After a decade of feeble economic growth, three years of messy Brexit negotiations (with more to follow), two years of U.S.-China trade tensions and looming threat of a tariff war with the U.S., a serious viral epidemic was the last thing Europe needed. Even before the outbreak, the continent’s major markets were barely growing, with Italy and Germany on the brink of recession. The virus may push them over the edge. The available data still shows little sign of impact, but the collapse of European equities is a sign that markets are pricing in a large hit.
Italy, the third-largest economy in the eurozone, is a particular concern. The country recorded its 17th consecutive monthly decline in manufacturing activity in February, even though the survey was completed before the outbreak intensified. Northern Italy, accounting for a little less than one-third of the nation’s economy, is currently under lockdown. Measures like these will only add to the woes of Italian manufacturers. Italy’s banks are among the weakest in Europe.
But even Germany, Europe’s largest economy, is facing a sizeable hit. The German automotive industry, already reeling under trade-related uncertainties, is bracing for further slump in demand and exports. According to a report from the Munich-based Institute for Economic Research, if the epidemic develops similarly to the SARS epidemic in 2003, a 1% slowdown in Chinese growth would reduce German growth by 0.06%. Given the virus’s fast spread within European borders, the actual impact will be far greater.
The impact to the U.K. economy, still the continent’s financial hub, was initially expected to be modest. But Brexit does not isolate the U.K. from a global downturn; the U.K.’s significant trade dependency on the EU and China, and slumping global equity prices, will weigh on its outlook.
Beyond supply-side disruptions in the manufacturing sector, domestic demand will also take a severe hit. The virus is affecting some of Europe’s most popular destinations. The tourism sector, accounting for 3.9% of Europe’s economy and nearly 12 million jobs, is suffering the most.
European banks carry high capital and liquidity buffers and are better equipped for a downturn now than they were during the 2010 sovereign debt crisis. But the higher defaults that would accompany a recession would force lenders to take losses. The region’s banks already have thin profit margins due to negative interest rates. While non-performing loans have fallen in recent years, they remain uncomfortably high in some regional economies.
Europe needs to use all appropriate tools and take concrete action to support growth and guard against downside risks. While the Bank of England (BoE) and the European Central Bank (ECB) stand “ready to take appropriate and targeted measures,” both are poorly armed for this battle. As discussed in the prior article, both have less room to cut interest rates than their U.S. counterpart does. And the ECB already deployed an asset purchase program last year. U.K. banks recently started issuing emergency loans to firms hit by the virus outbreak. More help from the fiscal side is desperately needed.
The Italian government has been quick to take this tack. It allocated €900 million worth of support measures, primarily targeting the north of the country. The package includes tax relief, a delay on utility bills and loan repayments, and a wage support scheme for firms temporarily cutting staff or working hours. The government then announced a second package worth €3.6 billion targeting affected sectors throughout the full country. Though significant, at about 0.3% Italy’s of gross domestic product, the measures are likely to fall short of keeping the country out of a downturn.
With these and additional support measures, Italy looks set to breach its deficit targets. The European Commission is lending support through its willingness to relax fiscal goals for Italy and others with large deficits. Emergency spending or lower revenues resulting from the outbreak will qualify for a waiver extended in the rules of the Stability and Growth Pact in 2015. Germany, meanwhile, has long honored its constitutional debt limit, resisting calls for fiscal stimulus. COVID-19 may finally force a shift toward accommodation. Germany’s finance ministry is looking to temporarily suspend the “debt brake” to help local government finances. The U.K. also has room to ease, and is set to announce a meaningful fiscal stimulus package in its formal budget next week.