COVID-19: a Financial Crisis and an Economic Recession

Apr 20, 2020

By Xu Chenggang, Professor of Economics, Cheung Kong Graduate School of Business

The widespread effect of COVID-19 has resulted in a major halt to both the Chinese and global economy. Its impact has been immense, far exceeding any expectation.

At present, central banks need to ensure that there is adequate liquidity in the market. Should there be a sharp decline in the financial market, it will lead to a major downsizing and a rapid shrinkage of liquidity. Monetary policy alone is insufficient given the widespread nature of this crisis.

With the epidemic now taking hold of the global economy, focus should be placed on guarding against a financial crisis. Ensuring ample liquidity not only saves the stock market and stimulates the economy, it is a measure to avoid a financial crisis.

I proposed this as an abstract argument at the end of February, when there was no serious sign of a financial crisis. Since mid-March, the signs have become very clear: international financial markets have fallen sharply, unseen since the global financial crisis. Given this context, prevention of a financial crisis must be the top priority.

A Reduction in the Reserve Requirement Ratio will have limited direct benefits for SMEs

If the financial situation further magnifies, resulting in a financial crisis, the entire global economy will face tremendous consequences. Immediate preventive measures against a financial crisis can mitigate the impact of a financial downturn and benefit the economy, however, benefits of these monetary policies and financial measures for SMEs in China are very limited.

The reason is simple: China’s financial system is generally not geared towards benefitting SMEs. Therefore, if we aim to resolve the problems faced by SMEs, we must come up with solutions beyond monetary policies. The problems Chinese SMEs are facing cannot be resolved solely through money supply or by strengthening the financial system.

Focus on resolving fundamental issues

It would be a misconception to think that economic stability and growth are guaranteed primarily by implementing monetary policies, particularly in the current climate. The fundamentals have been greatly impacted and the source of the problem is not monetary or financial, but the fundamentals of the economy.

In the current scenario, a robust monetary policy is critical to preventing a financial crisis, but it is not enough to resolve the impact of the epidemic at its core.

Understanding the current situation

We need to understand what we are facing, as that is still the most crucial and basic issue.

The global epidemic originated in China, and has now spread to the rest of the world. In terms of epidemiology, the general public still has little knowledge about COVID-19. According to official data provided by the Chinese government, there are more than 80,000 cases of COVID-19 in China, but how many of them have been completely cured in the sense that they are not infectious? Has transmission of the disease been controlled? How many of them are missing in the data? These issues are global challenges and not just limited to China.

Over a month ago, epidemiologists around the world were predicting the current situation. For example, researchers at the Harvard School of Public Health, at the Imperial College London, developed models for the epidemic. In the Greater China region, the University of Hong Kong created predictive models of the global spread of this epidemic. According to these model-based predictions, COVID-19 had the potential to infect 70% to 80% of the global population by the end of the year. These predictions were made in February, and the models are continuously updated based on new information. According to the development of the pandemic, their predictions have so far been more accurate than most weather forecasts.

I want to point out that their models are based on the premise that we fail to control the spread of the epidemic. The World Health Organization (WHO) announced in early March that we had a very narrow window of opportunity for controlling the spread of the epidemic, but two weeks later, this window of opportunity has missed.

The current situation has changed dramatically, and these model-based predictions are gradually becoming a reality, at least partially, that people must face and accept. If the epidemic only spread in Wuhan alone (in one city or in some cities of Hubei), we could control it for some time, as the national medical system could support this area. However, if the epidemic breaks out throughout the country in multiple cities, the entire Chinese medical system would be overwhelmed and the outbreak results in a national calamity.

If the medical system is overwhelmed, the epidemic will be far beyond an infectious disease. It would trigger medical paralysis of the entire society and threaten the life and property of all citizens (including those not infected by the epidemic).

Impact on supply chains is related to demand

Demand-side problems were quite serious at the beginning of the epidemic. The entire hospitality industry was suspended with the initial outbreak, with the flow on economic impact directly hitting and affecting the hospitality industry, including air and railway transport. This impact is a lot more serious compared to that during the financial crisis.

During the financial crisis, people remained at home because they didn’t have enough money. Now, people are staying at home because of the epidemic. Due to the outbreak of COVID-19, most flights have been cancelled and border crossings closed. From an economic perspective, the first round of impact of the epidemic was felt by the entire hospitality industry and then on the supply chain. It started from the supply chain in China, now it has affected North Americans, the Europe, and perhaps most nations in the world.

Let’s take the aircraft manufacturing industry as an example. When airlines stop flights, they are bound to stop ordering aircrafts because there is no value in doing so. Lufthansa announced to permanently retire selected A380, A340 and B747 aircrafts. Hong Kong’s Cathay Pacific has now ceased almost all of its passenger flights, and is now focusing on cargo flights. Thus, Lufthansa and Cathay Pacific will not order new aircrafts in short run or even longer run. In turn, the aircraft manufacturers will suspend their production, thus aircraft parts suppliers will have to cut down their production. Similarly, the impact on one company’s supply chain will affect its upstream and downstream suppliers and vendors.

Impact of the epidemic may be mid-term, long-term, or even permanent

At the very beginning of the outbreak, some experts assumed that it would be similar to SARS back in 2003, which was a short-term epidemic.

Right now, we know for sure that this epidemic is not like SARS, this is an indisputable fact according to epidemiologists, doctors, and biologists. In mid-March the WHO has announced that COVID-19 is a global pandemic and has spread all over the world. All developed countries (like the UK, the US, France, and Germany) have declared a national emergency to deal with spread of the epidemic. So, there is no doubt that its impact is at least mid-term, possible to be long-term or even permanent.

We know that COVID-19 has had a very serious impact on global financial markets, and people have seen its all-round impact, and are working on solutions against subsequent impacts.

Of course, some aspects of the impacts are predictable. The impacts may last until a vaccine is successfully developed, put into mass production, and provided universally. One year may be the shortest timeframe for a vaccine to be successfully developed and put into mass production, and another half a year before the vaccine is able to be applied universally. Therefore, it will take one and a half years at the minimum to control the disease medically and scientifically.

Implement fiscal stimulus with caution

Under this situation, any government focuses solely on the economy without considering the epidemic, it would cause a catastrophe. With regard to fiscal stimulus, if a government has more than sufficient resources, where to spend the money should be less an issue, as long as individuals and SMEs are safe, the more the better. However, the resources of the Chinese government are in reality, severely limited.

Today, the fiscal resources of the Chinese government are far less than that in 2008. Back then, the Chinese government and the entire Chinese economy were very healthy in terms of debt. When sovereign and corporate debts are low, financial leverage may be comprehensively adopted and used to support the fiscal policy.

China is now one of the countries with the highest leverage level, e.g. measured by debt-GDP ratio. With an overly high leverage ratio, drastic over-spending will put China into the risk of a financial crisis. Thus, China should not repeat what it did, back in 2009.

Where should China allocate its limited resources in the face of the epidemic? What is the greatest difficulty the Chinese economy is facing? We must answer these questions carefully.

Due to the epidemic, SMEs will suffer the most. Bankruptcy of SMEs would cause an extremely high unemployment as most of the Chinese population is employed by SMEs. Therefore, it is crucial to ensure that SMEs survive.

Second, neither the financial nor usual fiscal policies directly benefit and alleviate SMEs. The government’s large-scale macro policies mainly benefit big enterprises, especially state-owned enterprises. So, any large-scale fiscal stimulus usually strengthens state-owned enterprises further, rather than assisting struggling SMEs. Nor will it help reduce large-scale unemployment.

The government must devise a meticulous plan, which will benefit SMEs. For example, the government can reduce SMEs’ costs, which can be viewed as a fiscal stimulus. In addition, it could also raise the income tax threshold to ease the burden on low and middle-income groups. Such a fiscal stimulus is easier to implement and is more targeted. By doing so, it can distribute wealth among low-income groups and SMEs immediately.

The government spending on infrastructure construction is not an effective means of a fiscal stimulus in dealing with the current crisis. Compared to just the government spending money, it is better if SMEs and the general population spent money to ensure their survival. By doing so, would help preventing the Chinese economy from potential bigger crisis or even collapsing.

The so-called ‘new infrastructure’ emphasizes importance on high-tech. The development of high-tech has its own regularities —it largely depends on the market. A strong fiscal stimulus will disrupt the market. Keeping this in mind, I believe that the market governs the development of high tech. The allocation of resources in the market is determined by the market, rather than by direct government efforts.

The development of high-tech depends on the development of SMEs. Here, we classify SMEs into two kinds: the first are labor-intensive SMEs in the service industry, and the second are high-tech SMEs.

High-tech SMEs also face the cost issue in their development. Therefore, efforts to reduce their costs (like tax exemptions and reductions, and fees exemptions) will help their development, which can be deemed as a more effective solution. The government should not design plans to just spend money. We saw this mistake and wastage occurring in the previous fiscal stimulus provided during the global financial crisis.

Back then, the Chinese economy was healthier compared to the current economy, so it could afford the wastage. However, if the economy itself is unhealthy and has a lot of structural issues, it becomes difficult to come up with massive amount of wastage, particularly when the epidemic is serious. If we talk about fiscal stimulus and infrastructure construction, we should remember that this epidemic is a lot more serious compared to earlier crisis’.

If governments at all levels focus on infrastructure construction, it will be very dangerous, because such a move will divert the general public’s attention and control of the epidemic. We must prioritize controlling the epidemic, and the governments should focus on this, and resume work only under the premise of ensuring safety.

Liquidity and human capital matters most for enterprises’ survival

Every enterprise should put the highest priority in finding a way to survive in this unprecedented challenge. Since the environment differs, every enterprise should adopt different means of survival.

However, we should know clearly that in the face of such a serious epidemic, enterprises must prioritize and focus on liquidity. Here, liquidity refers to cash and any asset that may be turned into cash quickly. This is the most fundamental factor for enterprise survival in such a crisis.

Just as important, is human capital. If an enterprise has to give up resources for its survival, it should ensure that it does so while protecting its human capital. If there is human capital, the enterprise will recover when things get better, if not, it will go bankrupt.

From the long-term development perspective, an enterprise must ensure liquidity for survival. In addition, it must make efforts to retain human capital because things will get better someday.

Solutions for a financial crisis differ from solutions for an economic recession

Globally, some experts have discussed openly the impact of the current epidemic on the global economy compared to the financial crisis during 2008-2009, such as the former Treasury Secretary of the United States, Lawrence H. Summers (President Emeritus at Harvard University) and Jason Furman, former Chair of the Council of Economic Advisors under President Barack Obama, who was directly responsible for the policies when the United States faced the global financial crisis.

Based on interviews, they believe that the impact of this epidemic on the global economy is far more serious than the global financial crisis during 2008-2009. On March 16th, many American economists and journalists pointed out that the economic recession triggered by the epidemic should be calculated from that day onwards.

How should we view this problem? As I said previously, believing that the problems of the epidemic now only exist overseas and that the epidemic is completely under control in China is a harmful mistake.

Comparing with the 2008 global financial crisis, this time, the financial crisis is attributed not to the inherent problems of financial institutions, but to the extraordinary impacts outside from the financial sector.

So far, the Federal Reserve has taken prompt actions, so has the Bank of England in the UK, and the ECB. The IMF and other international financial institutions are working to coordinate and unite all countries. Such measures will help avoid a financial crisis. But that is quite different from dealing with an economic recession.

The previous economic recession resulted from a financial crisis, but the current financial problems are triggered by the fundamentals rather than finance. Therefore, efforts to ensure financial stability does not mean they are solutions against an economic recession.

This time, a recession is due to the epidemic. With the outbreak of the epidemic, we must focus on people’s health and safety, to ensure their life and basic happiness. Due to the widespread outbreak of the epidemic and a lot more people get sick and die, lockdown is implemented in most developed economies and it is impossible for people to work. This is the main cause of the recession. The epidemic is the core factor and has the largest impact on the economy.

Currently, there is no treatment or preventive medical measure against this epidemic. The only preventive measure is quarantine, a medieval approach. However, quarantine measures are bound to have an impact on the economy. When can quarantine be completely lifted? This has to be waited until a vaccine has been successfully developed. As long as a vaccine is not developed, we should not abandon quarantine measures completely.

Given we cannot completely lift quarantine measures until a vaccine is successfully developed some experts believe that sort of quarantine measures may last for a year or one and a half years. The next question is what kind of an impact it will have? What will be the impact if the epidemic spreads and there is no measure against it? For core and important enterprises that depend highly on human capital, the loss of human capital will have a strong bearing on their bankruptcy. Therefore, we must focus on this fundamental issue whilst discussing the economic recession.

The ultimate purpose of financial policies or fiscal countermeasures is to guard against the immediate financial crisis and the subsequent economic recession. In case recession takes place, we need to take measures to take preventive measures to help future recovery from the recession. All of these preventive measures, including policies designed by the government and self-protection measures taken by enterprises for their survival, must be well thought out in advance.

This article was originally published by Professor Xu Chenggang on NetEase in Chinese.

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