COVID-19 economic update – June 10, 2020

After the steep drop in March and April, confidence indicators in the EU have showed some signs of improvement in May, albeit with considerable variations across sectors. The comprehensive Economic Sentiment Indicator, which represents a weighted average of consumers and business surveys across the European Union, increased 2.9 points to 66.7 (the long-term average is 100, while the February reading was 103). The expectation components of the indicator are typically recovering more promptly. For example, the Employment Expectation index improved faster, rising 11.3 points to 70.9. May surveys show a high degree of variation among economic sectors. Manufacturing confidence improved quite significantly (from -32.3 to -27.3), while retail trade and consumer confidence saw less improvement. Confidence indicators for services and construction are still declining. Wide differences among countries also persist.

The coincident indicators developed by the EIB’s economics department confirms a deep contraction for largest EU members (Figure 2). Electricity demand and survey indicators are slightly improving (with the exception of Italy, for which April figures were not released and May PMIs were not yet available). However, hard data on production and consumption for March and April are still extremely weak. The coincident indicator for Italy now stands at -3.65, close to the level at the peak of the financial crisis in April 2009 (the long-term average of the indicator is 0). The French indicator remains close to the 2009 levels as well, but has improved slightly. Previous declines in Spain and Germany were less steep. A clearer picture will be available when hard data is released for the on the first full month since the end of the lockdown.

Unemployment has started to rise in the European Union. In April, the EU seasonally-adjusted unemployment rate was 6.6%, up from 6.4% in March 2020. Eurostat estimates that about 14million people in the European Union were unemployed in April, an increase of 397 000 from March. Youth unemployment rose to 15.4%, a rise of 160,000 compared with March.

All in all, a strong contraction of economic activity is projected for 2020 in the latest euro area forecasts. The new release of ECB forecasts projects 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, although one in which GDP will take longer to return to pre-crisis levels. Growth projections have been significantly revised downward by 9.5 p.p. for 2020 and upward by 3.9 p.p. and 1.9 p.p for 2021 and 2022, respectively, compared to the ECB March forecast. Inflation is expected to slow substantially, reaching 0.3% this year before increasing to 0.8% and 1.3% in 2021 and 2022, reflecting to large extent energy prices. Core inflation (all prices excluding energy, food and changes in indirect taxes) is expected to reach 0.8% in 2020, 0.7% in 2021 and 0.9% in 2022. The ECB also expects the unemployment rate to peak at 10.1% in 2021, and average general government debt in the euro area to reach 101% in 2020. Due to the high uncertainty, the ECB also developed two alternative economic scenarios¹. In the mild scenario, the euro area would contract by 5.9% this year, before expanding 6.8% in 2021 and 2.2% in 2022. In that scenario, GDP would return to its pre-crisis trajectory by 2022. In a more negative scenario,  GDP would contract by -12.6%, before increasing 3.3% in 2021 and 3.8% in 2022.

1.2. Financial markets and access to credit

European stock markets, corporate financing and banks

European stock markets strengthened in recent weeks. Stock prices of non-financial corporations in the European Union have continued to slowly rise from their lows of late March. Since then, non-financial corporation stocks  have recovered about half of their price, bouncing back from the lows (about a 30% loss) recorded since the beginning of the year. Conversely, since late March, banks stock prices have remained almost flat, hovering around 40% below January 2020 levels.

Economic sectors have been affected unevenly by the crisis. Since the beginning of 2020, stock markets have priced in a large decline in certain sectors, namely industrial goods, travel and leisure, and automobiles, than for any other sectors. Conversely, pharmaceutical, retail, telecom and health care services have not only rebounded from the lows hit in late March but are also close to or above December 2019 levels (Figure 3). According to many analysts, given expectations for company earnings, equities valuation is very high, supported by ample liquidity provided by central banks.

Corporate bond yields remained unchanged over the month and moved within a narrow range of 15 basis points in May (Figure 4). After rapid gains during the first half of March, the yields of non-financial corporate bonds have declined since late April, declining from 160 basis points to 130 basis points for BBB-rated corporates and from 120 basis points to 80 basis points for A-rated corporates (Figure 9). Since peaking  late March, the price of risk has decreased despite credit downgrades of many companies². The net effect on firms’ funding costs is unclear.

The latest recorded data, from March and April 2020, show that corporate bank loans have picked up strongly, rising sharply to €189 billion in the euro area. Lending to non-financial corporations was 6.6% higher year-on-year in April, up from 5.5% in March (Figure 5). According to the latest euro area bank lending survey, the main factors underlying firms’ demand in the first quarter of 2020 were financing needs for inventories and working capital, while demand for loans for fixed investment declined in net terms. Given that the financing needs were mostly related to liquidity needs, the rise in corporate loans was noticeably stronger for short-term loans than for long-term loans.

So far, corporate debt issuance has not substantially deviated from historical norms. From the beginning of the year until the end of March, net issuance of long-term debt has followed a similar pattern to last year, while net issuance of short-term debt is slightly lower, but still within the bands of normal volatility (Figure 6).

Owing to the specific public policies implemented, companies maintained confidence and have continued to access external finance. However, early signs point to a sharp rise in indebtedness. Despite waves of downgrades, the capacity to issue debt has enabled larger companies to cover their higher liquidity needs. Credit has flowed to the corporate sector and a liquidity crunch has mostly been avoided. Corporate debt, however, continues to rise. With the removal of restrictions, the slow economic recovery is likely to be accompanied by a rise in indebtedness. In the special feature (Part II), we analyse corporate financing and corporate investment outlook in greater detail.

The credit risk of European financial institutions continues to decrease, but remains higher than before the COVID-19 pandemic. Credit risk as measured by financial market indicators such as the Itraxx indexes (a measure of credit risk represented by an average of credit default swap spreads for senior and subordinated debt of major European banks) continues to decrease (Figure 7). Both the senior and subordinated debt indexes have been declined substantially since mid-March, but remain at higher levels than before the COVID-19 pandemic (42 basis points for senior debt and 110 basis points for subordinated debt as of 2 June). This positive evolution shows that proactive intervention by both central banks and governments was able to stem the immediate risk of financial turmoil. However, spreads remain above their pre-COVID-19 levels, signalling that markets are still pricing higher risks, possibly anticipating a weakening in the quality of bank assets.

Emerging markets 

Emerging market stocks also climbed to their highest level in almost three months. Losses for emerging market stocks now stand at about 14% year-to-date, as investors focused on improving economic data after the end of lockdown measures across much of the globe. The spreads between emerging market (dollar denominated) government debt and US Treasuries dropped to 180 basis points at the beginning of June, down from 279 basis points a month earlier. The improvement in emerging market asset performance is also reflected in foreign exchange markets. The depreciation of a basket of emerging market currencies (which is a weighted average of major emerging market currencies vs. the dollar) eased to 10.7% year-to-date from 13.7% a month earlier. Finally, the price of Brent crude oil increased to almost $40 per barrel from $26 per barrel a month earlier.

Emerging market sovereign ratings are still under pressure. Moody's downgraded India on 1 June to the lowest investment grade level and surprised economists by keeping it on a negative watch. Specifically, Moody’s cut the India's foreign currency and local currency long-term issuer ratings to Baa3 from Baa2 and retained a negative outlook. Argentina announced a new debt offering, envisaging a two year moratorium on interest payments and a delay in principal repayment for five years. Argentina’s exchange bondholder group said it was confident that its joint debt proposal with the Ad Hoc Argentine bondholder group provided a sound basis for a collaborative solution to the debt talks.

High levels of emerging market debt could amplify the adverse impact of the COVID-19 pandemic. Total outstanding debt in emerging markets has increased by $43 trillion in the last decade to $71 trillion at end-2019 (Figure 8). The increase was largely attributed to non-financial corporate debt, which has been rising steadily over the past decade. Non-financial corporate debt has increased by $18 trillion to $30 trillion before the COVID-19 outbreak. During the same period, financial sector debt (defined as the sum of outstanding bonds and cross-border loans) has increased by around $6.4 trillion to $11 trillion. By comparison, emerging market nations increased their indebtedness by $9.5 trillion to $16.7 trillion in the same period.

While the bulk of the rise in emerging market corporate debt has been in local currency, foreign exchange denominated debt has nearly doubled to some $7 trillion since 2009. The emerging market corporate sector is confronted with significant debt redemptions over the next three years, which could potentially amplify the slowdown to economic activity caused by the COVID-19 pandemic. The combined debt redemptions for non-financial and financial corporations once bonds and loans in all currencies are included surpasses that of sovereigns (Figure 9).

1. See Box 3 of the Eurosystem staff macroeconomic projections for the euro area, June 2020, for more details on scenarios.

2. In late May, more than 70% of firms´ debt was rated below investment grade.

Firm size differ greatly across the corporate sector, varying the impact (Figure 12). Small and medium-sized enterprises (SMEs) – or companies with less than 250 employees – would suffer a reduction in net revenues of 6% and 11% of assets. Larger corporates, of more than 250 employees, would be significantly less impacted, with the reduction representing 2% to 4% of assets.

Given that larger corporates account for a larger share of the EU economy, weighting the estimates by size would reduce the overall decline in net revenues to 4% to 8% of total assets. Since non-consolidated total assets in the European Union amounts to €42.5 trillion, the decline represents a loss of €1.9 trillion and €3.4 trillion, or 13 to 24% of EU GDP¹.

Larger debt stock and bleaker investment outlook

We have applied a simplified accounting to illustrate the impact of lower revenues on companies’ balance sheets². The simplified approach assumes that all earnings are retained. Net revenues finance the accumulation of cash and liquid assets, of real investment and of debt reduction. Lower net revenues therefore result in a reduced cash balance, and/or increased indebtedness and/or lower investment.

Historical suggest that cash buffers can absorb a small part of the revenue reduction, as EU corporates entered the crisis with sizeable cash positions. During the lockdown period, these positions decreased. Post crisis, it is unlikely firms will fully restore their cash positions. We estimate that during the Lehman and sovereign debt crises, cash positions were reduced by 2% of GDP (Figure 13). According to current forecasts, during the pandemic, output will be reduced by more than during the financial crises, up to twice as much. Moreover, the given the current very low interest rate environment, return on cash and liquid assets is almost zero. Hence, we assume that following the current crisis, cash positions will absorb losses equal to 3% of GDP.

In the three-month normalisation scenario, EU corporate investment shrinks by 31% to 52%, while corporate indebtedness rises by 4% to 6% of GDP (Figure 14). According to the EIB Investment Survey, two-thirds of EU corporate investment is financed internally. After drawing on cash positions, two-thirds of the losses in net revenues (about 13% of GDP) would be absorbed by lower investment or 52% in corporate investment. Debt would also contribute to fill up the gap, rising by 4% of GDP. Alternatively, corporations could increase their access to external finance. Assuming that the whole sample of firms tap external finance, even those that would not do so in normal times, the share of external financing would rise from about 30% to 60%³. Investment would then decline by 31% compared to 2019 levels, or 4% of GDP, but indebtedness would increase by 6% of GDP.

Conclusions    

We may have reached the peak of the COVID-19 crisis, but the return to normal economic conditions will be slow. The crisis will have a major and long-lasting impact on corporate balance sheets. Despite the various policy measures implemented to support companies, revenues will be lower. These lower revenues will likely hamper investment and increase indebtedness, forcing companies into a trade-off between leverage and investment. The  analysis estimates a greater investment impact than during the financial crisis, possibly up to two times more. To compare, corporate investment fell 19% during the financial crisis (Figure 15). GDP is also expected to be hit.

The simulations may indicate optimal times to phase out policy intervention during the crisis. In an immediate response, policymakers have implemented various initiatives, such as payment deferrals, repayment delays and guarantees to ease access to credit and preserve firms’ liquidity. These policies are by nature limited in time. Overall, the bleak outlook for EU corporates suggests the need for new policy tools to support corporate solvency through longer term equity instruments, thereby avoiding a protracted period of weak economic growth.

2.2 Policies supporting the corporate recovery

Public policy has an important role to play in tackling a liquidity crunch. Distressed firms are likely to cut investment, reduce their business activity and lay off their employees. Lenders with underperforming loans are also likely to halt further lending. By supporting the cash flows and revenues of troubled firms, governments can limit the effect of the crisis, helping firms to continue to pay employees, suppliers and creditors. Liquidity is also important to keep firms afloat.

Overview of measures by Member States and the European Union

Central banks have played an important role in aiding liquidity and funding conditions. In this respect, the ECB has expanded its pandemic targeted asset purchase programme (PEPP) June 4⁴.The envelope for the PEPP will be increased by €600 billion to reach a total of €1.35 trillion in support for the euro area economy.  The purchases will continue to be conducted in a flexible manner. The horizon for net purchases will be extended to at least the end of June 2021, and the maturing principal payments from securities purchased under the PEPP will be reinvested until at least the end of 2022. Net purchases under the Asset Purchase Programme will continue at a monthly pace of €20 billion as well as reinvestments of the principal payments from maturing securities. Moreover, the ECB indicated that interest rates will remain at their present or lower levels until the inflation outlook converges to a level sufficiently close to 2%.

Other large-scale measures supporting access to external finance have also been crucial. Policymakers have acted swiftly, pledging support and stepping up measures to support companies as developments unfolded. Policy responses by national governments, including fiscal stimulus and liquidity support measures, are estimated to be worth about 20% of EU GDP. However, the various national schemes differ significantly in size and design, with the risk of creating an uneven playing field across EU members. At the same time, boosting access to (emergency) loans has clearly been one of the most popular responses to the crisis. National measures supporting corporate lending are complemented by EU-level instruments, such as the Pan-European Guarantee Fund.

While accumulating debt may be necessary in the short term, companies will have a hard time sustaining high levels of indebtedness. As discussed in the previous section, a large number of European firms are likely to reach excessive levels of debt as the COVID-19 crisis unfolds. The consequence is that a large share of EU firms will enter the recovery period with pressure to reduce debt. That pressure is likely to weigh on companies’ investment plans.

Wage subsidies, tax deferrals and loan payment deferrals can alleviate the cash flow problems, but their impact is limited. All Member States have implemented some form of tax holiday as part of their policy response measures. Similarly, a large majority of nations have implemented some form of wage subsidies, such as short-term work schemes to maintain employment and support corporate liquidity (Table 1). However, these programmes are limited in scope and scale, and they do not necessarily specifically target those firms that are most in need.

In many cases, grants can also play a role in aiding companies with excessive leverage. Business grants are part of the policy response in about two-thirds of Member States. As part of the overall stimulus package, the grant component is relatively strong in Germany and Austria⁵. In Germany for example, the government support included grants to small business owners and self-employed people severely affected by the crisis, with additional support possible from the federal level and a protective shield put in place for start-ups. In Austria, the €15 billion “Corona assistance fund” for support to sectors particularly affected (notably with huge decline in revenue during lockdown) includes a grant and guarantee component.

Publicly funded equity instruments can also complement loans and guarantees, alleviating leverage constraints. Equity instruments could absorb losses and also share eventual future profits. However, reaching out to firms, especially to SMEs, with equity instruments is difficult, as owners are often reluctant to bring on outside owners, especially if they have  voting rights. To overcome this problem, various solutions have been proposed. For instance, a creative academic proposal suggests cash could be offered to firms in exchange for a temporary increase in the tax rate of company profits after the crisis⁶. Another difficulty in reaching small companies is their lack of familiarity with some equity  instruments, which reflects the less-developed capital markets in many parts of the European Union. Only some Member States put dedicated equity instruments into operation as a response to the previous financial and sovereign debt crisis⁷.

Equity instruments are an integral part of the EU recovery plan put forward as part of the Next Generation EU package. While equity instruments have been implemented as part of the national crisis management programmes, these instruments often target large firms with strategic importance (such as airlines) or start-ups/scale ups through public venture capital schemes. The new Solvency Support Instrument (SSI) proposed as part of the European Commission’s Next Generation EU package aims to fill this gap. It will help match the recapitalisation needs of otherwise healthy companies across Europe. The instrument proposed would work in conjunction with a EU guarantee of €26 billion provided under the European Fund for Strategic Investments (EFSI). The guarantee will be used to provide financing directly or invest fund or guarantee equity funds, special purpose vehicles, investment platforms or national promotional banks, with the aim of mobilising € 300 billion for the real economy.

2.2 Discussion and pitfalls

Public support to the corporate sector inevitably raises the question of moral hazard. While this time the crisis was not triggered by excessive risk-taking by banks or firms, moral hazard exists even in the current situation. Governments have acted at an unprecedented scale, and the measures pledged and provided  will shape expectations for future crises. To limit moral hazard, measures need to be designed carefully. Support measures that restrict direct benefits for existing creditors, such as limiting dividend payments, giving taxpayers’ funds higher status in the credit hierarchy in case of restructuring, can protect against moral hazard issues. Temporary measures and built-in sunset clauses can help to avoid permanent market distortions. In addition, increasingly targeting support and devising measures with “smart conditionality,” such linking support to steps that improve firms’ longer-term resilience, such as the adoption of new business processes or digitalization, can be a way to preserve activity but also strengthen firms going forward.    

To avoid misallocation of resources in the economy, efficient insolvency procedures are key. Where insolvency regimes do not inhibit corporate restructuring, improvements in bank health tend to be associated with relatively fewer zombie firms⁸. Simplification and speedy court procedures matter. The time to resolve insolvencies varies significantly across EU countries, but overall the process takes longer in the European Union than, for example, in the United States or United Kingdom. (see Figure 16).

Policy support measures need to go beyond existing businesses and preserving employment and incorporate and look forward. To that extent, micro measures, such as targeted support for some firms such as start-ups or “smart conditionality” measures and improvements of the macro and business environment need to limit the ‘status quo bias’, zombification, and misallocation of resources in European economies. Some policy support measures put forward by Member States have included stronger “forward-looking components,” supporting transformation processes at the firm level, for example through digitalization or retraining possibilities, or on a larger scale, by supporting green renovations of public housing or climate-change related investment projects. These initiatives will be important to boosting the recovery  (Table 2). At the EU level, structural transformation is at the core of the Next Generation EU plan (Box 1), which integrates climate change mitigation and digitalization into recovery support.

1. According to Eurostat, EU GDP amounted to 13.9 EUR tn in 2019.

2. ∆Net revenues = ∆Cash – ∆Debt – ∆Inv. Where Inv stands for investment.

3. According to the EIBIS, around one-half of corporates access external ressources to finance their investment. When they do so, their funding mix consists of 60% of external finance and 40% internal finance (median values).

4. See also the ECB Monetary Policy Decisions, June 4 2020.

5. Based on IHS Markit information.

6. See Arnoud Boot, Elena Carletti, Hans‐Helmut Kotz, Jan Pieter Krahnen, Loriana Pelizzon, Marti Subrahmanyam: Coronavirus and financial stability 3.0: Try equity – risk sharing for companies, large and small, VoxEU, 3 April 2020 and Arnoud Boot, Elena Carletti, Hans‐Helmut Kotz, Jan Pieter Krahnen, Loriana Pelizzon, Marti Subrahmanyam: Corona and Financial Stability 4.0: Implementing a European Pandemic Equity Fund, VoxEU, 25 April 2020.

7. Examples include altum in Latvia or BPI via its investment arm. See Wruuck (2015): Promoting investment and growth: the role of development banks in Europe. EU Monitor Deutsche Bank Research.

8. Adalet McGowan, M and D Andrews (2018), "Design of insolvency regimes across countries", OECD Economics Department working paper 1504.