COVID-19 and its Implications for Financial Stability in the Eurozone

Alexandros Seretakis, Trinity College Dublin

 

Even before the outbreak of COVID-19, numerous international organizations, including the IMF and leading economists, were warning of a forthcoming crisis in the world economy. The world economy was already vulnerable to the trade war between China and the US and high private debt levels. The COVID-19 pandemic has forced governments to impose severe lockdowns with economic activity grinding to a halt. The European Commission predicts that the Eurozone’s GDP will contract by more than 7.5%, the worst recession in the Eurozone’s history. In contrast, during the financial crisis, the recession in the Eurozone did not exceed -4.5 % of GDP.

 

During the past decade the Eurozone has witnessed two major crises, the 2008 financial crisis and the Eurozone sovereign debt crisis. The 2008 financial crisis, which started in the US, was caused by excessive risk-taking and the irresponsible behaviour of financial institutions. The 2008 crisis was predominantly a liquidity crisis, which led to the near collapse of the financial system. The financial crisis set the stage for the sovereign debt crisis in the Eurozone. The Eurozone debt crisis saw numerous Eurozone governments, including Ireland, unable to access government debt markets due to investor fears regarding the ability of these countries to repay their debt. The current pandemic driven crisis in the Eurozone economy is markedly different. Nevertheless, it has the potential to morph into a new financial or sovereign debt crisis for the Eurozone.

 

In contrast to the financial crisis and the sovereign debt crisis, the COVID-19 pandemic is a crisis engulfing the real economy. The lockdown measures have resulted in both a supply and a demand shock to the economy. For instance, the closure of factories and retail shops, which can be seen as a supply shock, has led to a surge in unemployment. The increase in unemployment has dented consumer income and spending power, a demand shock. The crisis has not yet spread to the financial system or sovereigns. Unlike the 2008 financial crisis, there is an abundance of liquidity in the financial system in part due to the quantitative easing programmes launched by central banks, including the ECB, during the preceding years. In addition, the new regulations introduced in the aftermath of the financial crisis have bolstered the resilience and loss-absorbing capacity of the banking sector and the financial system more generally.

 

As a result, with the support of Eurozone governments, which have extended guarantees and loans to struggling firms, banks are currently able to withstand losses in their loan portfolios. Furthermore, the decisive intervention of the ECB in the government bonds market has resulted in a drop in the funding costs of Eurozone governments. In 18 March 2020 and while Italy was witnessing a rise in its borrowing costs, the ECB announced the launch of the so-called Pandemic Emergency Purchase Programme. The programme involves the purchase of private and public sector securities with the overall amount of purchases reaching 750 billion euro. The launch of the programme contributed to the sharp decrease of government bond yields and has prevented a repeat of the sovereign debt crisis.

 

Nevertheless, a second wave of coronavirus will result in a prolonged recession with severe consequences for the financial sector. A surge in bankruptcies across the economy will lead to an explosion of non-performing loans. It should be noted that certain Eurozone countries, including Greece and Italy, are still grappling with elevated levels of non-performing loans. Furthermore, in case of a second wave, the support of governments to struggling firms and households will be limited due to lack of fiscal space. Even assuming that there will not be a second wave or that the second wave will be mild, the public expenditures of governments to support their economies and the severe recession will increase the already high government debt levels of Eurozone countries. For instance, it is estimated that the government debt level of Italy will reach 160% of GDP, of Portugal 130% GDP while that of Greece will surpass 180%. The possibility of investors reassessing the ability of Eurozone countries to repay their debt should not be underestimated.  

Overall, the Eurozone economy is unlikely to recover rapidly to its pre-pandemic levels. The danger exists that the Eurozone will be mired in another financial or sovereign debt crisis. As a result, common European initiatives of a fiscal nature, such as the so-called Next Generation EU recovery plan proposed by the European Commission, are of outmost importance in dealing with the consequences of the crisis. The recovery plan includes the creation of a 560 billion euro fund to support specified investments in EU Member States through grants and loans. The creation of the fund has been opposed by four Member States, Sweden, Finland, Austria and Denmark, which insist that the financial support should come in the form of loans and with more stringent conditions attached to it. Provided that the recovery fund involves predominantly grants to Member States, these investments will allow the European economy to rapidly bounce back from the pandemic crisis. However, if the fund involves predominantly loans, then these loans will only add to the already high debt burden of European countries hurting thus their long-term growth potential.

 

Alexandros Seretakis is an assistant professor in Trinity College Dublin and a member of the  COVID-19 Law and Human Rights Observatory

 

Suggested citation: Alexandros Seretakis, ‘COVID-19 and its Implications for Financial Stability in the Eurozone’ COVID-19 Law and Human Rights Observatory Blog (22 June 2020) http://tcdlaw.blogspot.com/2020/06/covid-19-and-its-implications-for.html

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