By Les Manison
The adverse economic impact of the coronavirus is likely to be severe and prolonged with some commentators now predicting a depression in many advanced countries.
For Cyprus in the short-term, while disruptions to supply will have negative effects on economic activity, it will be demand shocks that will most likely plunge the economy into a freefall.
Firstly, there will be a sharp contraction in external demand for the Cyprus tourist product. Cyprus relies heavily on tourism and will be disproportionately affected adversely by the lockdown of air travel and the closure of its borders.
Secondly, the policy of social distancing and the shutdown of many business units will depress private consumption, which is equivalent to 65 per cent of GDP. Demand for entertainment, leisure, hairdressing, physical exercise and other related activities and services will be particularly hurt.
The uncertainty as to how long the measures and actions to combat the spread of the virus last, both in Cyprus and in countries such as the United Kingdom and Russia on which Cyprus depends for tourism, renders it difficult to produce a baseline scenario for the economy. However, in what follows an attempt is made to present a rough scenario of developments in important areas of the Cyprus economy predicated on certain key assumptions.
For this rough scenario it is assumed that the Cyprus economy begins recovering from September onward following the lifting of the lockdown and regulations on social distancing and the related re-opening of borders and businesses. It is assumed also that air travel to and from Cyprus for most air carriers is restored. Furthermore, account is taken of the impact of the proposed official income and liquidity support measures for businesses and individuals on economic activity.
With most hotels not being re-opened and airline travel not being resumed until September tourist arrivals during the peak summer months would be almost zero and contribute importantly to an estimated decline in tourist arrivals of 70 per cent in 2020. And with hoteliers and travel agencies offering cheaper prices to attract tourists, tourism revenue is estimated to decline by around 73 per cent.
With the closure of many shops and businesses, social distancing, and no spending by foreign tourists in the five months from April to September together with limited official income support for many households, private consumption will be decreased markedly during these months and more than offset higher consumption in the first and later parts of the year. Accordingly, real private consumption is roughly estimated to fall by 5 to 6 per cent in 2020.
Real fixed investment
Regarding real fixed investments the closure of construction sites and the great uncertainty about undertaking investments when the economic outlook is gloomy and unclear are likely to contribute to a sharp decline in real capital formation in 2020. As a result, real fixed investment is estimated to decline by at least 15 per cent in 2020.
However, such declines in these key aggregates are likely to be a little offset by increased public expenditures on renting hotels for persons in quarantine and isolation and outlays on other medical and pharmaceutical supplies. Also, imports are expected to record a substantial fall due to weaker domestic demand and supply shortfalls. And adjusting for these two expenditure components it is estimated that real GDP could contract by around 15 per cent in 2020 under this rough scenario.
Monetary and proposed banking measures may be counter-productive
Monetary measures taken by the ECB including the latest 750 billion bond purchase programme and the reduction of the capital buffers for banks are aimed at increasing their liquidity so that they can use their excess reserves to support the real economy. But banks in Cyprus already have abundant liquidity, which they are failing to lend productively in financing economic activity. Indeed, the acquisition of more loanable funds is unlikely to have much impact in stimulating bank lending, especially at a time when the creditworthiness and investment opportunities for many potential customers are being diminished by the current crisis.
The government’s proposal to provide guarantees on bank loans at subsidised ultra-low interest rates up to a total of two billion euros to induce banks to lend appears to be doomed for a number of reasons. In fact such loans would raise further the debt of the already heavily indebted private sector without there being any prospect that most of these loans would be used productively and repaid, thus eventually burdening the government with the large payment of guarantees to banks. Even the agreed temporary suspensions of principal and interest payments as proposed by the government could perpetuate the culture of debt defaulting by the undeserving debt delinquents, while adding to the longer-term debt burden including accumulated interest of the more deserving debt-repaying clients.
It should be stressed that providing liquidity in the form of low-interest rate loans and suspending debt servicing can help businesses and laid off workers weather the storm, but is insufficient and even could be considered counter-productive, especially in Cyprus where the private sector is already grossly overloaded with debt. Loans do not compensate businesses and workers for their losses. In the case of the coronavirus, it makes sense for the government to compensate struggling businesses for their losses with cash grants so that each business can re-emerge almost intact after the hibernation due to social distancing ends.
Fiscal policy response somewhat in right direction, but inadequate
It can be argued that the government with its proposed fiscal measures via cash grants, apart from the guaranteeing of bank loans and temporary suspension of loan repayments, is moving in the right direction to combat the very damaging economic impact of the coronavirus. That is the government whether explicitly or implicitly is moving to replace the contracting demand for the goods and services produced in Cyprus with measures such as subsidising the wages of private sector workers whose employer’s operations have been shut down, payments to the self-employed and for parents to take care of children as well as for Cyprus students who remain abroad. In addition, there is government expenditure for the renting of hotels for quarantine purposes and payments to private hospitals to care for coronavirus patients.
But there are questions as to whether the fiscal measures in terms of providing recommended grants instead of loans to households are adequate and well-targeted enabling the bulk of population including the more vulnerable individuals to satisfy their basic needs. What will be the extent to which persons working part-time and temporarily such those involved in leisure and entertainment activities (theatre, cultural events, concerts, art exhibitions etc.) are compensated for income losses arising from their work duties grinding to a halt? Surely, the self-employed and employees in the large informal or shadow economy of Cyprus who do not pay social insurance, but contribute importantly to domestic demand, are unlikely to be compensated for their income losses! Possibly for employees who are not eligible for social security benefits a system can be devised whereby following applications to and scrutiny by the government, payments can be made to cover the monthly utility bills, accommodation costs and healthcare expenses of deserving applicants.
Financial support for the emergency economic programme
With the government contemplating replacing financial assistance to households and businesses by government loan guarantees with more cash grants or “helicopter money” it is difficult to estimate the magnitude of the fiscal package and the need for financing from sources other than government reserves. Reports indicate that the government has around two billion euros in “reserves”. In this respect the Finance Minister Constantinos Petrides stated on March 31 that the government had a buffer, but still required additional borrowing to cover its needs. And given that the EU has suspended the Stability and Growth Pact, but as yet has not formulated a programme or facility for lending to members which have been negatively affected financially by the coronavirus, the government may have to resort to borrowing in international markets or from domestic banks. At this juncture borrowing in international markets for Cyprus would be very expensive. Accordingly, it would be advisable for the government to tap the large amounts of excess liquidity of Cyprus banks at very low interest rates, preferably by arranging a large credit line say of around two billion euro rather than issuing a government bond.
However, with the prospect that the government financing situation becomes more desperate for many euro area members including Cyprus as a result of the prolonging of the coronavirus, the EU would be pressured to activate (such as credit lines of the ESM) and create (such as Corona bonds) financing facilities carrying low conditionality in order to arrest the precipitous decline in the economies of Europe. And possibly threats by distressed countries such as Italy and Spain that they would leave the Euro area if sufficient financial help from the EU was not forthcoming should galvanise the Germans and other Euro area leaders into action.
Alternatively, without the event of adequate financing by EU institutions other than the ECB one can envisage a situation in which the ECB follows the US example of the Federal Reserve Bank and becomes the lender of last resort and engages in direct lending (monetary financing) to the governments (spenders of last resort) of euro area members in order to combat the coronavirus and its dire health and economic consequences.
Leslie G Manison is an economist and financial analyst. He is a former senior economist at the International Monetary Fund, an ex-advisor in the Cyprus finance ministry and a former senior advisor at the Central Bank of Cyprus