Leonardo Badea (BNR): The economic recovery and the evolution of the health crisis – the threat of the fourth pandemic wave
Opinion by Deputy Governor of the National Bank of Romania (BNR), Leonardo Badea
“The recovery of the economy after the pandemic period is a complex subject in a continuous evolution determined by the health crisis and the transformations induced by it, including by accentuating some pre-existing vulnerabilities and creating new frictions on the markets.
We all know that during this period “uncertainty” is the term that best defines the environment in which people and companies make their estimates or build their plans for the future. At the same time, we are in a situation that demands a solidarity response to combat the effects of the crisis, but also to strengthen the structure of the economy and the society. The nature of the threat we are facing emphasizes that no country will be fully protected from the virus until global health security is ensured, which is unfortunately very difficult, not only in terms of financial effort but especially because it requires a change of mentality and overcoming cultural barriers. Local vaccination successes will not be enough to protect individual countries from potential further outbreaks, especially in cases of new variants, as in many countries the situation is not homogeneous even from a regional perspective (see the recent experience of Spain).
Although at the beginning of the summer we had reasons for optimism, the evolutions of the last days show that the virus remains a formidable and surprising opponent. The signs of a new pandemic wave, the fourth wave, which was estimated to manifest much later, at the beginning of autumn, are already becoming more and more visible.
The most topical questions are related to the amplitude of this wave and whether the results of the vaccination effort so far will prove sufficient to reduce its amplitude. The concern is natural given the higher degree of contagiousness of the Delta variant of the virus. Therefore, the race against the clock continues in order to improve the vaccination rate – the only solution that reduces the risk of developing serious forms of the disease in the general population, allowing a lower level of restrictions.
Challenges that affect the evolution of the economy
The current situation of uncertainty is generated mainly by the unpredictable evolution of the pandemic but is also exacerbated by other challenges that transform society and the economy: the climate crisis, the demographic crisis in most developed countries, the migration, the accelerated growth of debt, the danger of inflation, the restoration of geopolitical balances, the changing the structure of the society and the erosion of the middle class, simultaneously with the increasing inequality, the signs of re-emergence of terrorist threats and the difficulty in controlling weapons and dangerous substances in the context of protecting individual freedoms, etc.
Beyond the pragmatic aspects, all these also generate important emotional reactions and influence the behaviors of consumers and investors. In a synthetic analysis of the main threats to the economy, which have been commented in the public space, we can identify ten challenges that affect the intensity and duration of the economic recovery.
Limiting environmental degradation and accelerationg the transition to a less polluting economy requires high costs in many sectors of activity (which will ultimately be passed on to consumers and exert inflationary pressures), major investments, and a potential resettlement of the labor market. Fortunately, climate goals also generate development opportunities. Innovation, digitalization, process adaptation have become levers for successful companies that have found solutions to adapt to the restrictions imposed by the struggle against the pandemic by developing new services and products or adapted to current market conditions.
The persistent threat of rising unemployment (in many developed countries) or of a difficult resettlement of the labor market (mostly in emerging economies). Technological changes, the adaptation of the economy to climate goals, and the structural transformations induced by the pandemic crisis lead to significant job reductions in some areas (following the reduction of the respective activities or the automation and digitization of processes). This implies the need for professional reconversion and absorption of labor force within the developing sectors, which is often difficult, especially for people close to retirement age. In many jurisdictions, the labor market is too rigid to facilitate such a rapid adjustment that would benefit both employees and economic growth. At the same time, a balance must be reached between the need for flexibility and the need to protect vulnerable employees. In the long run, for an already burdened public budget, it will always be more efficient to support professional reconversion (which in the future would indirectly lead to increased tax revenues on economic activity generated by the professionally reconverted employees) than long-term social protection. In addition, the effort to support reconversion costs could be split between the state and the future employer through a fair and transparent partnership.
Population impoverishment at the global level. According to a World Bank report from October 2020, the growing trend of poverty from 2020, as a result of the pandemic crisis, will continue in 2021, and the number of affected people will increase by 115 to 150 million. Previously, during the last three decades, the only other increase in the global number of people affected by poverty caused by a crisis was recorded during the Asian crisis (then the number of people affected by extreme poverty increased by 18 million in 1997 and by another 47 million in 1998). Before the pandemic, the extreme poverty rate followed a long-term downward trend and was expected to decline by 7.9% in 2020. The economic effects of the emergence and spread of the new virus led to an unfavorable reversal of this trend so that the new estimates of the extreme poverty rate are between 9.1% and 9.4% of the world’s population this year. Population impoverishment, accelerated mainly in certain areas of the globe as a result not only of the pandemic but also of local military or ethnic conflicts or specific regional factors, can lead, among other things, to amplifying the migration phenomenon that brings along the entire array of economic and social effects, both positive and negative, from one extreme to another.
Differences between countries regarding the levels of economic development and fiscal space becomes a problem in the adoption of economic recovery measures. Flexible programs must be used to take account of the existing gaps, which have widened during the crisis. The economic effects of the pandemic have been heterogeneous, including within national borders, due to the different structures of regional economic kernels. As always during a crisis, the areas already lagging in terms of economic development, with more difficult access to finance, less diversified types of activities, lower degree of incorporation of modern technologies, and oriented mainly towards activities that involve a greater degree of interaction had suffered the most. Increasing inequality reduces the potential for post-pandemic economic recovery because it maintains a level of underutilization of production factors in affected areas, caps potential demand and blocks public resources.
Capital markets are still decoupled from the evolution of the real economy. The combination of broad fiscal and monetary stimulus needed to actively support the economy and mitigate the effects of the pandemic shock has further fueled the rising of financial asset prices (which was observed even before the crisis). On the other hand, the continued low level of real interest rates (often negative) maintained the “search for yield” behaviors o (also pre-existing), reducing the risk aversion of most categories of investors.
The risk induced by the decoupling from the fundamentals in the capital markets could lead to a sudden and massive increase in risk aversion, if the speculative bubble will burst (as opposed to a gradual deflation managed by adequate macroprudential policies), with simultaneous negative effects on liquidity (which, as we have seen during all crises, is vital for the functioning of the economy). At the same time, it could lead to investment reduction, increase of risk premiums (hence the cost of debt), and, to a certain extent, it could affect the net worth of the population (more so in developed countries with a long stock market tradition), which negatively influences consumer behavior and the ability to maintain debt service – hence a potential increase in non-performing loans.
The dramatic rise of the cryptocurrencies exacerbates the risks to financial stability, as a possible bursting of the speculative bubble in this segment could spread rapidly in the capital market. The interconnections between the two have become increasingly important, fueled by both behavioral factors, as well as real economic flows (for example, significant portfolios of traditional financial assets held by issuers of stable coins).
The insufficiently regulated market for cryptocurrencies is already a danger due to the high level of volatility and the opacity of the mechanisms for retail investors. It is obvious that this market offered gains without economic justification, and the phenomenon of communication through social media amplifies the attractiveness of these instruments, appearing as real engines of immediate enrichment. Many investors in cryptocurrencies do not understand their underlying features and the risks they are exposed to. And most importantly, they confuse the economic and social utility of the underlying technologies with their economic value. While technologies are already proving their efficiency and applicability in many areas of the real economy and even in the financial sector (increasing the speed of transactions, reducing costs, increasing security, reducing human error, etc.), the assets themselves have, in most cases, only the ephemeral and subjective value resulting from the interaction of demand with market supply, without having the basis of future financial flows from real economic profits. Financial regulators are concerned about the risks posed by cryptocurrencies to consumers and potentially to the financial system as a whole, but the emergence of an appropriate supervisory framework is still in its infancy.
Prospects for increasing price volatility reappear on the horizon. The increase in the money supply in the developed economies as a result of central bank liquidity injections, the increase in pent-up demand and consumption immediately after the easing of restrictions (fueled by the release of precuationary savings made during the lockdown), and the positive fiscal impulse, corroborated with the rigidity of supply due to supply chain bottlenecks are elements that have a strong impact on prices in the economy.
Beyond the ample discussions on its persistence vs. transitory nature, on the estimates of the amplitude and duration, on the exogenous or endogenous structure and on the nature of the factors that generate it, the increase of prices in the economy is nevertheless an indisputable reality of the moment. Central banks in developed countries are likely to maintain a loose monetary policy in the coming period so as not to affect the post-pandemic economic recovery. In this respect, rising price volatility remains a negative factor for firms as it reduces predictability on future business developments and may constitute a brake on investments, even if their financing remains cheap (given the low level of real interest rates).
8.Global public debt is rising to a historic level. The high level of public debt is one of the most important constraints of government policies, after those on the level of revenues, the rigidity of expenditures, and administrative capacity. An increased public debt exposes the public budget to both interest rate risk and currency risk, in different manners, depending on the currency structure of the debt. In the context of the prospects of increasing real interest rates in the future (even if not immediately or in the short term), the growing burden of debt service could narrow the room for maneuver of fiscal policies, which limits the capacity for the intervention of governments to mitigate future crises or to alleviate structural deficiencies. At the same time, a rapidly growing debt service may require an increase in taxation, which is difficult to orchestrate without affecting the economy and the well-being of the population. In such a situation, other measures aimed to increase budget revenues should be targeted first, for example, the real improvement of the collection, the additional taxation of luxury goods, gambling, and unhealthy consumption habits – alcohol, tobacco, etc.
The transition to greater diversification and localization of global supply chains. Closure of borders and shipping delays due to the pandemic has disrupted the supply of goods and services to companies. We all noticed in the period following the initial pandemic shock how the globalization trend was temporarily diminished, leaving room for more localization of supply chains in response to rising costs and risks in cross-border trade relations, at least for certain categories of products of strategic importance. Economies are trying to stimulate local production to meet domestic demand, with fewer supply chain disruptions caused by the limited movement of goods and people. The results of recently published scientific studies investigating the potential gains from locating supply chains, aiming at reducing vulnerability to external shocks, have not yet reached a unanimous conclusion. It is clear that globalization has merit in terms of cost-effectiveness and price-quality competitiveness, but the harmful effects of cross-border syncopes seen during the onset of the pandemic were equally evident. As in many other situations, the middle way is probably the most appropriate. For the time being, it is a reality that producers tend to further diversify their supply chains by focusing on partners “closer to home” or other regional substitutes. Sometimes a higher cost is the price paid to reduce dependence on long-distance external suppliers. As well as increasing financial stability (by analogy) involves the cost of maintaining larger buffers of own funds and liquidity. For the economy as a whole, a greater degree of localization of supply networks is an opportunity but also a risk (of rising costs – indirectly of inflation – and reducing external competitiveness – thus deteriorating the trade balance). To avoid this risk and take advantage of the opportunity economies need imports and adoption of the newest technologies, digitalization, automation, expansion and improvement of freight infrastructure, greater labor mobility and a better level of workforce practical skills, etc. All these require a very good synchronization of public policies with the efforts of the business environment.
Carrying out the global vaccination campaign. Against the background of the COVID-19 pandemic, vaccines were developed at a record rate. As of 5 April 2021, there were already 13 approved vaccines, 291 ongoing studies, and approximately 104 vaccines candidate for market approvals. From the perspective of international policy coordination, the immediate challenge is how rich and poor countries can work together to increase and especially standardize vaccine coverage rates in as many countries as possible. The COVAX program (an international effort coordinated by the WHO to provide vaccines to poor nations) and the problems it currently faces show that such international coordination is possible, but also difficult.
Although the process of globalization is likely to have slowed down in 2020, the world’s economies remain seriously interconnected through trade, so it is generally difficult to imagine a significant long-term increase in the well-being of the population of an isolated country compared to what is happening globally, even in less developed or more distant countries. Most of the world’s economies are open economies for which the external environment is an important variable contributing to development. Therefore, the global vaccination effort and especially international solidarity are aspects that cannot be ignored and whose unfavorable evolution leaves room for significant exogenous risks.
Opportunities and options for recovery
Although Romania currently has one of the highest rates of economic growth and thus a rapid recovery of (nominal) output losses caused by the pandemic, this does not mean that the economy will be in better shape by the end of this year compared to the one before the onset of the health crisis. An important part of the growth comes against the background of the base effect and a large part of the pre-existing structural deficiencies have deepened. In this context, at least in terms of sustainability, we have not made much progress, and a possible new external shock would not find us in a better position. Therefore, it is still necessary not to lose sight of the need to seize the opportunities of the moment in order to increase the robustness of the economy.
From this perspective, the main opportunities for economic recovery are related to the necessary fiscal consolidation. In other words, we need to manage the public finances very well and find ways to increase the revenues to the state budget. The advancement of digitalization in many private sectors of the economy must be closely followed by the digitalization of tax administrations and customs control (the state must not waste the gain of operability and efficiency brought by digitalization in the private economy) in order to bring to light as much of the underground economy as possible. More digitalization in public companies and administration means less corruption, more resources for government programs, more respect for citizens and the private sector, more transparency. When looking for new sources of funding we may need to rethink the tax system for the gambling industry (broadening the tax base) or discourage (by taxation) the consumption of products that affect health.
At the European level, we have two major priorities for the allocation of development funds: the digital agenda and the green economy agenda. A new “Fit for 55” document has recently entered the public debate, which is a broad package of actions for deep restructuring taking into account ample goals of increasing renewable energy use and energy efficiency, as well as the creation of a new EU system for trading emission allowances for buildings and road transport.
The “Fit for 55” package aims to include the transport and construction sectors in the decarbonisation process. As the two sectors account for 22% and 35% of the EU’s carbon emissions respectively, decarbonising them is key to achieving climate goals. These two sectors are both extremely important for the Romanian economy. As we have seen, in our country the construction sector supported the economy during the peak period of the health crisis, but which is estimated to experience a slowdown and a reduction in the future contribution to GDP compared to 2020. Also, much has been written about the strategic importance of the transport sector, as well as about the geographical advantages it enjoys in Romania. Therefore, the “Fit for 55” package, if accompanied by stimulating financing sources, may be a new opportunity for Romania, for the sustainable development and transformation of the economy, at the end (hopefully!) of the pandemic crisis”.