What is the likely economic and financial market impact following the outbreak of the coronavirus (or Covid-19) in China, and its global spread? Naturally, the main focus – as it should be – is on the health implications and containment of this contagious virus. Also, the better the health responses are in limiting the virus’s spread, the more short-lived it will be and the lower the economic cost.
“Don’t panic, but avoid complacency” is the main message. Thus, markets need to not only reflect on the risks associated with the virus but also need to factor in the most likely scenarios, including policy actions (whether to address the virus itself or to minimise the economic fallout).
Let’s consider the downside economic risks first.
The immediate risk is contagion as the virus spreads not only within China but also in a globalised world economy with travel and integrated supply chains. The other immediate challenge is uncertainty, so much so that the fear of the virus spreading forces people across the globe to act – cancelling travel and going out, for instance – and dampens economic activity. The latter is already happening across Asia, and it could happen in any country (even the UK but this seems very unlikely at present) if there was a fear that the virus was now at large within it.
At the beginning of this year, China and the rest of Asia were expected to account for approaching two-thirds of global growth this year. Now, China, the world’s second largest economy, appears at a standstill, reflecting the impact of quarantine and the limit on travel and trade. It is hard to predict how long this stagnation of the Chinese economy will last, but it will certainly linger throughout Q1.
Then there is the negative impact on trade in a globalised world economy with integrated supply chains. The longer the virus persists, the more regional trade will suffer across Asia and further afield. Because this virus has a long incubation period and thus requires quarantine to limit its spread, this compounds the likely near-term negative effect and could make it longer to determine whether the virus has spread, or has been contained.
The biggest downside risk is one that the markets are not yet discounting, that the virus becomes a global pandemic that is hard to control. The measure of how it impacts people may not be captured by a normal distribution, with a low probability of extreme outcomes, but rather by a higher possibility of something going wrong, which in this case unfortunately means much higher mortality rates.
In a nutshell, if it goes badly wrong the impact on health and economies is huge. It is more likely it won’t go this way but we can’t be certain.
While these are the risks, market attention is focused on a host of metrics showing whether the virus is being brought under control, or not.
Currently markets appear to be relatively relaxed about the virus. That is because the expectation is that the crisis will be contained and that economic policy will be eased (as is the case already in China) or remain accommodative (as in the US and the UK too, although largely driven by other factors) to mitigate any economic impact.
Based on the assumption it will be contained and that fatality rates are low, the virus would be expected to have a temporary V-shaped impact on Chinese growth, while also dampening global activity temporarily. The scale of the initial downward economic move in China may be significant – as the nature of the virus clearly necessitates draconian action to contain its spread.
Given this, the three most likely paths are:
- Temporary economic impact, focussed on China: the virus is largely contained within China, but public fear and the quarantine needed to contain the virus occurs at a price of a short-term stagnation of the Chinese economy and supply chains across Asia. The world economy weakens through the first half of the year, prompting policy easing in affected countries, led by China.
- Temporary economic impact, but global: the virus spreads to other countries, on a larger scale than at present, with negative impacts on spending and growth. Overall, inflation should remain muted, but there may be some relative price changes if shortages emerge. In this environment, the markets expect policy to stay accommodating globally, with central banks adding liquidity.
- The virus materialises as a global pandemic with more severe health and economic implications. This is the worst-case scenario, as it would imply a more severe, widespread and prolonged impact before the virus is contained. It is this third path that would have a profound impact on markets, triggering a flight to quality, favouring bonds and safe haven currencies.
Perhaps the least economically costly outcome for the markets is one where the Chinese economy – and Asian supply chains – are at a standstill for only a short while, perhaps the rest of Q1. If there is clear evidence the spread of the virus has peaked then it is possible to look ahead to the economic rebound.
The worst-case economic and market scenario would be if the virus truly went global, triggering similar responses in China elsewhere. One might imagine the Chinese authorities would be more effective in imposing quarantine than some other countries might be. For the UK, it is largely this global impact that is key – only if the virus took hold here would the economy be impacted. The virus, in its present state, reinforces the bias towards easier policies.
Notwithstanding this risk, one should not panic. The authorities – both in China and globally – have responded in a proactive way, taking action. The challenge is that the Chinese economy is far bigger and its global tentacles stretch far wider (with its firms heavily integrated into global supply chains) than during the last such crisis – the 2002-03 Severe Acute Respiratory Syndrome (SARS) outbreak that impacted China and Hong Kong.
China’s economic output is worth over $14 trillion and accounts for just above 16% of the global economy and is vital for world trade. In contrast, at the time of SARS it accounted for around 4% and had only recently joined the WTO in 2001 and thus had not yet become fully integrated into supply chains.
Today’s virus hits discretionary spending in China, as people stay at home, away from public venues, and limits the internal flow of goods and services. It is also adversely impacting supply-chains in China and across Asia. China’s central bank, the PBOC, has injected liquidity, with rates trimmed, too. This is necessary, and it is likely more will be done as China’s growth rate slows. Fiscal stimulus, as well as further monetary easing, is likely. Overall, though, this will be seen as fine-tuning, as opposed to a change in direction of policy. The upward leg of the V will be seen once the virus subsides and there is a return to normal.
The global impact
From a global perspective, and as has been evident in recent years, the world economy has appeared vulnerable to economic shocks, prompting policy easing across the globe as we moved through last year. The global slowdown in 2018 was triggered, largely, by three factors: monetary tightening globally, tighter policy in China and an escalation of the US-China trade dispute.
Last year, the first two of these went into reverse, highlighted by rate cuts and China relaxing controls, while this year trade tensions eased. The world economy improved, but still appeared fragile and thus vulnerable to shocks like this virus. At Davos in January, before the scale of the virus was made public, the IMF had projected that global growth would rise from 2.9% last year to 3.3% in 2020 and 3.4% next year. The virus will knock this year’s global growth figure as China slows. It is hard to be precise but perhaps 3.1% is more likely now, even allowing for a rebound later this year.
This is linked to the global importance of China and Asia now to the world economy. Already the prospect of a slowdown has weakened commodity prices, easing global inflationary pressures, and triggering further supply cuts by oil producers keen to limit the fall in oil prices.
These effects of easing commodity prices will help, marginally, consumer spending and economies not directly impacted by the virus. This disinflationary global backdrop has underpinned bond markets globally.
The impact on China
The virus is the latest opportunity for markets to take a critical view on developments in China. In recent years, it has been the build-up of debt and increased leverage that has triggered concerns. While such worries are valid, they need to be kept in perspective. Likewise, too, in terms of focusing on the present slowdown in China.
The concern is that the pace of slowdown in China could be dramatic. Last year China slowed to an annual rate of growth of 6.1% from 6.6% the previous year. It seems inevitable that China’s quarterly pace of growth will suffer significantly in the early part of this year, certainly in Q1 and perhaps in Q2 as well.
The key Chinese economic policy making event is the annual Economic Work Conference (EWC) in Beijing each December. It provides the basis for the Party Leader’s speech at the subsequent March congress in Beijing, at which the economic growth targets are announced.
Last December’s 2019 EWC concluded that “key progress” had been made in China’s three major battles of the last few years: poverty alleviation; the ecological environment; and prevention of risks, particularly the build-up of leverage and debt.
This coming year, the EWC concluded, China will have established a “well-off society”. Most likely, although not stated in December, it will require achieving 5.5% growth in 2020 to meet their previous objective of doubling real incomes over the 2011-21 decade. This is a major achievement and one that suggests they will be keen to ensure a sufficient policy response this year to mitigate the negative economic impact of the coronavirus.
The EWC outlined six areas for this year. Notwithstanding the virus, these are likely to be reiterated by the Party Leader in March. The six issues, not in order of importance, are:
- to implement the new development concept, encompassing issues such as innovation, the green agenda and high-quality development;
- to continue to fight the battle in the areas of pollution, poverty reduction and prevention of risks within the financial sector;
- improving people’s lives, covering a multitude of areas such as jobs, housing and social policy;
- a proactive fiscal policy and a prudent monetary policy. Linked to this are financial sector reforms, to aid policy effectiveness and reduce the cost of financing for small and medium sized firms;
- promoting high-quality development, with a wide range of issues including getting rid of zombie firms. Within this point is another of the success stories of recent years, the focus on promoting certain regions, with a focus on three regions: Beijing, Tianjin, Hebei; the Yangtze River Delta; and the Greater Bay Ara that includes Hong Kong;
- deeper reform of the economic system, including a high-standard market system, and reforms to a host of areas such as state-owned enterprises and land reform.
This is a vast agenda. Perhaps, for the markets, of immediate importance are preventing a build-up of financial risks, while pursuing a proactive fiscal and prudent monetary policy. It suggests gradualism is the most likely economic policy response to any further slowdown in domestic demand and trade, as the economic impact of the virus becomes apparent.
As the virus is seen as negative for demand and supply – within China, across Asia – and there are downside risks if it were to spread, then the market response is to expect further policy easing globally, if needed. Clearly there is little evidence of complacency in the policy response, but because the lesson from previous shocks is a likely ‘V-shaped’ economic impact, which is temporary, not a permanent shock, markets are not panicking. But they should certainly not be complacent.
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