It is now a forgone conclusion. The coronavirus crisis will drive many economies into recession. What remains to be seen is the extent of the recession and its structural legacy. This will depend on the shape of the recession, which in turn is influenced by the degree of damage to an economy’s supply side, precisely, capital formation. Economists use the shapes of recessions to describe different types of recessions although there is no classification system or theory for the shape of recessions. The most common recession shapes are the V-shaped, U-shaped and L-shaped recessions. These names are simply approximations of the shape of the data when plotted in graphs. Ultimately, the severity and the policy response to a recession determine the shape of the recession.
The charts above show how different economies reacted differently to the same shock (the 2007-09 global financial crisis) and took different paths to recoveries. Canada avoided a severe banking collapse, managed to keep credit flowing and staved off a significant disruption to capital formation. This helped to keep labour in place and averted skill atrophy. The Canadian GDP declined significantly but sharply rebounded to its pre-crisis path. This is an example of V-shaped recession. South Africa and experienced a U-shape recession which tends to be longer than a V-shaped recession and does more damage to labour supply and productivity. An L-shaped recession is the worst form among the three and leaves long-lasting and repeated damage to capital, labour and productivity. This is the kind of damage the global financial crisis inflicted on the economy of Greece. The intensity of a V- or U- or L-shaped recession varies and may be shallow or deep.
The Coronavirus Crisis: A Recession Like No Other
The coronavirus crisis presents an entirely different kind of recession. “Economists are discussing if it’s a ‘V-shaped curve’, or a ‘U-shaped curve’ – it’s meaningless. What they don’t get is that this isn’t just a pause – it’s an entire reset of our economic system”. This is according to South African billionaire, Johann Rupert, in a recent interview with the Financial Mail. Although some commentators are predicting a V-shaped recession, this coronavirus crisis is an entirely different crisis. Nouriel Roubini, Professor of Economics at New York University, argues that the ensuing contraction might not be a V- or U- or L-shaped but I-shaped (a vertical line representing a sharp and drastic decline of financial markets and the real economy).
The damage to the global economy from the coronavirus crisis has been quicker and more intense than the 2007-09 global financial crisis and even the Great Depression. These two major preceding crises witnessed a collapse in stock markets by 50 per cent or more and liquidity freeze, followed by massive bankruptcies. The rates of unemployment increased above 10 per cent with GDP contracting at an annualised rate of 10 per cent or more. Debilitating as these crises were, it took about three years for all this to unravel. The coronavirus crisis presents similarly severe financial and economic damage but materialised over a very short period of time. The bulk of economic activities did not abruptly shut down during the Great Depression or the Second World War as they have currently in most advanced and emerging economies. Roubini concludes that the public-health responses in advanced economies have been woefully inadequate to curb the pandemic, and the fiscal policy packages being debated or implemented are neither rapid nor large enough to support a quick recovery, therefore, the probability of a new Great Depression, more severe than the Great Depression of 1929, is increasing by the day.
The Financial and Economic Damage
The coronavirus pandemic has generated massive stress in capital markets around the world. This crisis simultaneously raises liquidity and capital risks in both the financial system and the real economy. Liquidity problems hamper credit intermediation and investment. This liquidity and capital problems can easily spill over to the real economy. Persistent liquidity problems will create real economy problems leading to write-downs (capital problems) and in the process, shutting credit channel and damaging capital formation. The pandemic has forced many economies into lockdowns and stringent social distancing. These lockdowns and months of social distancing could disrupt capital formation and ultimately labour participation and productivity. Every element of aggregate demand is in unprecedented free fall. Early projections by the South African Reserve Bank are that the 21-day lockdown, aimed at containing the spread of the coronavirus, may lead to about 370 000 job losses and 1 600 business insolvencies in the country. An extended coronavirus crisis will lead to an increase in the number job losses and bankruptcies.
Over-estimation of Fatalities
John Ioannidis, professor of epidemiology and population health, and professor by courtesy of biomedical data science at Stanford University, who is also one of the most cited epidemiologists, believes that although the current coronavirus pandemic has been referred to as a once-in-a-century pandemic, it could also be a once-in-a-century evidence fiasco. Many infected people experience only mild or moderate symptoms that clear out quickly. Most people infected with the virus never get tested and therefore, don’t get counted. Some studies find that, possibly, a greater percentage of infected people could be asymptomatic. There are some interesting information emerging as the coronavirus crisis rages on: Estimates of the lethality of the virus are continually being revised downwards. On 26 March, a model developed by the University of Washington, predicted that if social distancing stays in place until June 1, the deaths reported in the United Sates over the ensuing four months could be around 81 000. There have been more than five downward revisions and the number now stands at 60 415, which is at par with the estimated number of people who will die of the flu in the 2019-2020 season.
John Ioannidis believes that the fatality of the coronavirus has been tremendously overestimated. He argues that when a model involves exponential growth, making a small mistake in the base numbers can lead to a final number that could be off by a very wide margin. “We don’t know if we are failing to capture infections by a factor of three or 300”. Since widespread testing only came in at a later stage, it was impossible to determine the number of existing asymptomatic cases. This means the number of infected people is larger than initially estimated, therefore, the fatality is lower. For example, if 1 person out of 100 people dies as a result of the virus, the fatality rate is 1 per cent. However, if it is 1 out of 1000, the rate is 0.1 percent.
Many economies have been shut down based on models and this has been helpful in dealing with the crisis amid huge uncertainty surrounding its spread and impact. The president, in addressing the nation on extending the 3-week lockdown pointed out that, two weeks before the lockdown, the average daily increase in new cases was around 42 per cent. The lockdown has led to a drastic decline in the rate of daily increase to around 4 per cent. Models are only as good as the data from which they are built. Ultimately, reopening the economy will depend on the rate of spread of the virus and the ability of our healthcare infrastructure to contain the pandemic once the economy is opened again. The new and encouraging information on the spread of the pandemic will allow policy makers to device a measured approach to dealing with the spread of the virus and possibly permit businesses that can demonstrate the ability to abide by proper social distancing rules to start operating again.
Path to Recovery
At this point, the only certainty is that any effort at a definitive forecast will fail. However, estimating various scenarios is still valuable in this period of high uncertainty. The economic impact of the coronavirus crisis will vary among countries due to differences in the structural resilience of economies to absorb the shocks and the capacity and response of policy makers. Ninety One Asset management, formerly Investec Asset management, designed an index that ranks emerging markets based on a Pandemic Vulnerability Indicator, Fiscal Space Indicator and a real time outbreak and response tracking. The Pandemic Vulnerability Indicator quantifies the ability of governments to absorb revenue losses from shutdowns, spending on fiscal stimulus measures and other costs. Figure 2 shows the pandemic vulnerability versus fiscal space. Currently, the majority of the outbreaks in emerging markets are occurring in countries with either substantial fiscal space and lower pandemic vulnerability – or a combination of both. Egypt and Sri Lanka are the most at risk in terms of fiscal space although outbreaks are relatively small. South Africa has a relatively better vulnerability and response score but has relatively little room for manoeuvrability within the fiscal space.
The intensity of a recession due to the coronavirus crisis will be dependent a number of factors, the main ones being the severity of the pandemic and policy response (both health and economic) as well as the change in corporate and consumer behaviour. Additional factors include the extent of disruption to credit intermediation and the damage to the growth of capital stock. The shape of the recession will be determined by the extent of damage the pandemic inflicts on the supply side of the economy.
In South Africa, the Reserve Bank just freed up half a trillion rands as coronavirus relief loans and the Prudential Authority have relaxed rules on liquidity requirements and capital buffers to protect the banking system from shocks. Other mechanisms implemented to soften the blow of the crisis include the establishment of a Solidarity Fund, the Debt Relief Finance Scheme and the Business Growth/Resilience Facility.
Achieving a V-shaped recovery path however, would be a herculean task, if trends from prior economic recoveries from pandemics are anything to go by. The San Francisco Federal Reserve report that there is a persistent macroeconomic after-effect of pandemics which lasts for about 40 years, coupled with substantially depressed real rates of return. This is based on a study of the rates of return on assets from data on major pandemics and armed conflicts which resulted in deaths of more than 100 000 people. Unlike armed conflicts, pandemics do not lead to the destruction of machines and buildings, therefore, there is nothing to rebuild after a pandemic.
The behaviour of real natural interest rates after pandemics is completely different from that of the impact of wars. The natural rate of interest is described as “the level of real returns on safe assets which equilibrates savings supply and investment demand - while keeping prices stable - in an economy.” All else being equal, greater economic activity is an antecedent for higher rates, and weaker economic activity comes with lower rates. A recent study by The Bank of England estimated real natural rates from 1311 to 2018 and concluded that wars lead to higher real interest rates whiles pandemics are followed by lower real interest rates. The implication is that the economic recovery from the coronavirus crisis likely to be slower, therefore, dimming the hopes of a V-shaped recovery.
Rallying behind the flag
For years, cries for reform from business organisations, rating agencies, banks and other influential groups have fallen on deaf ears. The lockdown, followed by Moody’s downgrade, raises the question, or even hope, that this crisis could be the catalyst for a long overdue structural reforms. This is what led to the finance minister’s “hallelujah moment”. The current situation places the president in a unique situation. Arguably, he has more power now than any of his predecessors. The wartime nature of this crisis may induce a “rally around the flag effect” to bolster his position to implement bold decisions. The president has received commendation both locally and internationally for his bold, albeit economically painful decision to impose a 21-day lockdown (now extended by another 14 days). In the coming weeks, the data will reveal that the country’s economic conditions have worsened and consequently, the economic situations of millions of South Africans have also worsened as well. Only drastic economic reforms can reverse this sharp decline in fortunes. At this juncture, “the choice have been taken out of the politicians hands”, as Johan Rupert puts it; the room for ideological squabbling is quickly diminishing, “they have to restructure the economy”.
The finance minister repots that Ramaphosa told him this is now the moment to implement the long overdue structural reforms. The minister says he will create a new unit within the Ministry of Finance to work on reform but did not specify when the unit would be set up. The severity of this crisis necessitates a speedy approach to reform. If anything is going to happen, it has to happen now.
Whether the impending recession will be short-lived, drag on a little longer before recovery, or leave lasting and repeated damage to the economy will depend on speedy public health response to the virus and speedy and effective economic policy response. Hopefully, the policy makers will appreciate the urgency of the situation and respond accordingly.