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The Eurozone economy comes crashing down due to COVID-19

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  • COVID-19 pushed the Eurozone economy into contraction in Q1, for the first time in 7 years
  • In Q1 the Eurozone economy shrunk by 3.8% q-o-q and by 3.3% y-o-y
  • Q2 will likely show a much sharper contraction on the back of national lockdowns
  • If lockdowns are lifted in early June, we expect a gradual recovery from Q3
  • Nonetheless prospects for some sectors will remain very poor
  • We forecast GDP to contract by 5.2% this year and to grow by 4.3% in 2021
  • Forecasts are clouded in a great deal of uncertainty

Eurozone

In Q1 COVID-19 pushed the Eurozone economy into contraction for the first time in seven years. The Eurozone economy contracted by 3.8% in Q1 2020 compared to Q4 2019 and by 3.3% compared to Q1 last year (figure 1). France has been the weakest performer among large member states (figure 2), though also Spain and Italy have underperformed the Eurozone average. It seems counter intuitive that France has performed much worse than Italy. We still lack the data to explain this, but a different sign for the contribution of net exports and data collection difficulties in Italy are potential candidates. Looking forward, activity will be much weaker in Q2.

Figure 1: Largest contraction on record
Figure 1: Largest contraction on recordSource: Eurostat
Figure 2: France was the worst performer among large member states
Figure 2: France was the worst performer among large member statesNote: Germany’s growth figure is estimated based on the growth figures of the Eurozone, France, Italy and Spain
Source: National statistics offices, Eurostat, RaboResearch

For most of Q1, economic damage was mainly related to China’s weakness (see exposure to China). The Chinese economy contracted sharply, harming import demand and consequently exports from Europe, especially from Germany. Furthermore, many countries faced supply chain disruptions and a lack of Chinese intermediate goods. Again, in this respect the German economy was most exposed, but Spain and France are relatively dependent on Chinese imports as well.

Strict virus containment measures were only introduced in Eurozone member states over the course of March, i.e. at the very end of Q1. Given the expectation that they will not be lifted before 1st June, domestic containment measures will have a much larger impact on economic activity in the second quarter than in the first. In addition, foreign demand is expected to be very weak on the back of global containment measures and a sharp global downturn. As such, the economy is likely to contract sharply in Q2 (Figure 3 and 4).

Figure 3: PMIs are at a historic low (April)
Figure 3: PMIs are at a historic low (April)Source: Markit
Figure 4: 18% of the economy to contract with more than 50% in Q2
Figure 4: 18% of the economy to contract with more than 50% in Q2Source: RaboResearch estimation

We expect that about 18% of the Eurozone economy will have to absorb a temporary shock to activity of 50% or more (Figure 3). This includes entertainment and restaurant services that are prohibited, but also car production due to supply chain issues and weak demand. Domestic trade will likely be just over 50% lower, due to retail stores being closed for much of the quarter. We estimate that another 60% of economic activity, including construction and manufacturing, will also take a substantial hit, but it will be lower than 50%. Even though most countries are still keeping their factories open, manufacturing production is suffering from supply chain disruptions, social distancing regulations and weak demand. That leaves 22% of the economy pretty much unscathed or growing at a higher rate, e.g. the health sector and supermarkets.

If containment measures are lifted by 1st June, we expect a recovery from Q3. Nonetheless, some sectors, specifically the hospitality and events sector, are expected to continue to perform very poorly. Until a vaccine is found, social distancing will still be with us even if restaurants and stores reopen. Moreover, income losses incurred and ongoing uncertainty are likely to put a lid on pent-up demand for the rest of the year. Yet that impact will differ substantially between member states (see below). All in all, we project the Eurozone economy to contract by 5.2% this year and to grow by 4.3% next year, based on the assumption that lockdown measures will be largely lifted in the course of the current quarter. We forecast unemployment to average 9% this year, from 7.5% last year, and inflation to average 0.5%. Some member states are likely to experience deflation for several months. Furthermore, public finances are set to worsen tremendously, jeopardizing future debt sustainability, the recovery, and medium-term economic growth, especially in southern Eurozone countries.

Our current projections suggest that by the end of 2021, GDP will have largely recovered from the losses incurred in the first half of this year. Yet estimates are clouded in a great deal of uncertainty, related to when lockdown measures will be lifted and to the speed of recovery. Currently we are assuming no recurrence of lockdown measures, a fairly swift return to normal from Q3 and no major long-lasting destruction of employment and solvent firms, thanks to supportive monetary and fiscal policy. But clearly these assumptions come with large downside risks and it is increasingly likely that society will need to adapt to a ‘new normal’.

Based on Q1 figures and new insights, it seems inevitable we will have to downgrade our forecast. In an upcoming pieces we take a more profound look at the scope for recovery.

Germany

Before COVID-19 arrived in Europe, the Germany economy was stagnating. COVID-19 deals another blow, pushing Germany into recession. We now project a GDP contraction of 4.6% for 2020 but given the recent figures in other Eurozone countries, it is inevitable that we will have to revise our forecast downwards.

Vulnerable sectors

Figure 5: Aggregate vulnerability of sectors
Figure 5: Aggregate vulnerability of sectorsSource: RaboResearch

Not all sectors are equally vulnerable to the crisis. We estimate that in roughly 21% of the economy activity will remain more or less the same. This holds for sectors like healthcare the financial sector. For roughly 60% of the economy activity will be reduced by 0% to 50%. For these category, think of sectors such as education, consultancy and some parts of manufacturing. For the last category, for a total of 19%, activity will plummet by more than 50%. Sectors such as the hospitality sector, air transport and the cultural sector fall into this category.

Shock absorption

Households and corporates hold relatively more savings now than they did before the GFC (figure 6), thus increasing the shock absorbing capacity. Interest payments have decreased steadily over the years (figure 7) due to low debt levels and subsequent low interest obligations. Companies will thus be able to sustain longer periods of lower revenues since their fixed costs are lower (keeping other costs fixed). All together, we could state that in general, companies and households are better equipped to weather the storm than they were prior to the GFC.

Figure 6: Currency and deposits % GDP
Figure 6: Currency and deposits % GDPSource: Eurostat
Figure 7: Interest as percent of income
Figure 7: Interest as percent of incomeSource: Eurostat

Government finances

Berlin has let go of its strict budget rules. The government has announced a number of measures to combat the crisis. The package of EUR 650bn that has been announced contains EUR 600bn of state-guaranteed loans and liquidity injections for large businesses. The remainder, EUR 50bn, will be used to support ailing SMEs. Additionally, KfW can provide liquidity for around EUR500bn.

The work reduction scheme enables employers to temporarily reduce the working hours of their employees and intends to prevent massive layoffs. The government promises these workers 60% to 67% of their pay for those reduced working hours. In the past two and a half weeks almost 500.000 companies have applied for the scheme. In 2019 only 1300 companies applied on a monthly basis. First estimates suggest that this will cost around EUR 50bn (1.5% of GDP).

France

The French economy still outpaced several other European economies (although that is not to say that things were great to begin with). But since COVID-19 things turned sour quickly. The preliminary GDP figures for Q1 state that the economy contracted by 5.8%. In our latest forecasting round we predicted a contraction of 4.6% for 2020 as a whole. Given the recent figures it is inevitable that we will have to downgrade our forecast.

Vulnerable sectors

We estimate that 24 percent of the economy will be able to more or less keep up its day-to-day operations. These sectors are either vital to the economy and thus excluded from the lockdown or can adapt to the social distancing guidelines. Another 54 percent of the economy will be hampered by the lockdown resulting in 0% to 50% less activity. Sectors like the retail sector and industry are (partially) closed. The remaining 22 percent, such as air transportation and restaurants, are closed all-together and may face a decrease in output of over 50 percent. These effects have translated into some data already (figure 9).

Figure 8: Aggregate vulnerability of sectors
Figure 8: Aggregate vulnerability of sectorsSource: RaboResearch
Figure 9: French retail trade plunges by unprecedented figures in March
Figure 9: French retail trade plunges by unprecedented figures in MarchSource: Banque de France

Labor market

President Macron started his presidency with ambitious plans to reform the labor market. To his success (and on the back of global economic growth), this has resulted in a significant decrease of the unemployment rate. COVID-19 is about to un-do all that. But the government is sparing no efforts to ensure that massive lay-offs are avoided through a temporary unemployment scheme. This scheme covers 84% of net wages for affected employees. The demand has been huge so far. As much as 700.00 companies and 40% of employees in the private sector have applied for the scheme.

Government finances

Despite the historically low interest rates on government debt, the French government has not been able to end any year with a budget surplus for the past 45 (!) years. Recent attempts to narrow the budget deficit were unfruitful; the Gilet Jaunes and the pension reforms protests forced president Macron’s hand, leading to widening of the deficit. The government has announced EUR 300bn of government backed loans and a package of EUR 110bn in direct measures such as tax deferrals and direct subsidies. In the (very) optimistic case that the measures that have been announced so far will prove to be sufficient to dampen the shocks of the lockdown, there will still be a need for a significant amount of spending to speed up the recovery process afterwards. Based on elasticities, the announced stimuli and our GDP forecasts we project the debt ratio to rise to 113%.

Italy

The Italian economy contracted by 4.7% q-o-q and 4.8% y-o-y in Q1. We think the contraction will be much sharper in the second quarter. Full recovery will likely take multiple years because of already very weak trend growth and the long-lasting impact of current demand fallout due to employment destruction and a spike in bankruptcies

In our latest forecasting round we projected Italy’s economy to contract by 7.2% this year and to grow by 3.4% next year. Yet given incoming data and updated views on the path of recovery, downward adjustment for this year is likely.

Italy not at the bottom of the list

According to the figures published on 30 April, Italy was not the worst performer in the Eurozone in Q1. This came as a surprise, given the fact that it was the first Eurozone country to endure a massive outbreak – from late February - and to implement harsh containment measures – from 9 March. We are lacking breakdown data to explain this, though it could have to do with a sharper fall in imports than in exports in Italy, as COVID-19 stifled domestic demand earlier and more than foreign demand. Furthermore, Italy’s manufacturing production is less dependent on Chinese inputs – which didn’t arrive - than that of France and Spain. And finally, Italy’s statistics office stated in its press release that the estimation of the GDP figure was very much complicated by problems with collecting data and that revisions are expected to be larger than usual.

Worse is in store for Q2

Looking ahead, the second quarter will likely post a much larger contraction, given that much more of the current quarter’s activity will be hampered by domestic lockdown measures. The government intends to open up non-essential production and construction sites, retail stores, catering and personal services early May. Though strict social distancing will remain in place and hence continue to significantly hamper economic activity. We assume most lockdown measures will be lifted by 1 June, giving room for recovery from the second half of the year. Yet some form of social distancing is likely to stay, especially hurting several services sectors.

Based on its sectoral composition, we estimate that 21% of the Italian economy will incur a shock of at least 50% to activity in Q2 (figure 2). This includes hospitality services, construction, and car production. Another 57% of economic activity, including most manufacturing, is likely to be substantially hit, but by less than 50%. Finally, we think that about 22% of the economy will remain more or less untouched during the lockdown or even grow at a higher rate, i.e. health

Weak outlook for recovery

The deep contraction in the first half of this year will leave its scars in the form of higher unemployment and bankruptcies. Despite supporting fiscal policy. Support measures introduced by the government will cushion the blow, but will not prevent long-lasting damage. This will hamper the speed of the recovery, and so will the economy’s very weak growth potential and the need to rein public spending further down the line to guarantee the sustainability of public finances. We expect public debt to rise to close to 160% of GDP.

Figure 10: Contraction much more severe than during the financial crisis
Figure 10: Contraction much more severe than during the financial crisisSource: Macrobond, ISTAT, RaboResearch
Figure 11: In Q2, almost 21% of the economy may face a shock of over 50% to activity
Figure 11: In Q2, almost 21% of the economy may face a shock of over 50% to activitySource: RaboResearch estimation

Spain

Spain’s economy contracted by 5.2% q-o-q and 4.1% y-o-y in Q1. We think the contraction will be much sharper in the second quarter, after which the economy can slowly start to recover. Full recovery will likely take over two years because of a vulnerable sectoral composition and demand fallout due to a spike in unemployment and bankruptcies.

Massive labour destruction

In our latest forecasting round we projected Spain's economy to contract by 6% this year and to grow by 5% next year. Yet given the first quarter’s figure, incoming data and updated views on the path of recovery, it is inevitable that we will have to downgrade our projections. Meanwhile, both official and temporary unemployment – via short-time work - are set to rise substantially. By mid-April, 16% of the labor force had entered the short-time work scheme ERTE and we expect official unemployment to average around 20% this year, from 14% last year.

Very weak activity in Q2

Lockdown measures have been in place since 14 March. Hospitality, recreation and non-essential shops have been closed since, non-essential production locations were only closed during 1.5 week in April, while social distancing commandments have reduced activity in most sectors. Assuming most lockdown measures will be lifted from 1 June, the economy can slowly start to recover in the second half of the year. Yet some form of social distancing is likely to stay, especially hurting several services sectors.

We estimate that almost one fourth of the Spanish economy will incur a shock of at least 50% to activity in Q2 (figure 2). This includes hospitality services, but also manufacturing of motor vehicles, which suffers from supply chain disruptions and a lack of demand. Another 56% of economic activity, including manufacturing, is likely to be substantially hit, but by less than 50%. Finally, we think that about 21% of the economy will remain more or less untouched during the lockdown or even grow at a higher rate, such as the health sector.

Improved balance sheets will not prevent bankruptcies and fall in demand

On average firms and households seem to be in a better position to absorb income shocks than in 2008, even though the metrics for firms have been worsening lately. Yet, due to the nature of the current shock, the shock is much larger for a number of sectors in which businesses tend to have weaker than average margins and reserves, such as in hospitality and tourism. Many (small-sized) firms in those hardest-hit sectors will likely have a very hard time surviving.

The drop in household income due to very large employment destruction will stifle consumer demand. Yet better household balance sheets and the existence of the short-time reduction scheme ERTE will likely pave the way for a relatively less protracted fall in demand than in the aftermath of the financial and sovereign debt crises.

Government debt to shoot up

The government tries to balance stimulating the economy and preserving sustainability of public finances. Still public finances are set to worsen significantly. We expect the budget deficit to reach double digits and the debt ratio to near 120%.

Figure 12: Contraction much more severe than during the financial crisis
Figure 12: Contraction much more severe than during the financial crisisSource: Macrobond, INE, RaboResearch
Figure 13: In Q2, almost 1/4th of the economy may face a shock of over 50% to activity
Figure 13: In Q2, almost 1/4th of the economy may face a shock of over 50% to activitySource: RaboResearch
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