by 4% to 6% of GDP, which would imply corporate investment shrinking by 52% and 31%, respectively. This drop in investment is more severe than during the financial crisis, when corporate investment fell by 19%. The drop in investment evokes some policy questions. In the first months of the crisis, access to liquidity was the main channel facing firms. In the medium term, however, support for the corporate sector with long term or equity instruments may help prevent excessive corporate leverage, while preserving investment and future business prospects.
Policy response – Public policy has an important role in tackling the corporate sector’s liquidity shortfall. The enhanced ECB measures as decided by the Governing Council on 4 June 2020 will further support funding conditions in the economy. When considering the specific dimension of corporate liquidity and funding, policymakers have acted swiftly, pledging support and stepping up measures such as wage subsidies, tax deferrals and loan payment delays that can alleviate the cash flow problems of both firms and households without increasing leverage. In addition, the provision of guarantee schemes (at the national and EU level) will allow the credit channel to continue to work. However, in the medium term, more structural issues of the EU financial ecosystem must be addressed. Equity instruments will be an essential part of the package, helping preserve firms’ investment, while avoiding excessive corporate leverage. As a matter of fact, equity-type of instruments represent an integral part of the EU recovery plan put forward in the Next Generation EU package (see Box). Public support to the corporate sector raises the risk of moral hazard. It is important that sufficient safety nets are put in place to prevent it. Finally, improving business environment to attract investment and support inclusive recovery should remain high on the policy agenda.
The authors of this note are: Simon Savsek, Joana Conde, Laurent Maurin, Rozalia Pal, Andrea Brasili, Matteo Ferrazzi, Aron Gereben, Emmanouil Davradakis, Koray Alper, Ricardo Santos, Sanne Zwart, Luca Gattini and Patricia Wruuck. Reviewed by Barbara Marchitto and Pedro de Lima. Responsible Director: Debora Revoltella.
1.1 The real economy
Various purchasing managers’ indexes (PMIs) generally point to an overall improvement of global economic conditions, but diminishing hopes for a quick recovery. The composite PMI for the euro area rose to 31.9 in May from a record low of 13.6 in April. The bulk of the improvement came from services, increasing from 12 to 30.5. The manufacturing PMI reached 39.4 in May, above April's all-time low of 33.4. Italy recorded the strongest rebound in manufacturing (with the index at 45.4 in May, up from 31.1 in April). In Spain manufacturing PMI rose from 30.8 in April to 38.8 in May. Despite these recent improvements, the composite PMI index remains at very low levels and well below 50, the dividing line between expansion and contraction, across the euro area but also in Japan, the United States, Australia and the United Kingdom (Figure 1). Notably, the composite PMI jumped across the 50 threshold on China, increasing from 47.6 in April to 54.5 in May. PMIs across emerging markets showed an improvement in manufacturing activities as well. May readings for Brazil, India and Russia all exceeded April levels, but remained below 50. While the improving indexes are in line with the gradual restart of business activities, they also illustrates the slow pace of the recovery. IHS Markit signalled that the index on “Backlogs of work”, a good indicator of capacity utilisation, continued to fall sharply in the euro area.
As discussed in Part I, corporate sector has been substantially hit by the pandemic. Our special feature below, “From liquidity shortfalls to increased indebtedness, a bleak outlook for EU corporate investment”, focuses on corporate financing and corporate investment outlook in the first part. The second part addresses the policy response.
2.1. Corporate financing and corporate investment outlook: From liquidity shortfalls to increased indebtedness, a bleak outlook for EU corporate investment
The swift and bold reaction of policymakers (see also the following section) has helped the EU corporate sector to face the immediate risks of liquidity shortfalls emerging from the lockdown. A combination of temporary measures, ranging from relaxes social insurance contributions, grace periods on various payments, debt moratoriums and guarantee schemes and facilities, have allowed to companies to temporarily reduce payments, while maintaining their access to credit. The measures were instrumental in avoiding the possible bankruptcies caused by a halt to commercial activities.
It is now widely accepted that the economic recovery will be slow and prolonged (U-shaped), amid high uncertainty. This section investigates the impact of the next phase of the crisis on the EU corporate sector. It extends the analysis presented in a previous issue of the Covid-19 bi-weekly (published online on 15 April 2020), assessing EU firms’ balance sheets and profitability and estimating the lockdown effects and policy interventions. The analysis goes on to assess the challenges firms will face in the medium-term as revenues remain weak. Months of inactivity followed by a slow return to normal will require European firms to make a trade-off between high debt and sharp cuts in planned investment. That dynamic will renew calls for alternative sources of finance for the corporate sector – sources that tilt more toward equity instruments.
We have developed various scenarios that take into account the reduction in corporate revenue resulting from the lockdown and the long recovery. In all, corporates net revenues could decline from €1.9 trillion and €3.4 trillion (13% to 24% of EU GDP). In our estimates, EU corporate investment shrinks from 31% to 52%, and corporate indebtedness rises from 4% to 6% of GDP. Firms will have to choose between higher leverage, potentially exposing themselves to solvency issues but allowing for some investment, or lower leverage and a more aggressive cut in investment.
Our analysis expects the impact on investment to be at least two times more than the 19% decline recorded during the financial crisis, commensurable with current macroeconomic forecasts that anticipate the impact on GDP to be much larger than during the financial crisis. The analysis begs the question of the most preferable policy intervention schemes overtime. In the first months of the crisis, extending access to liquidity and credit has been the main instrument for preventing liquidity shortfalls. In the medium term, however, growing indebtedness might drag investment down and create financial stability concerns. Going forward, support for the corporate sector will have to complement liquidity and credit instruments with more longer term equity instruments, which avoid excessive leverage.
The impact of the COVID crisis on the net saving capacity of non-financial corporations
We present four scenarios to illustrate the impact of the COVID-19 crisis of non-financial corporations to weather the pandemic. The scenarios combine views on the lockdown and the length of the recovery (see Tables 1A and 2A in Appendix).
- First, the impact of the lockdown. During the lockdown period, sales activity is assumed to decline by 70%. Input and production prices are less flexible, and, as a result, margins erode, potentially turning negative. Governments implement exceptional measures that, in the absence of data, potentially follow two different scenarios. In the policy support scenario, intermediary consumption, the value of goods and services consumed as inputs in the production process, is reduced by 60%. Temporary unemployment measures reduce salaries by 40% while moratoriums reduces rent and interest payment by 40%. In the heightened policy support scenario, intermediary consumption is reduced by 75%, temporary unemployment policies reduce salaries by 60% while moratoriums reduce rent by 60% and interest payments by 90%.
- Second, the length of the normalisation period. We assume that the lockdown lasted for three months, from mid-February to mid-May, with economic conditions normalising progressively afterwards. In that case, a return to normal economic conditions can be expected by the end of the third quarter or by the end of the year.
We use a comprehensive dataset of more than 1.4 million of non-financial corporations located in the European Union (EIB computations based on ORBIS). We use both balance sheet and profit and loss information. The sum of assets covered in the database amounts to around €8 trillion. For each company, we compute the cumulated change in net revenues until the end of the normalisation process in 2020 under the four scenarios, each considered separately for each corporation. The change in net revenues is computed as percentage of assets.
Across the four scenarios, the median reduction in net revenues would represent 5% to 10% of total assets (Figure 10). The least disruptive outcome is provided by stronger policy support with a three-month normalisation period. The most adverse outcome is the result of a less robust policy support with a six-month normalisation period. Comparing the four scenarios across the length of the normalisation period, a six-month normalisation process would naturally be more disruptive than a three month normalisation period, resulting in a further decline of 1.5% of total assets. Comparing the four scenarios across the intensity of the policy support, heightened policy support could limit the reduction by 3% of assets compared to normal policy support.
For 16% to 25% of EU companies, the reduction in net revenues would be equal to to more than half their capital base (Figure 11). With a three month normalisation period, in the less robust policy scenario, two-thirds of corporations would record declines in net revenues of more than 10% of their capital and 25% of firms would suffer declines of more than half of their equity. In the stronger policy scenario, the impact is mitigated. Two-thirds of companies would record declines in net revenues equal to more than 5% of their capital, while one-fourth would see declines worth 25% of their capital. Interestingly, only a very small portion – less than 5% of corporates – would suffer losses whipping out more than 95% of their entire capital.
Economic data show some signs of improvement, although many indexes remain negative. The sentiment confirms the idea that the EU economy will face an unprecedented contraction in 2020. The policy focus is shifting to measures that will put the recovery on a solid footing and address the long-standing challenges EU countries will face as a result of the pandemic.
EU public support will therefore remain crucial going forward. It will also need to take into account elevated debt levels, in the public or private sector. As public support to the private sector always raises the question of moral hazard, transparency and smart incentives will be crucial. Also, going beyond the immediate liquidity needs of the corporate sector, longer term, equity instruments should be considered to avoid excessive corporate leverage and preserve financial stability.