Europe: Moment Of Truth

Summary

• The sharp drop in euro area gross domestic product (GDP) in the first quarter and the likelihood of a much more dramatic plunge in the second quarter are consistent with our forecast that the euro area economy will contract by around 10% this year, with risks skewed towards a larger contraction.
• These risks stem in part from the potential second-round effects on the economy from high unemployment, corporate bankruptcies, damaged animal spirits, and behavioral changes.
• The fact that many business models are unlikely to go back to normal for a long time to come (or in some cases for good) speaks to the need for fiscal support to be not just aggressive, but also long-lasting and broader, encompassing for example more grants and capital injections into struggling sectors.

The sharp drop in euro area gross domestic product (GDP) in the first quarter and the likelihood of a much more dramatic plunge in the second quarter are consistent with our forecast that the euro area economy will contract by around 10% this year, with risks skewed towards a larger contraction. These risks stem in part from the potential second-round effects on the economy from high unemployment, corporate bankruptcies, damaged animal spirits, and behavioral changes.

Recent anecdotal evidence confirms that these risks are very much alive. One major airline announced that it may need to lay off around one-third of its staff, and reports suggest three-quarters of U.K. restaurant and bar operators risk going bankrupt. In Italy and Spain, tourism represents around 12% and 14% of respective GDP, according to the World Travel and Tourism Council, and it's hard to see these activities coming back anytime soon. Added to this, Danish authorities last week warned that the early relaxation of the lockdown in the country may be leading to a reacceleration of coronavirus infections.

The fact that many business models are unlikely to go back to normal for a long time to come (or in some cases for good) speaks to the need for fiscal support to be not just aggressive, but also long-lasting and broader, encompassing for example more grants and capital injections into struggling sectors. Central banks, meanwhile, need to coordinate with fiscal decisions by anchoring sovereign balance sheets.

To avert the risk that the crisis breaks the social fabric across countries, policymakers need to act decisively and in concert.

Europe: Extraordinary times demand extraordinary responses

Our analysis suggests that, in order to hit the economically effective figure of €1 trillion (or more) in the much-awaited EU Recovery Fund, most of the support to countries would need to be in the form of loans, rather than grants. Otherwise, the European Commission would likely not be able to issue that much debt in public markets without losing its AAA rating. Deploying larger grants would in theory only be possible if countries decided to upsize the EU budget by more than 1% of GDP, and for longer than two or three years, which is unlikely, in our view - the current Recovery Fund proposal faces enough hurdles already.

With grants likely amounting to no more than 0.5% of euro area GDP, the lion's share of the fiscal support would be in the form of loans to sovereigns. Such loans would be helpful at the margin if given with very long maturities, at very low rates, and with little or no conditionality. However, agreeing on these conditions could be a struggle, given recent comments by some Northern European officials.

As mentioned in previous blogs (see Anti-Crisis Euro Package: Not Good Enough and In Europe the Crisis Policy Response Is Substantial But More Is Likely Needed), the burden of the pandemic-related economic crisis will likely remain on national governments and the European Central Bank (ECB). In this regard, the ECB did not deliver much in its 30 April meeting, other than adding more generous terms to its Long-Term Refinancing (liquidity) Operations (LTROs) for banks. The central bank was keen to highlight that its €750bn Pandemic Emergency Purchase Program (PEPP) can be upsized and adjusted as needed to support the economy, but it refrained from giving a clearer unconditional commitment to contain sovereign spreads. The central bank's actions validate its message: ECB asset purchases have been front-loaded and skewed towards the periphery, but have not been enough to prevent spreads from remaining volatile.

Another warning sign: Italy's credit downgrade

This was the same week in which Fitch unexpectedly downgraded Italy's sovereign debt to Low-BBB (with a stable outlook), a decision taken outside the rating agency's regular review schedule. Fitch mentioned that Italy's projected debt ratio of 156% of GDP for 2020 is well above the "current BBB median of 36% of GDP."

We note that Fitch rates Japan at Mid-A, by comparison, when the country had a debt ratio of over 230% of GDP in 2019, and rising. This difference is likely explained by the Bank of Japan's unconditional monetary support of Japanese government bonds (JGBs), and the fact that the JGB market is mostly domestic. The presence of clear monetary anchors also explains why Fitch rates the U.S. and U.K. sovereigns at AAA and Low-AA respectively, despite debt at around 110% and 85% of GDP in 2019, and rising fast ahead. This is how much being able to finance one's debts counts - which is what still separates much of Europe.

A solid fiscal/monetary partnership is urgently needed. We think that policymakers in Europe will ultimately end up doing what's needed, but time is of the essence: the longer a convincing policy response takes, the greater the risk of economic and social damage, and the higher the risk of losing control. Europe faces a moment of truth.

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