Covid-19 and the 2020 financial crisis

In addition to people and governments having to react to the actual illness of Covid-19, there is also the fast emerging issue of a serious economic and financial crisis affecting economies across the world.

The shift in projected rates of economic growth for 2020  has been dramatic: from steady or reasonable, to the prospect of a serious recession.

The 20 members of the G20 (including the EU) collectively constitute 85 per cent of the global economy. One group that tracks and projects economic developments of the G20 is The Economist Intelligence Unit recently reported that global rates of growth will decline from a pre-crisis projection of 2.3 per cent to a contraction of 2.2 per cent. Such a dramatic rewriting of growth projections globally is unprecedented. The following chart provides a picture of these dramatically changed projections by country:

 

 

The impact country to country will vary. Brazil’s economy is now projected to suffer an almost 8 per cent reverse in projected growth rates. Meanwhile Japan is now projected to suffer a more modest 1.9 per cent reversa. Australia is currently projected to see a 2.4 per cent drop in growth rates while Indonesia is projected to see a 4.1 per cent change downwards.

Capital markets often act as lead indicators of subsequent impacts on the so-called “real economy” of farms, factories and households. Current moves in the capital markets indicate that we are all in for some tough times. The roller coaster of rises and falls in share prices in recent weeks reflects only part of the challenge. Indeed the impact can vary between markets. Some markets will be more severely affected than others and reflect greater or lesser losses of the collective wealth of a society. In addition to share market indices, currency fluctuations also reflect the changed status of a nation’s relative wealth and asset valuations.

In considering the variability of how several economies have been impacted I have attempted to develop a crude picture of where we stand.

To begin, I looked at the movements in currencies since the start of the year and thus just before Covid-19 became an issue of serious global interest. I have used the USD as the basis for comparison. The date of comparison is with the end of March 2020.

Currency and equities market valuations provide responsive, perhaps hyper-responsive, reactions to changed or perceived changed circumstances. Other assets such as property are usually much “stickier” and slower to move or respond to changes than equities markets.

I then looked at the value of the equities market indices of these countries comparing movements in their core indices between the start of the year and 31 March. The chart below provides a picture of both sets of movements for each country reviewed.

 

 

Of note here is that there has been a decline in the value of the capital base of every country reviewed.  For some countries, notably Australia and New Zealand, there has been a major hit to currency valuations. For the major European economies and among two of the big ASEAN economies of Philippines and Thailand it is their equities markets that have been most severely affected. Indonesia has suffered big losses in terms of currency and stock exchange index as has the UK but to a lesser extent.

To provide an easier means of seeing the big picture of national valuations movements, I have combined the two factors (equities and currency) into a single figure for each economy. See below:

 

 

So what are you still worth?

Imagine that you invested USD 100 in the stock market of each of these countries at the end of 2019. What did you have at the end March 2020? It is not a pretty picture.

 

 

This loss of global wealth has taken place in just three months. I would not be at all surprised if there is worse to come.

Two of the three most negatively impacted economies are currently Indonesia and Australia.

In the case of Australia the surprisingly large fall in currency valuations is, I would suggest, connected to the fact that interest rates in Australia had never fallen to the more-or-less zero rates found throughout many developed economies over the last few years. This has given the RBA (Reserve Bank of Australia) greater flexibility to cut interest rates than has existed elsewhere. However as they have done so aggressively lately the impact has been to see AUD currency valuations fall fast in response. At the same time, as an energy exporter, the country is also feeling the impact of lower energy prices on its terms of trade and ultimately the valuation of its currency.

The latter issue may have affected an energy exporter like Indonesia too, which, while now a big oil importer, nonetheless remains a huge exporter of coal and the dominant global exporter of palm oil (the price of which has tanked nearly 25 per cent this year). Indonesia too has had some room to reduce interest rates. Recent sharp cuts in key interest rates by the central bank (Bank Indonesia) was followed with quick depreciations of the rupiah. In addition it is noteworthy that in several recent cases of global or regional financial instability, Indonesia has tended to get hit hard early but also recover quite quickly as its underlining economic robustness leads to corrections against the “oversell”. This suggests some market “skittishness” about Indonesia that can lead to these over-reactions.

Historic comparison

This current financial crisis is not the first one in recent memory; the Global Financial Crisis of 2008/09 being the most recent. From the perspective of our region, the Asian Financial Crisis of 1997/98 was also very significant.

I remember the debates that took place during the Asian Financial Crisis: speculation about which country was most badly affected.

While Thailand was the first nation to take a currency hit on 2 July 1997, others soon followed: Philippines, Malaysia, Indonesia, Singapore and then beyond ASEAN until all were affected – but how badly?

It was during this time that I decided to try to measure the losses on a comparable basis. I used a similar means as above – compare currency movements against the USD then compare stock exchange indices against a baseline date. The date used was 1 July 1997 (the day before the Thai Baht began to fall and coincidentally, I think, the day Hong Kong was returned to China. )

The end date used was late September 1998. This provided sufficient time for the dust to have settled on the crisis yet not enough time for the full and longer term impacts of policy initiatives to have filtered through.

Most people focused on “economic fundamentals” to explain the varying extents to which countries were affected. I was never convinced. Certainly, when comparing the kind of economic fundamentals that people often offered as an explanation for why this or that country was affected, it struck me as odd that Australia’s current account deficit was, as a percentage of GDP, larger than Indonesia’s. On national debt, Australia’s was, as a percentage of GDP, larger than Indonesia’s. On commodity exports (seen as more vulnerable to price swings) Australia was more dependent than Indonesia. Australia’s fiscal deficit was again larger than Indonesia’s. If the “economic fundamentals” argument was so valid Australia should have been more negatively affected than Indonesia.

In my view the Asian Financial Crisis was less a crisis of economic fundamentals than of systems of governance. Take a closer look at that list above and think back 23 years to 1997 and ask about issues of trustability, transparency and accountability in governance systems. Those was among the lessons that Indonesians did learn from that experience. The investments the country made in subsequent years in reforming and transforming systems of governance have stood the country well.

The chart below represents the impact on asset valuations: how much you would have left in these currencies in September 1998 if you had had USD 100 in July 1997.

 

 

In the Global Financial Crisis of 2008/09 Indonesia sailed through barely skipping a beat in its growth rates even as the global economy actually contracted. I believe it was clear that one of the reasons is that many of the fatal flaws in governance and financial systems ethics revealed in 1997 had been rectified before this Global Financial Crisis.

Options

Will the impact in our region of the financial crisis of 2020 exceed that of the Asian Financial Crisis?

Recall that the regional economy of Asia actually contracted by .01 per cent in 1998. While minute, it is well to note that this was the first actual contraction since at the least start of 1960s. It need also be recalled that this time the crisis is global in nature, not just regional. The only time the global economy has contracted in the past 60 years was in 2009 in the wake of the Global Financial Crisis.

In many respects the challenges we all face now is not a financial crisis in any traditional sense of the term. This is in essence a crisis of consumption – a collapse in the velocity of economic activity and consumption and also of production. Part of the answer to this economic crisis must include a serious focus on boosting or at least securing levels of consumption – especially in the face of community lockdowns.

In facing this financial, and ultimately economic, crisis it is notable that some traditional options for stimulating an economy are quite limited in the case of many economies.

For most major economies pre-existing interest rates were already at record low levels. So slashing interest rates to stimulate investment is not a realistic option. Australian interest rates have already been lowered considerably – a factor that has no doubt contributed to the sharp fall in AUD valuations. Indonesia does have more ability to cut interest rates than most other major economies, but decreases in interest rates such as announced in mid-March will see the rupiah fall further, perhaps to new lows.

Many countries, especially in Europe and also, frankly, in the USA, face limited options for expanding budget deficits to stimulate expenditure given the size of pre-existing budget deficits. Here, Australia has some more wiggle room than many other nations. Indonesia has some but not huge scope for expanding its fiscal deficit.

Fortunately for many nations across the Southeast Asia region, including Australia, levels of national debt are quite modest. For the major economies of Europe, USA and Japan, pre-existing levels of debt were already very or extremely high.

Of some value is that inflation is also at extremely low levels – indeed deflation is arguably a greater threat than inflation. Here, arguably, the biggest potential surge in inflation will be related to break downs in supply chains. City, regional and national lock-downs threaten supply chains even for basic food needs. Panic buying and other such behaviour will also impact on prices and availability in places. Authorities may feel compelled to essentially suspend market-based mechanisms to “stabilise” these situations.

I think a Nobel Prize in Economics awaits anyone who is able to put this combination of new challenges and pre-existing dynamics together to foresee a pathway through this crisis.

Indonesia’s new financial and economic stimulus package

On 31 March President Jokowi  signed into effect Perppu (Government Regulation in Lieu of a Law) No.1/2020 on Policies for State Financing and Financial Systems Stability to Manage the Covid-19 Pandemic and/or on Facing the Threats that Endanger the National Economy and/or Stability of the Financial System (hereafter referred to as Perppu). A perppu is an emergency legal instrument that carries the same legal power as a law (legislation). The substance of a perppu must be endorsed by Parliament by the end of its next session.

The key contents of the new Perppu cover a range of areas including:

• National and regional budgetary policy
• Taxation and customs, and
• Financial system stability.

On national and regional budgetary policies, most notable is the relaxation of the 3 per cent budget deficit limit imposed by the 2003 State Budget Law. No new maximum is mentioned, although this fiscal relaxation is permitted until the end of fiscal year 2022 after which the budget must return back to the 3 per cent deficit limit or be on track to do so. Other aspects include adjusting budget lines and allocations to prioritise funding for Covid-19 related costs – health and financial/economic. Provincial and local authorities are also enabled (within certain limits) to reallocate funds from their own budget to fund Covid-19 related challenges.

On taxation and customs related issues the minister of finance will be able to waive customs and excise related costs on goods that can alleviate economic pressures or support or stimulate economic activity. There are also several reductions to rates of income tax. Foreign sourced digital economic entities will be expected to pay tax on an electronic basis, although exemption remains for countries with double taxation arrangements with Indonesia. Taxpayers will also have a longer grace period during which to meet their annual tax payments.

On financial systems stability, the Perppu broadens the technical means by which the Financial System Stability Committee (the KSSK) can operate – including, now, through virtual/digital meetings and decision making. The central bank (Bank Indonesia or BI) is enabled to guarantee and support major banks in distress and issue other financial instruments to raise capital from markets in order to secure the financial system. BI may also purchase instruments from the Savings Guarantee Institute (LPS) to ensure major banks remain solvent. BI and the Financial Services Authority (OJK) are to collaborate in evaluating the financial health of major and other banks in recovering any liquidity loans provided. The LPS is authorised to engage proactively with OJK on preparing for any contingency measures to redress problems with banks including whether to support a non-major bank in stress, taking into account the wider financial and economic implications of any action. The Government is also authorised to provide financial loans to the LPS should this be required.

The closing article of the Perpu declares that any costs expended by the Government or any state financing authority (such as BI) are to be considered as economic costs to secure the economy from a crisis and are not be considered as losses of state finances. This is a very interesting article and is crafted as a means of ensuring that any financial action taken to secure financial stability, for example through financial bailouts, cannot later be prosecuted as corruption based upon the “catch all” article in the anti-corruption law that can equate any loss of state finances to be a corrupt act. This issue is clearly intended to pre-empt the kind of legal fall-out that affected government figures associated with the bailout of banks during the Global Financial Crisis of 2008/09.

The package of reforms contained in the Perppu changes articles in several earlier laws including those on Laws (1983), the Central Bank (1999), State Finances (2003), Treasury (2004), Savings Guarantee (2004), Regional Financing (2004), Health (2009), Villages (2014), Local Governance (2014), the Legislatures (2014), Financial Crisis Prevention (2016) an the 2020 State Budget (2019). While an emergency regulation, this Perppu has been thought out in some detail.

The total financial value of the support program captured through this Perppu is some Rp. 405 trillion (about AUD 40.5 billion). This is expected to raise the fiscal deficit to just above 5 per cent of GDP. This program consists of four key components:

1. Health care – Rp. 75 trillion (AUD 7.5 billion): This is for purchasing necessary equipment (test kits and ventilators) as well as providing additional income to health workers. This figure actually doubles the pre-existing health budget.
2. Social protection – Rp. 110 trillion (AUD 11 billion): This component will support 10 million families from the Hopeful Families program and 15.2 million families in the Staple Foods program. There will also be doubling of the unemployment benefits budget to support a projected 5.6 million newly unemployed and informal workers and small business owners. Also covered will be the electricity bills for 24 million small scale electricity users.
3. Tax and business incentives – Rp. 70.1 trillion (AUD 7.01 billion): Low income workers, earning below Rp. 200 million (AUD 20,000) per year will be exempt from tax for six months. Import taxes for 19 manufacturing sectors will be deferred. Overpaid taxes will be reimbursed without internal audit. Corporate income tax will be reduced to 22 per cent from 25 per cent until financial year 2021 and dropped further to 20 per cent in financial year 2022.
4. Economic recovery program – Rp. 150 trillion (AUD 15 billion): This program will cover credit restructuring and financing for small to medium enterprises.

In terms of wider management of the crisis, the Government has been very cautious about trying to lock down regions. Given recent experiences in India where a lockdown was applied before any social safety net was announced, this may have been a reasonable position to take.

In India the lockdown led to panics and the potential dissemination of the virus as migrant urban workers sought to flee cities for the greater economic security of their villages.

In Indonesia it may be that as these welfare support programs are being rolled out there will be less fear as lockdowns are announced. There are already major efforts to prevent people returning to villages in the lead up to Ramadan. Difficulties in managing the annual Chinese New Year mass movements in China earlier this year are said to have added to the spread of the disease there.

These financial and related stimulus efforts are focused significantly on supporting the lower income members of society and micro, small and medium enterprises. Given these groups form the basis of consumption and employment in the economy, this was a positive step. The provisioning of new flexibility to react fast in the face of the potential solvency of banks also represents a big step forward.

Concluding remarks

These economic and finance-related initiatives are welcome advanced. They do appear focused on attacking the core economic challenge of this crisis – namely a sudden collapse in consumption and production. The cause of this collapse was not due to financial imbalances or overproduction, as was the case in so many earlier economic downturns and crises.

Rather, the cause has been a new, contagious and lethal virus against which there is no preventive or curative medicine. Given this is the cause, it is fair to conclude that until this health issue is brought under control other issues, including economic and financial initiatives, will operate as holding activities. The longer it takes to get the spread and virulence of this disease under control, the more expensive will become these holding initiatives.

In part the capacity to contain this disease is not dependent solely on any individual country. It requires the collective effort of all nations. While closing borders may work for a while, at some time they will be re-opened. However if some regions have been ineffective in stemming this disease, there is every possibility of re-introductions into regions that had managed to contain the disease. No doubt epidemiologists and virologists can advise on these dynamics. Nonetheless further outbreaks, before a vaccine or cure is found, will leave societies and their economies vulnerable to future “snap backs” to economic retractions.

In the meantime, Indonesia’s economy retains considerable sources of resilience under these circumstances. Levels of foreign indebtedness are relatively low; foreign reserves are significant; and the economy, driven by domestic demand for many years, and, somewhat ironically, less engaged than many in global economic value chains, is now less dependent upon wider regional and global economic dynamics.