In focus

Europe’s fiscal response to coronavirus: “Whatever it takes”

The coronavirus crisis is forecast to cause the deepest recession since the 1930s. With Europe now the epicentre of the outbreak, how are governments responding to the economic crisis, and how successful will they be?

The first point to make is that announcements made so far will not be the last. We have already seen several rounds of measures being unveiled, in the same way that the European Central Bank and Bank of England were forced to follow up with more measures after initial easing.

More easing from central banks is possible, but the efficacy of their actions is almost at an end. Therefore, investors are turning their attention to the details of fiscal packages as they are unveiled.

EU budget limits suspended

An important initial barrier that was removed on 23 March were the European Union (EU) budgetary rules as set out in the Maastricht Criteria. Member states are not allowed to run a deficit of more than 3% of GDP, and where debt is higher than 60% of GDP they must seek to lower gross debt over the medium term.

European finance ministers along with the European Commission suspended the rules using the general escape clause – reserved for coping with recessions or significant economic shocks. State aid rules have also been suspended, allowing governments to provide public support to companies to mitigate the economic impact of the crisis.

The EU is often accused of a lack of co-ordination when it comes to fiscal policy, yet for those familiar with the structure of the EU, there is an understanding that member states are independent in deciding on their own fiscal policy. As a result, there has been a procession of announcements from prime ministers and ministers of finance over the past two weeks.

Huge fiscal packages unveiled

The approach most member states have taken is to help businesses and households bridge the gap between the loss in income during this period of disruption and the expenditures required to survive.

For business, this means loans/grants/tax deferrals and help covering the cost of holding on to staff.

For households, in addition to the obvious additional spending on healthcare, most policies aim to replace lost income. This is either through traditional social security benefits, or payments that help avoid people becoming unemployed, by either cutting hours or being furloughed.

Most governments have also announced huge loan/credit guarantee schemes, where the government offers to partially cover losses from loans covered by the scheme which banks join. Typically, in exchange for a fee, a bank will be able to enrol new and refinanced loans into the scheme, which then limits the potential loss from a default or a “haircut”, typically to between 10-30%.

In Germany, the government’s direct stimulus package is worth about 4% of GDP. About half of the package has been designated to tax deferrals along with making the existing short-time work programme easier to access. This is a programme which helps cover lost income for staff that have been asked to reduce working hours. Another 40% of funds have been made available as grants and loans for very small businesses, with the final 10% allocated for increased public investment, though these programmes run between 2021-24.

In addition to the direct stimulus, the German government announced an increase in guarantees for Kreditanstalt für Wiederaufbau (KfW – Germany’s state owned development bank), from €460bn to €822bn (23.9% of GDP). Moreover, a new €600bn (17.5% of GDP) economic stabilisation fund was announced, with two-thirds of the money to be used to guarantee firms’ capital market financing, with the rest split evenly between a loan to KfW and direct stakes being taken in companies to support them.

France announced a €45bn (1.9% of GDP) package of subsidies including short-time work support (including support for the self-employed), €32bn in deferred taxes and €2bn in solidarity grants for small firms. The French government also announced a €300bn (12.4% of GDP) of government backed loans for large businesses. A further €4bn (0.2% of GDP) will be made available to help start-ups to maintain cash levels between funding rounds.

Italy announced a fiscal rescue package worth €25bn (1.4% of GDP). This mainly consists of additional health spending, the deferral of tax payments until the end of May, one-off payments for the self-employed and seasonal workers (€600 each), and help for companies struggling to pay redundancy payments. Italy also mentioned loan guarantees for business, but these are being channelled through existing schemes run by Cassa Depositi e Prestiti (CDP) – an investment bank that manages public long-term projects. €114bn of funding is estimated to be in place (6.4% of GDP). 

Spain initially announced €3.8bn (0.3% of GDP) of additional health spending, and €14bn (1.1% of GDP) through tax relief for SMEs (small and mid-sized enterprises) and the self-employed. However, the government has since announced another €200bn (16.1% of GDP) with €117 billion coming from public money and the rest from the private sector. The package includes loan repayment holidays, for companies and households, along with income protection for those that lose their jobs and have their hours cut.

The UK initially announced £30bn or about 1.4% of GDP of support at the March Budget. Half of this amount was set aside for loan guarantees with the rest allocated to direct aid, tax cuts and additional health spending.

However, following the response in mainland Europe and an escalation in the social response (moving to a lockdown), the UK's package was upgraded to £350bn (15.8% of GDP). This includes grants for smaller companies in the retail, hospitality and leisure sectors, along with further tax relief.

Finally a third round of measures was announced and aimed at replacing the incomes of furloughed workers. This is the first time the UK has ever used such measures. Up to 80% of incomes for furloughed employees (below a certain threshold) will be paid by the government, estimated to cost £3.5bn (0.2% of GDP) for every three months for each 1 million workers. For the self employed, a similar package was announced which is expected to cover approximately 95% of the self-employed workforce, and will be based on their expected profits (from past tax filings). The help for the self-employed is estimated to cost £3bn per month.

Direct stimulus vs. loan guarantees: what’s the difference?

It is important to distinguish the difference between direct fiscal stimulus and loan guarantees, especially as most of the cash announced is going to the latter. Direct stimulus can be described as the “vanilla” response, including tax cuts, spending increases, direct aid. These aim to help boost incomes at a time when the disruption to activity could leave households and businesses short of cash.

In contrast, the loan guarantees should be seen as a form of insurance rather than direct stimulus. Though each country is introducing different schemes, typically they work by allowing banks to make loans with a proportion of the value (50-80%) being backed by state guarantees in exchange for a fee. This means that should the borrower fail to repay a loan, or if the loan is restructured and a “haircut” (reduction in value) is applied, the government will compensate the lender (mostly banks).

The use of commercial lenders rather than direct government, and not guaranteeing 100% of loans ensures loans are only made to credit worthy institutions/people – avoiding moral hazard.

Who takes the first loss from a bad loan matters. Where losses are shared on a pro-rata bases, the scheme will be more effective in maintaining credit provision. This is the case in Germany, France, Austria, the Netherlands, Spain, Sweden, and Switzerland. However, where the lender takes the first loss, as in Belgium, and potentially the UK (expected but unconfirmed), lenders will understandably be more reluctant, especially as deep recessions are expected.

Banks will certainly be under pressure to extend credit lines for viable businesses that already have existing relationships, but firms that were scraping by before the crisis are likely to struggle to secure new credit. Even with the government guarantees, a 20-30% loss on a loan for a bank is a serious matter.

Another benefit of the schemes is to safeguard the banking system. One of the legacies of the global financial crisis is that banks have been forced to significantly strengthen their balance sheets. Arguably, they have never been more resilient. However, if the recession turns into an extended crisis, then their resilience will be tested, and government support or bail-outs may be required. Use of loan guarantees helps mitigate those risks early on.

Will loan guarantees encourage more lending? It is highly questionable. The take-up of similar schemes during the global financial crisis was lower than anticipated. In any case, companies will now be in cash preservation mode while they assess the extent of the crisis. Therefore, any new demand for cash will be to cover expenses, rather than investment.

How powerful will fiscal stimulus be?

The funds allocated to the guarantee schemes (about 15% of GDP on average) are essentially contingent liabilities for governments. These will only be used and recognised if loan defaults rise sharply, and those loans were covered by the scheme.

Therefore, when considering the scale of effective stimulus, investors should focus on the direct packages being announced (averaging around 2.5% of GDP in Europe). This is a relatively small amount compared to the scale of the downturn expected. However, these figures do not include projections for the cost of automatic stabilisers – social security systems that kick in as soon as the economy needs it.

Automatic stabilisers are very generous in Europe compared to, for example, the US or parts of Asia. Hence there is less need to announce large direct stimulus packages in Europe, as normal social benefits will be there as a safety net.

Public finances are expected to deteriorate rapidly as a result of the crisis. Deficits could easily reach double digit percentage points of GDP by the end of 2020. However, the broader the support, the more likely that most firms survive the lockdown periods, minimising the rise in unemployment and supporting the “V-shaped” recovery we have in our baseline forecast.