Forget about a V-Shaped Recovery

Massive shocks to the global economy and financial markets portend a slow, difficult recovery from the coronavirus recession.
April 23, 2020
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HUNTINGTON BEACH, CA - APRIL 20: An aerial view shows an oil pumpjack at the Huntington Beach Oil Fields amidst the coronavirus pandemic on April 20, 2020 in Huntington Beach, California. Oil prices traded in negative territory for the first time as the spread of coronavirus (COVID-19) impacts global demand. (Photo by Mario Tama/Getty Images)

Anyone confident that the U.S. will experience a V-shaped economic recovery later this year has not been paying attention to the rapidly deteriorating global economic and financial market outlook.

In particular, they are choosing to ignore the toxic combination of a record-high global debt-to-GDP ratio and the deepest worldwide economic recession in the post-war period. The resulting risks include a vicious return of the European sovereign debt crisis, the abrupt shift of the Chinese economy to a lower long-run growth path, and a wave of debt defaults in emerging markets.

If each of these risks were to materialize, they would constitute strong headwinds against any U.S. recovery from the coronavirus-induced recession. Global financial markets, key to an energetic rebound, would be particularly unsettled.

The specific case of Italy, which has an economy about ten times the size of that of Greece, underscores the risk of a Eurozone sovereign debt crisis later this year. Before Italy became the center of the European coronavirus epidemic, it already had public debt equal to about 135 percent of GDP and a shaky banking system. Its sclerotic economy had barely recovered from the Great Recession.

According to the IMF, Italy will be among the European economies hardest hit by the coronavirus epidemic and could see its GDP shrink by as much as 10 percent in 2020. Were that to occur, Italy’s public finances would become unsustainable. With a widening budget deficit, its public debt-to-GDP ratio would skyrocket to 160 percent. At the same time, the country could be headed for a banking sector crisis, with companies and households struggling ever harder to make debt payments.

Anticipating that Italy’s public finances might not be on a sustainable path, investors are starting to shun the Italian bond market. This is reflected in the widening spread between Italian and German government bond yields: The difference is approaching levels last seen in 2012.

Should investors continue to have doubts about Italy’s public finances, the country’s European partners might be called upon to bail it out to prevent it from defaulting on its debt, which could trigger a run on Italian banks and force the country to crash out of the Euro. This would pose a major challenge to the frugal, bailout-averse, Northern European countries like Germany and the Netherlands, since it might take up to €2 trillion to keep Italy afloat.

Like Europe, China too is casting a dark cloud over the global economic outlook. This is not simply because of the direct impact of the coronavirus pandemic on its economy. It is also likely that the epidemic will have punctured China’s enormous credit bubble, resulting in a spate of household and corporate bankruptcies. As a consequence, China should expect to shift to a much lower long-run economic growth path than before. It could repeat the Japanese experience following the bursting of its asset and credit price bubble in the 1980s and 1990s.

Over the past decade, China was the main engine of world economic growth and the world’s largest consumer of internationally traded commodities. A permanent long-run slowing in the Chinese economy would almost certainly have profound implications for the world economic outlook.

Especially in the context of a Chinese economic slowdown, the emerging market economies are likely to constitute yet another major source of prospective weakness in the global economy. They will now face a perfect economic storm of a coronavirus hit to their economies, a collapse in international commodity prices, a record rate of capital reversal, and weak external demand for their exports. With $70 trillion in debt now on the emerging economies’ books, many will likely have no choice but to restructure their debt or default.

As policymakers in the U.S. mull “opening up” the economy in an attempt to prevent further damage, one can only hope that they recognize that there is no miracle bounce-back coming. Even if the virus disappeared tomorrow, the world economy and global financial markets will still be stalked by structural risks. Whether it starts sooner or later, American policymakers should plan for a slow and difficult recovery.

Desmond Lachman

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.