What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
When the Covid-19 outbreak began, the major countries of Europe, North America, and East Asia pursued a similar combination of policies. These were to lock down economic activity in order to keep people apart and suppress the virus, and to use the tools of government to protect households and businesses from massive disruption. The latter was meant to be temporary and was predicated on the expectation that the lockdowns would successfully reduce the risk of the virus. Moreover, most countries set about creating a regime of testing and tracing so that, if the virus were to return, it could be quickly suppressed in a more targeted manner without having to lock down the economy again. These policies have largely succeeded in Asia and Europe, albeit with minor hiccups. In Western Europe, there is no significant return of the virus and, as lockdowns have been eased, economic activity has rebounded, strongly in some locations.
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Yet the United States appears to be an exception. Although fiscal and monetary policy was successful in protecting people and businesses, lockdowns in much of the country failed to stifle the virus. That could be because they were either too weak or lifted too early, and because large numbers of people did not wear face masks and did not engage in social distancing. The result was that despite massive fiscal expenditures, the virus continues to be a problem in the United States with the number of cases rising rapidly in recent weeks. Moreover, because of the renewed outbreak, economic activity is once again at risk, potentially requiring very large fiscal expenditure again.
Where do things stand now? In the United States, the number of infections, hospitalizations, and deaths continues to rise, especially in key hotspot states, such as Florida, Texas, and Arizona. For example, as of this writing the number of infections per capita in Florida exceeds the level reached in New York in April. In Miami, the number of infections per capita is about twice the level reached in New York City in April. The number of deaths per capita, while still far below the level reached in New York in April, is rising rapidly in hotspot states. In Arizona, this measure has doubled in just the last two weeks. Last week, the daily number of new infections exceeded 70,000 for the first time. The reproduction rate, known as R, is now above the critical level of 1.0 in all but five US states. This is the highest share of states so far. Keep in mind it is currently below 1.0 in Europe and much of East Asia. An R level of just 1.2 could lead to an exponential rise in the number of infections. That being said, no state currently has an R level comparable to what happened in New York early in the crisis. While no state has yet to return to a full lockdown, a debate is now under way as to whether state and local governments should impose more stringent restrictions in order to halt the virus. Some states, such as California, have moved in the direction of tighter restrictions. There is also debate about whether governments should require face masks.
The resurgence of the virus is evidently having a negative impact on economic activity, according to high-frequency data. In hotspot states, overall consumer spending peaked in mid-June and has gradually declined since. This has been especially true for spending on restaurants, hotels, and entertainment—all industries that employ large numbers of low-wage workers. In addition, small-business revenue peaked in hotspot states in mid-June and has fallen sharply since. In Arizona, for example, small-business revenue reached pre-crisis levels throughout May and early June but is currently about 14% below pre-crisis levels. Finally, the number of people passing through US airport security checkpoints peaked at the start of July and has not grown since. Thus, it appears that consumer-related economic activity in a significant portion of the United States is starting to either stagnate or decline.
What happens next? The path of the economy will likely depend on two factors: the path of the virus and the policy environment. For now, it appears likely that the virus situation will get worse before it gets better—at least based on what public health officials are saying. As for what will happen in the long term, there has lately been positive news from Oxford University regarding progress on creation of a vaccine. If a widely distributed and successful vaccine becomes available sometime next year, it will be a game changer and likely lead consumers to resume spending at normal levels. Meanwhile, so long as the virus remains a threat, and so long as it is not successfully suppressed, economic activity is expected to be suppressed.
Meanwhile, the policy environment could have a big impact. The enhanced unemployment insurance payments that have supplemented the income of unemployed workers are set to expire at the end of this month. Moreover, moratoria on evictions and forbearance on mortgages and student loans will soon expire. Thus, without new action by Congress, there will be a historically large fiscal contraction in August and, soon thereafter, a shift in the regulatory environment that could lead to increased financial stress for millions of households and their creditors. These factors could substantially intensify the economic downturn that is already likely to take place. Currently, there is debate in Washington about a new fiscal program. Senate Majority Leader McConnell says that no bill will pass without liability protection for businesses and other institutions. He also wants a cut in the capital gains tax. The White House has said it will oppose any bill that includes increased funding for testing and tracing. Democrats want to extend unemployment insurance and boost support for fiscally stressed state and local governments. Yet Republicans worry that excessively generous benefits will deter people from returning to work. Thus, there remain significant differences. In addition, even if the most generous bill is passed, it will only have a temporary impact if the virus is not brought under control. Consequently, any fiscal bill will potentially offer the country a second chance to get it right.
Meanwhile, in the most recent week there were 1.416 million new claims for unemployment insurance in the United States, more than in the week before. It was the first weekly increase since March. This suggests the possibility that, with the viral outbreak rising in much of the South and West, the US job market is starting to weaken. As the virus spreads, consumers are evidently taking precautions in where they go and what they do. This, in turn, is likely causing a decline in employment in consumer-facing industries, such as restaurants, retail stores, and hotels. Moreover, if the economy remains weak for a prolonged period, there could be disruption of other industries due to overall weak demand. That, in turn, could unleash a more traditional recession.
When Shinzo Abe became Japan’s prime minister for the second time in 2012, he launched an economic program that came to be known as “Abenomics” that included three “arrows.” These were monetary stimulus, fiscal stimulus, and structural reform. The first and second arrows were implemented, although the net impact on growth was modest at best. That might be because the third arrow never really got off the ground. However, according to a new study by the Peterson Institute, the Covid-19 crisis might wind up creating the structural reforms that have so far been missing.
The term structural reform was meant to encompass changes to rules and regulations that could liberalize domestic and external markets as well as encourage productivity-enhancing investment. Despite having some of the world’s most productive and iconic companies, Japan has long suffered from inefficiency in domestic markets and weak adaptation of new technologies. The coronavirus crisis has begun to change some of that. There are two reasons for this.
First, the threat of the virus has led many individuals and businesses to change behavior in ways that will likely boost productivity. This includes more use of information technology for human interaction, including working from home, shopping from home, and using digital technology to undertake transactions.
Second, the Japanese government, like many other governments, has responded to the crisis with a massive increase in spending meant to assist troubled households and businesses. And within that extra expenditure are programs that will likely boost productivity. These include spending to increase digital health care services, boost digitization of government services, and invest in the implementation of fiber optic networks. The digitization of government services has included a requirement that, in order to obtain cash transfer payments, individuals must use new digital personal identification cards. In so doing, it is likely that the government will spur greater use of digital spending as opposed to the use of cash. Japanese consumers have been the last holdouts in developed countries in switching from cash to non-cash transactions. Yet sanitary considerations are likely causing many people to switch to digital transactions, so they do not have to handle cash.
In addition, there have been changes in government regulations meant to smooth the transition toward a more digital world. These include the lifting of restrictions on online medical services. Also, the government increased the subsidy available to individuals who work from home. The government is also providing small- and medium-sized companies with financial incentives to invest in equipment for home working. The shift toward teleworking could be especially helpful in boosting female participation in the labor force, especially when it concerns women who have small children.
Overall, these shifts will likely boost the growth of productivity, thereby enabling faster economic growth. They will also help Japan to address the growing labor shortage that stems from a low birth rate and the resulting decline in the working age population. It appears that the Covid-19 crisis might accelerate the transition to a digital world that will enable businesses in multiple industries to become more efficient. It is nice to see a silver lining coming from this crisis.
After a prolonged period of fraught debate, the European Union (EU) has reached an agreement to borrow massively in order to provide support to member states. The landmark agreement, which required unanimous approval of the 27 member states of the EU, did not go as far as supporters had hoped, but it is nonetheless an important milestone in that it sets a new precedent for EU action. Here is what happened.
The EU agreed on a EUR750 billion stimulus meant to support economic recovery in member states. What is unique is that the EU itself, rather than individual members, will directly issue bonds to fund the stimulus. Never before has the EU borrowed more than a pittance. Moreover, the money raised will be used to provide direct grants of 390 billion euros to member states, with the remainder being provided in loans. The original proposal from Germany and France called for EUR500 billion in grants, so this represents a considerable downgrading of that plan. As of yesterday, supporters of the fund called for EUR400 billion in grants while the so-called “frugal four” countries (the Netherlands, Sweden, Denmark, and Austria) called for EUR350 billion. Thus, the EUR390 billion figure shows that the compromise involved a greater concession on the part of the frugal four. In any event, French President Macron said this is a “historic day for Europe” and European equity prices increased on news of the deal. There will be an increase in the supply of high-rated sovereign debt, possibly boosting yields. If the issuance of euro-denominated bonds by the EU becomes a trend, it could boost the global role of the euro.
In order to obtain support from the frugal four, the other member states agreed to provide them with bigger rebates from their EU budget contributions. The EU also agreed that some of the money will be earmarked for research and health, both priorities of the frugal four. Still, most of the money will go to a general recovery fund. The allocation of funds by country will be determined by the economic harm stemming from the coronavirus pandemic. The debt incurred will be financed out of future EU budgets, with the goal of fully paying off the debt by 2058. Although there had been discussion about tying the fund to future EU-wide taxes on pollutants and on digital transactions, nothing was done in this regard. As such, it is possible that the new fund will likely lead to some suppression of other spending priorities in the EU in the years ahead.
What is clear, however, is that Europe has crossed the Rubicon. This new deal is, by far, the biggest unified fiscal action undertaken by the EU. When the EU acted during its debt crisis nearly a decade ago, it mostly involved a shift in monetary policy and an agreement to jointly fund action meant to help troubled members. This time is different in that the EU itself is acting directly. As such, it is a step in the direction of fiscal integration, although the process of getting to this point (a 20-hour marathon negotiation) was ugly and contentious. It revealed deep disagreements along regional lines, raising questions as to whether this will be a new trend or a breaking point for Europe. As Bismarck once remarked, “If you like laws and sausages, you should never watch either one being made.”
The latest purchasing managers’ indices (PMIs) for July from IHS Markit indicate that the Eurozone and UK economies are roaring back, the US economy is just barely staying above water, and the Japanese economy continues to decline. Thus, the developed world remains a mixed bag in terms of recovery. The PMIs are forward-looking indicators meant to signal the direction of activity in the broad manufacturing and services sectors. They are based on sub-indices, such as output, new orders, export orders, employment, pricing, inventories, orders, and sentiment. A reading above 50 indicates growing activity. The higher the number, the faster the growth—and vice versa. Here are the details from Markit’s latest flash estimate.
The PMIs for the Eurozone indicate strong growth in July. The PMI for services increased from 48.3 in June to 55.1 in July, a level indicating strong growth. The separate PMI for manufacturing increased from 47.4 in June to 51.1 in July, a level indicating modest growth. The composite index increased from 48.5 in June to 54.8 in July. The latter indicates that the overall economy is strengthening. Markit commented that output grew “at the fastest rate for just over two years in July as lockdowns continued to ease and economies reopened.” However, Markit warned that weak backlogs of work and stagnant employment pose a risk to the recovery. Markit commented, “Firms continue to reduce headcounts to a worrying degree, with many worried that underlying demand is insufficient to sustain the recent improvement in output. Demand needs to continue to recover in coming months, but the fear is that increased unemployment and damaged balance sheets, plus the need for ongoing social distancing, are likely to hamper the recovery.” Thus, although the Eurozone economy is starting the third quarter on a very positive note, risks remain.
Meanwhile, the British economy also had much-improved PMIs. The services PMI increased from 47.1 in June to 56.6 in July, a five-year high. The manufacturing PMI increased from 50.1 in June to 53.6 in July. This strong growth comes after an especially sharp decline in activity in the second quarter. Markit suggested that the strong rebound was related to pent-up demand. However, it commented on weak new orders and a continued decline in employment, thus boding poorly for continue strength of spending. Moreover, Markit commented that “the recovery could be smothered by a lack of post-Brexit trade deals.”
For the United States, the services PMI increased from 47.9 in June to 49.6 in July, a level indicating that activity continued to decline modestly. The separate manufacturing PMI increased from 49.8 in June to 51.3 in July, indicating modest growth. The composite PMI increased from 47.9 in June to 50.0 in July, indicating no change from the previous month. The weakness of services is especially worrisome and likely reflects the impact of the current wave of the virus. New orders for services were down. Markit commented that “many companies, notably in consumer-facing areas of the service sector, linked falling sales to re-imposed lockdowns.” Markit also noted that firms’ costs have skyrocketed recently, “in part due to the additional burdens of safeguarding against the coronavirus,” thereby creating downward pressure on profitability. On the positive side, Markit reported that business confidence improved. Overall, the report signaled that, as the third quarter began, the US economy was barely growing.
Finally, the PMIs for Japan remained disappointing. The services PMI was nearly unchanged, moving from 45.0 in June to 45.2 in July, a level indicating a continued sharp decline in activity. The manufacturing output index increased from 32.3 in June to 41.2 in July, a level indicating a sharp decline in output. The composite index for July was 43.9, indicating that economic activity was declining as the third quarter began. Markit noted that “subdued global trade flows and restrictions on travel” contributed to the downturn by dampening new orders and export orders. In addition, employment continued to fall and business sentiment remained pessimistic. Then again, the government has eased economic restrictions, which could have a positive impact on domestic demand.
China’s economy grew strongly in the second quarter—after having fallen at the fastest pace on record in the first quarter, real GDP grew at the fastest pace on record in the second quarter. Specifically, real GDP was up 11.5% from the first quarter, which translates to an annualized rate of 54.6%. It was up 3.2% from a year earlier. China is the only major economy to experience strong growth in the second quarter. It is the first economy to be hit by the virus and the first to begin to recover. Most other large economies will see significant growth in the third quarter. We expect most of them will have declined sharply in the second quarter. However, despite the positive numbers for China, investors reacted negatively, driving Chinese equity prices down sharply today. Why? It appears that the economy’s strength derives from strong growth of the industrial sector, largely driven by government investment in infrastructure as well as a strengthening of exports. Yet consumer spending appeared to remain weak, with retail sales declining. Evidently, many consumers remain wary of social interaction given that the virus has not gone away. Moreover, many investors are likely concerned about a variety of risks, including the increasingly fraught relationship between the United States and China, the risk of more US sanctions and trade restrictions, and increasing tension between China and the European Union (EU).
For the third consecutive month, Chinese industrial production was up from a year earlier. In June, industrial production was up 4.8% from a year earlier, the best performance since December. Output in the manufacturing sector was up 5.1%. By industry, output was up 13.4% for automotive, up 12.6% for computers and electronics, and up 8.7% for electrical machinery. Meanwhile, Chinese retail sales were down 1.8% in June versus a year earlier. This was the sixth consecutive month of declining sales, but the best performance since December. It was a mixed picture, with spending up strongly for some categories, but down for others. Spending was up 20.5% for cosmetics, 16.9% for personal care products, 18.8% for telecoms equipment, and 9.8% for home appliances. It was down 0.1% for apparel, 6.8% for jewelry, 8.2% for automobiles, and 1.4% for furniture. Consumers tended to avoid locations that require social interaction, including stores, restaurants, and cinemas. Online shopping was strong and is now a much larger share of retail spending in China than in the United States and Europe.
Despite increasing tensions between the United States and China, US companies continue to demonstrate interest in China. Specifically, foreign direct investment (FDI) by US companies into China increased 6.0% in the first half of 2020 versus a year earlier. This took place even as overall inbound FDI into China fell 1.3%. The Chinese government has attempted to attract US companies even as the US government has imposed sanctions related to Chinese actions in Hong Kong. President Xi Jinping, in a letter to global business leaders, noted, “China will provide a better business environment for Chinese and foreign enterprises to help them explore new opportunities and new prospects. You have made the correct choice of putting down your business roots in China.” Xi’s comments come at a time when some companies are seeking to diversify away from China. Even before the crisis, there were indications that some global companies were becoming wary of dependence on China. To offset this, the Chinese government eased restrictions on inbound foreign investment. Still, a recent survey found that 95% of 200 US companies that were polled indicated an intention to become less dependent on Chinese suppliers. Interestingly, the same survey data revealed that less than half of European companies polled expressed a similar intention. Evidently, the main focus on companies is the US-China relationship and not China’s relationship with Europe.
Meanwhile, the Chinese government is especially concerned about a potential exodus of Japanese companies from China. As part of its emergency increase in spending meant to offset the negative impact of the crisis, the Japanese government included a provision whereby Japanese companies can obtain government assistance to make their supply chains more resilient. Specifically, they can obtain help to move facilities out of China, either back to Japan or to other countries. The Japanese government announced the first batch of companies to get such subsidies. Most will use the money to move facilities from China to Japan, while some will shift to ASEAN. At a recent event, Japanese Prime Minister Abe said, “Due to the coronavirus, fewer products are coming from China to Japan. People are worried about our supply chains. We should try to relocate high added value items to Japan. And for everything else, we should diversify to countries like those in ASEAN.” Larry Kudlow, the Director of the US government’s National Economic Council, said that the US government should consider absorbing the cost of having US companies shift facilities from China to the United States.
There are several things happening. First, the shock that came when Chinese supply chains were disrupted during China’s lockdown in February has led to concerns about resiliency, redundancy, and diversity of supply chains. Second, the increasing tension between China and the United States is likely causing some companies and governments to become averse to dependency on China. Finally, in both the United States and Japan, there is an increase in protectionist sentiment, with a view that countries will benefit by being less dependent on trade and cross-border investment flows. The last trend, in my view, is worrisome. Consumers around the world have seen their purchasing power increase considerably because of growing trade and the optimization of supply chains. A move away from that trend will likely reduce spending power and will not necessarily boost employment.
In the first six months of this year, Southeast Asia became the biggest trading partner with China, surpassing the EU. China’s trade with the rest of the world has been rising recently, but the increase has varied by region. Specifically, Chinese trade with the EU fell 5% in the first half of 2020 versus a year earlier, and Chinese trade with the United States fell 10%. Meanwhile, Chinese trade with Southeast Asia increased considerably. Why? It appears that Chinese manufacturers are shifting some production to Southeast Asia, in order to both reduce costs and avoid US tariffs. Thus, there is more movement of components between China and Southeast Asia. In addition, increased trade with Southeast Asia gives Chinese producers access to technologies that, increasingly, the United States is making difficult to obtain. Singapore, for example, is a prime supplier of high value-added components, such as semiconductors, while Vietnam is helpful in providing low-wage production.
The increased trade between China and Southeast Asia has also entailed direct foreign investment in Southeast Asia by Chinese companies, although such investment has lately decelerated during the coronavirus crisis. Finally, to facilitate greater trade and cross-border investment, China and ASEAN signed a trade deal late last year that reduced trade barriers and intensified an existing free trade agreement. In addition, China is utilizing its Belt and Road Initiative to enhance the relationship. This has involved loans to and investments in ASEAN countries. From a geopolitical perspective, this puts Southeast Asian nations in an awkward position. They are mostly dependent on China for economic success, but dependent on the United States for protection from Chinese aggression.
The US housing market is showing considerable signs of strength even as some other parts of the economy remain suppressed. The government reported that, in June, housing starts jumped to a level close to pre-crisis levels. Specifically, housing starts were up 17.3% from May to June and were only 4.0% below the level from a year earlier. The monthly increase was strongest in the Northeast, with starts up 114.3%. Starts were weakest on the West Coast, down 7.5%. And in the Midwest and South, the increase was moderate. This news comes as the National Association of Home Builders (NAHB) reports that builder confidence has returned to pre-crisis levels. The high degree of confidence reflects the factors that are driving demand. The most important factor is the low cost of obtaining a mortgage. Indeed, the average interest rate on a 30-year fixed rate mortgage fell to under 3.0% last week for the first time ever. That, in turn, reflects the massive asset purchases undertaken by the Federal Reserve. The Fed has purchased mortgage backed securities that are issued by Fannie Mae and Freddie Mac.
Some analysts say that the average rate would have fallen even more if not for heavy demand for mortgage refinancing. Moreover, lenders are reluctant to provide mortgages to those with less than stellar credit because they worry that such borrowers will seek forbearance, something that is currently available under the CARES Act. In fact, the delinquency rate on mortgages, including those in forbearance, hit a record high in April. Thus, it is mainly credit-worthy, higher-income, employed households that are buying homes. This is a cohort that has not been substantially disrupted by the crisis. In fact, there is anecdotal evidence that many professionals who are currently working from home, and who expect to continue working from home even after the crisis abates, are moving to larger homes with better home offices. This, in part, explains strong demand.
Michael Wolf, a global economist with Deloitte Touché Tohmatsu Limited, writes about the impact of the pandemic on remittance payments to emerging countries.
Emerging market economies are facing numerous pandemic-related challenges this year, including weak global demand, a pullback in foreign direct investment, and portfolio outflows. An additional challenge is falling remittances, the funds that foreign workers send home. Remittances to low- and middle-income countries amounted to US$554 billion last year, and the World Bank expects them to drop by 20% this year due to the pandemic. These funds can be critically important in some of the world’s poorest countries, such as Haiti and South Sudan, where they account for more than a third of annual income. Even larger emerging markets, such as Ukraine and the Philippines, derive a relatively large portion of their income through remittances.
There are several reasons for this crucial source of income for low- and middle-income countries coming under pressure. The first is that nearly the entire world is mired in recession and facing steep increases in unemployment, which has reduced incomes for foreign workers. Typically, when recipient countries are in economic trouble, more remittances are sent their way. Unfortunately, the global nature of the current crisis is preventing flows from being countercyclical this time around. In addition, countries around the world are restricting the movement of people and the functioning of some businesses to limit the spread of the virus. These sensible health policies inhibit some migrant workers from getting to their place of work or returning home with their earnings. Plus, money transfer businesses are closed in some parts of the world as they’re not deemed essential services there.
The transaction cost for transferring remittances back home is relatively high at 6.8% on average. For sub-Saharan Africa it is closer to 9%. Research suggests that when these transfer costs rise, migrant workers hold off on sending funds home or use informal channels, such as in-person couriers. The restrictions on movement of people have removed many of the informal channels, forcing migrant workers to pay the higher fees or hold off on sending money altogether. Transaction costs typically rise with exchange rate volatility. Although exchange-rate volatility in emerging markets has come down from its highs in March, risks of a resurgence remain elevated. For example, uncertainty over the US outlook amid rising contagion could have serious implications for foreign exchange markets. Plus, a growing share of emerging markets are at a high risk of debt default, which could add to volatility. Nuances in the recipient country can also raise the cost of remittances. Countries with higher shares of unbanked populations typically face higher transaction costs for remittances. Unbanked populations are prevalent among the world’s poorest countries, but some medium-sized economies, such as Egypt, Pakistan, and Vietnam, also struggle with access to financial services. Recipients in high-inflation countries often prefer remittances in goods rather than currency to preserve the value of the transfer. Such goods transfers frequently occurred in person, but given restrictions on movement, some of these transactions are impossible, dangerous, or considerably more expensive.
The largest sources of remittances are the United States and oil-exporting countries, which are dealing with their own unique issues during the pandemic. The infection rate is rising again in the United States, which is likely to result in worsening economic outcomes and therefore less money available for remittances. The particularly restrictive US immigration policies implemented recently may also deter migrant workers even after the pandemic is over. Recipient countries in Latin America and East Asia have the most exposure to remittance flows from the United States. Oil exporters have cut back production amid low crude prices, and some are also struggling to contain the spread of the virus. Recipient countries in the Middle East, Africa, and South Asia are most exposed to flows from oil exporters.
In January, the US-China trade dispute was effectively put on hold when the two sides agreed on a sort of truce. It involved a commitment by China to significantly boost imports of specific goods from the United States. In exchange, the United States agreed to cut some tariffs and forego others. While the import targets were aggressive and not necessarily achievable, the deal at least bought both sides some time. For China, it provided a reprieve from the tariff war. For the United States, the deal was likely to please investors and possibly boost business investment—and both were helpful to the US administration in an election year. Then the COVID19 crisis came along, and it quickly became apparent that the import targets were not likely to be met. As of May, Chinese imports were far below the level needed to achieve the targets. This reflected the sharp decline in Chinese aggregate demand that took place when the government imposed economic restrictions in order to compel social distancing. Moreover, among the targets is a dollar value of energy imports. Yet energy prices have fallen precipitously, meaning that China must boost the volume of energy imports even more than previously anticipated in order to meet the dollar target. Instead, the volume of energy purchased has been much lower than anticipated, largely due to weak demand. Thus, China’s purchase of US energy products has been less than 20% of what was planned.
Meanwhile, the US administration has signaled that it expects China to meet its targets, regardless of the COVID-19 crisis. The deal allows the United States to implement significant tariff increases by the end of the year if the targets are not met. From China’s perspective, there is not much it can do to avoid a deterioration of trade conditions. Even if the current US administration is not re-elected, the next administration would likely face pressure to be tough with China in early 2021. Thus, it might be the case that China’s leadership foresees no upside potential for trade relations with the United States. Indeed, the focus of Chinese economic policy during the crisis has been to boost domestic demand, further lessening the country’s dependence on exports. From a geopolitical perspective, China has been willing to engage in actions to which the United States objects, knowing that there is likely not much more the United States can do that has not already been done. If the United States were to boost tariffs even more than threatened, it would likely hurt its own economy, not just China’s.
However, the one thing the United States could do that would be detrimental to China’s economy would be to weaponize the US dollar, something it has already done with some other countries, such as Russia and Iran. In the case of Iran, the United States has imposed sanctions on businesses that trade with Iran using US dollars. The United States can do this because of the dominance of US dollar-based trading in world markets. It is feared that, because of China’s enactment of a new national security law for Hong Kong, the United States could decide to do something similar with respect to China, although it does seem unlikely. Nevertheless, there are growing calls within China for a decoupling from the US dollar. That is, it is hoped that China could boost the global role of the renminbi and, therefore, reduce dependence on the dollar as well as remove the potential impact of US sanctions. Another reason to do this is that China is likely to generate external deficits in the coming decade and might prefer to fund these deficits with its own currency rather than having to borrow in another currency, such as the US dollar. However, to boost the role of the renminbi, China would have to allow greater transparency of its financial system and make the renminbi fully convertible. There remain political obstacles to doing this and doing so would likely take an extended period of time. And, if it happens, it could have significant implications for the United States. After all, the United States has long been able to run large external deficits knowing that they can be funded in US dollars. This has helped to elevate the value of the dollar and suppress US bond yields. If the dominant role of the US dollar is undermined, the United States would likely face either a weaker currency and/or higher bond yields. In addition, if the US dollar is weakened, the euro could emerge as a more important currency in global markets, especially if the European Union (EU) follows through on its plan to issue EU bonds to support member countries. China’s central bank could potentially be a major purchaser of such bonds as part of a shift away from massive holdings of US dollar-denominated bonds.
Although China is increasingly likely to take its own path, it nevertheless is not eager to see the relationship with the United States deteriorate. Foreign Minister Wang Yi recently said, “What is alarming is that the China-US relationship is one of the most important in the world and it is facing its most serious challenge since diplomatic relations were established…. China has never had the intention of challenging or replacing the US and has no intention of entering into total confrontation with the US.”
Meanwhile, although the COVID-19 crisis has hurt both China and the United States economically, the relative success of China in quickly suppressing the virus and renewing the economy has likely boosted China’s geopolitical footprint. China has offered itself as a model for how an emerging economy can grow rapidly, which is being seen as an alternative to the Anglo-American model of market-driven capitalism. At a time when both the United States and United Kingdom appear to be struggling to get the virus under control, China’s quick return to relatively strong economic growth may give it greater credibility in the global arena.
China’s government has approved a plan to boost the role of state-owned enterprises (SOEs) in the economy. Earlier in this century, the Chinese government appeared to be moving away from dependence on the state sector, with the goal of creating an even playing field for both state-owned and private sector businesses. In recent years, however, the government has made life easier for SOEs, by assuring them preferred access to credit, land, and other resources. Its trading partners in Europe and North America have complained that SOEs are given an unfair advantage that violates the rules of the World Trade Organization. Thus, China’s latest decision will not be warmly welcomed in Brussels or Washington. More importantly, it raises questions about the future path of the Chinese economy. Research has shown that SOEs tend to be less efficient than private companies and that investment in SOEs generates a weaker return. Still, President Xi Jinping said, “We will improve their economic competitiveness, innovation capabilities, their ability to control the economy, their influence as well as their capability for control of and resistance to risks.” Another senior official said that SOEs will play a role in technological innovation.
Technological innovation usually arises from small and lean private sector entrepreneurial businesses. In the past two decades, the Chinese government has attempted to have it both ways, by attracting private capital to be invested in SOEs, but the result has not been promising. At the same time, there are significant obstacles to creating a level playing field or privatizing SOEs. First, such action would likely result in significant unemployment if inefficient businesses are downsized or closed entirely. Many large SOEs are the only major employers in some large cities. Second, political control of the economy might be undermined if the private sector is permitted to dominate the economy. Finally, reducing the role of SOEs would be hugely disruptive and costly. There are 130,000 SOEs in China, mostly controlled by local governments. There are 97 large SOEs controlled by the central government and they employ a high number of workers. Meanwhile, the announcement that SOEs will retain their dominant role in the economy likely means that economic growth will be slower than otherwise.
The Eurozone is in the midst of a strong recovery fueled by consumer spending. The EU reports that retail sales rebounded strongly in May, growing at the fastest pace on record and hitting a level only slightly lower than a year earlier. Recall that it was in May that European governments began to lift economic restrictions following successful suppression of the virus. Specifically, retail sales in the Eurozone were up 17.8% in May versus the previous month, following a decline of 10.6% in March and 12.1% in April. The result was that, in May, sales were 5.1% below a year earlier. The biggest increase was in textiles, clothing, and footwear with sales up 147% from April to May but still down 50.5% from a year earlier. Sales gains were also strong for furniture and electric goods (up 37.9% for the month, but down 14.3% from a year earlier) and computer equipment (up 26.8% for the month but down 26.6% from a year earlier). Non-store retailing continued to gain market share, with sales rising 7.0% from the previous month and up 31.2% from a year earlier.
By country, sales growth from April to May was 13.9% in Germany, 25.6% in France, 18.0% in Spain, and 8.9% in the Netherlands. Sales in Germany and the Netherlands were higher than a year earlier while sales in France and Spain remained well below year ago levels. The strength of consumer engagement in Europe is helping to offset weaker growth of the industrial sector. Europe is being hurt by weak global demand for its exports and weak business investment. For example, Germany reports that factory orders, after having fallen 15% in March and 26.2% in April, increased only 10.4% in May. This means that, for German manufacturers, the worst is behind them, but the recovery is relatively muted. Meanwhile, the strong consumer numbers bode well for third-quarter economic growth.
Finally, the improvement in consumer spending might, in part, reflect pent-up demand following lockdowns as well as a decision by households to dramatically boost saving in the first quarter when the virus first reared its ugly head. The EU reports that, in the Eurozone, the personal savings rate increased from 12.7% in the fourth quarter of 2019 to 16.9% in the first quarter of 2020. This was due to a small increase in income combined with a sharp decline in spending. The dramatic shift most likely took place in March, when governments introduced measures to enforce social distancing.
IHS Markit released its final purchasing managers’ indices (PMIs) for services in multiple countries. Around the world, the services industry has taken a massive hit owing to government lockdowns as well as voluntary consumer decisions to avoid businesses that entail social interaction. Services encompasses finance, retail, wholesale, transportation, tourism, hospitality, professional services, telecoms, healthcare, and education. PMIs are forward-looking indicators meant to signal the direction of activity in the broad services environment. They are based on sub-indices, such as output, orders, export orders, employment, pricing, pipelines, and sentiment. A reading below 50 means declining activity; the lower the number, the faster the decline. The global services PMI increased from 35.1 in May to 48.0 in June, after having declined very sharply in the previous month. The worst sub-index was export orders, signaling that global trade in services remains muted. The best sub-index was sentiment about the future, which was up strongly, indicating that service businesses are optimistic.
By country, the services PMI for the United States rebounded sharply from 37.5 in May to 47.9 in June, indicating declining activity at a much slower pace than previously. IHS Markit commented that the rebound bodes well for a return to economic growth in the third quarter. It noted that “financial services and technology companies are now reporting improved demand, as are many consumer-facing companies. Many, however, remain constrained by social distancing measures.” Ominously, it warned that “there remains a strong possibility that growth could tail off after the initial rebound due to weak demand and persistent virus containment measures. The potential need to reintroduce lockdowns to fight off second waves of coronavirus infections will pose a particular threat to recovery momentum and could drive a return of the recession.”
For the Eurozone, the services PMI increased from 30.5 in May to 48.3 in June, signaling a near return to growth in activity. This was the best services PMI since February. Still, it means that activity continues to fall from an already low level. Markit reported that profit margins for services businesses are under pressure due to weak demand, and noted that many companies “remained risk averse, being reticent to commit to spending and hiring due to persistent uncertainty as to the economic outlook, and in particular the likely sustained weakness of demand for many goods and services due to the need to retain many social distancing measures.”
In Asia, the services PMI for India remained very suppressed. The PMI increased from 12.6 in May to 33.7 in June, a huge increase but still at a level indicating a continued sharp decline in activity. Markit said that India is “gripped in an unprecedented downturn.” It noted that “"some companies have seen activity stabilize, but this is most likely just reflecting closures and temporary suspensions. While this will have contributed to a rise in the PMI figures, this certainly isn't a promising sign.” In contrast, China saw strong growth of services activity for the second consecutive month. The PMI increased from 55.0 in May to 58.4 in June, indicating rapid growth of services. Markit said that both “supply and domestic and overseas demand recovered.” Markit attributed the stunning improvement to success in suppressing the virus. It noted that there have been intermittent and geographically isolated outbreaks, but that these have been successfully squelched.
Finally, Japan’s services PMI followed a pattern similar to that of Europe and the United States. The PMI increased from 26.5 in May to 45.0 in June, indicated decline at a much slower pace. Markit commented that “the state of emergency ending has improved social mobility and encouraged a slow resumption in economic activity. However, growth hasn't come roaring back and a further sub-50.0 reading suggests the downturn is only easing, not ending. We have to remember that Japan's economy was already in a recession before the second quarter and 2020 was set to be economically challenging, notwithstanding the huge COVID-19 shock.”
One could take the perspective that the decline in economic activity in recent months was principally the result of government-imposed lockdowns. The view is that once businesses reopen, consumers will quickly return to stores, restaurants, bars, movie theatres, bowling alleys, and airplanes. But the data suggests otherwise. A new study by economists at the University of Chicago found that only 7% of the change in consumer mobility in the United States in recent months can be explained by lockdowns. The rest is due to consumer aversion to social interaction because of the virus. In other words, most people would avoid restaurants and theatres even if they were open. Using high-frequency mobility data, the researchers compared the experiences of consumers in locations with severe lockdowns to those in locations with no or limited lockdowns. They found there wasn’t a big difference between the two.
Indeed, one can examine the recent history of consumer spending by state at www.tracktherecovery.org and note how similar the trend is among states that have followed very different policies. This suggests two things: first, the lockdowns alone are not the primary reason for the sharp decline in economic activity in April and May. Second, easing economic restrictions alone will not be enough to significantly boost economic activity. In fact, the only way to bring activity back to pre-crisis levels is to convince consumers that the virus is no longer a risk. This, in turn, will require a vaccine or a treatment.
>Viral outbreak worsens in the United States, potentially causing economic trouble
For some time now, Deloitte’s baseline forecast has been that there will be moderate positive growth of the US economy in the third quarter, largely due to the reopening of economic activity that took place in May and June. We did see a moderate but significant rise in consumer spending and mobility since the economy bottomed in March, although growth appeared to subside by late May. Last week marked the first day of the third quarter and there are already indications that in some sectors of the economy, activity is starting to decline. This is likely because there has been a severe outbreak of the virus in about half of the US states. The number of new cases is increasing rapidly. In many major cities, hospitals are becoming overloaded. Dr. Anthony Fauci, the lead infectious disease specialist of the US government, said, “I am very concerned because it could get very bad.” He noted, “What has happened, I guess understandably, but nonetheless regrettably, is that people took the attitude in some places of either all or none. Either you’re locked down, or you just let it fly and you just ignore many of the guidelines.” And US Health Secretary Alex Azar said, “The window is closing, we have to act, and people as individuals have to act responsibly. We need to social distance. We need to wear our face coverings if we’re in settings where we can’t social distance, particularly in these hot zones.”
In some US states, reopening orders are being reversed. In others, the process of reopening is being halted. In Florida, the Mayor of Miami-Dade County said that Miami’s beaches would be closed for the July 4 holiday weekend. In Texas and Florida, access to bars is being restricted. In California, indoor restaurant dining is being restricted. In fact, the states that are renewing restrictions account for about 40% of the US population. Even in New York, where the virus was brought under control as early as May, the state is postponing the easing of restrictions on indoor dining. It will also restrict visits from 14 US states where the outbreak is worsening. On the Memorial Day weekend in late May, large numbers of people visited beaches, bars, and parties without masks and social distancing.
Some authorities believe that the current wave is, in part, related to these events. Consequently, the goal of policy now is to avoid a repetition of the outbreak. The latest actions by state governments, meant to contain the spread of the virus, are likely to curtail economic activities that involve human-to-human contact. Moreover, there is evidence that people are choosing to engage in social distancing even in the absence of government orders. High-frequency data on restaurant visits indicate that in states currently experiencing severe outbreaks, the number of visits has declined in the last two weeks after having increased substantially in previous weeks. Mobility data that tracks the amount of time spent at retail and recreation venues indicate there has been a decline lately in Florida and Texas.
If, in the coming weeks, the outbreak worsens further (as expected by public health officials), lockdowns are renewed, and more people choose to stay home, then it’s possible that economic activity in the third quarter will either grow more slowly than we expected or not grow at all. One unknown factor is whether the Congress will extend the enhanced unemployment insurance payments that are set to expire at the end of this month. If this program is not sustained beyond July, there will be a sharp decline in consumer income in August, which will likely have a negative impact on consumer spending. It could also lead to an increase in consumer defaults and bankruptcies, thereby potentially creating financial market stress.
During the crisis, things have changed so quickly that economic data published by governments is often a mere snapshot of recent history rather than an indicator of where we are or where we are headed. That is certainly the case with the jobs report published last week by the US government. It shows in June, there was strong job growth and a decline in the unemployment rate. But the survey on which this data is based was completed in the first half of June. Meanwhile, events changed quickly in the second half of June—the viral outbreak worsened significantly, leading state governments to reverse the easing of economic restrictions and consumers to become more cautious about social interaction. Notably, a significantly large share of the jobs gained in June were in leisure and hospitality apart from retailing. These are the kinds of jobs that are likely to be negatively affected by recent decisions taken by state governments. As such, the latest jobs report must be taken with a grain of salt.
The US government publishes two reports: one based on a survey of establishments and the other based on a survey of households. Let’s consider both.
The establishment survey found that 4.8 million jobs were added in June. This follows an increase of 2.7 million jobs in May and a decrease of 20.8 million in April. Meanwhile, employment remains nearly 13 million jobs lower than a year earlier. Much of the June increase in employment was related to industries that reopened as state governments attempted to revive economic activity. Employment increased by 2.1 million in the leisure and hospitality sector and 740,000 in retailing. In addition, manufacturing jobs increased by 356,000 and health care jobs increased by 475,000. The manufacturing gain was largely due to a 196,000 increase in automotive employment, driven by pent-up demand for cars. The health care gain was driven by reopening of offices belonging to doctors and dentists. Average hourly earnings were up 5% from a year earlier. This was a smaller gain than in May, reflective of the fact that many low-wage earners returned to work in June.
The survey of households found that 1.7 million people re-entered the labor force, either by working or by seeking work. The participation rate increased by 0.7 percentage points—a very big rise. Moreover, because employment increased so much more than the growth of the labor force, the unemployment rate fell sharply—from 13.3% in May to 11.1% in June; keep in mind, however, that the figure was 3.7% a year ago. Also, because so many of the jobs created were in restaurants or retail stores, it is not surprising that the unemployment rate among teenagers (16 to 19 years old) fell from 29.9% in May to 23.2% in June—a decline of 6.7 percentage points.
The problem with drawing conclusions from this report is that the circumstances changed quickly after the survey was conducted. The viral outbreak worsened considerably in the last half of June and early July and many state governments have recently taken steps to reimpose restrictions on economic activity—especially by placing limits on restaurants and bars. In addition, high-frequency mobility data indicates that consumers are already spending less time at stores and restaurants. Assuming that the locking down of the economy continues for the next few weeks and that consumers further avoid locations that involve social interaction, it seems likely that many of the jobs gained in June will be lost in July.
One way to judge the recent situation is to examine weekly initial claims for unemployment insurance. In the most recent week, there were 1.427 million initial claims for unemployment insurance, a small decline from the previous week’s 1.482 million. Since March 21, 48.7 million people have filed claims for unemployment insurance. In addition, the number of people continuing to collect unemployment insurance increased slightly from the previous week. This suggests the jobs market started to face headwinds as the end of June neared. Financial markets were pleased that job growth in June exceeded market expectations. However, many investors are likely wary of another revival of the outbreak. As such, equity prices rose only modestly on news of the jobs report. Going forward, if enhanced unemployment insurance payments—which are set to expire at the end of this month—are not extended, there could be a sharp drop in personal income in August. This could have negative effects on consumer spending and, consequently, on employment.
The Federal Reserve has taken extraordinary measures meant to assure that credit markets stay open and available amid the viral outbreak. At the beginning of the crisis, indicators of financial stress started to rise, leading the Fed to act quickly. It cut interest rates, bought assets on a massive scale, and loaned money to inject liquidity into the economy. These actions were successful in that measures of financial market stress quickly improved. A potential seizing up of credit markets was averted.
However, one Fed leader is worried that the financial system is not yet out of the woods. James Bullard, the president of the Federal Reserve Bank of St. Louis, said, “Even though we got past the initial wave of the March-April timeframe, the disease is still quite capable of surprising us. Without more granular risk management on the part of the health policy, we could get a wave of substantial bankruptcies and that could feed into a financial crisis.” He added, “I think it’s probably prudent to keep our lending facilities in place for now even though it’s true that liquidity has improved dramatically in financial markets.” Some critics have complained that the Fed has gone too far and that by intervening in so many asset markets, it is removing price discovery from markets, potentially leading to misallocation of assets. But Bullard defended the Fed, saying, “With all these programs, the idea is to make sure the markets don’t freeze up entirely, because that’s what gets you into a financial crisis, when traders won’t trade the asset at any price. It’s not my base case but it’s possible we could take a turn for the worse at some point in the future.”
In Europe, the unemployment rate has remained quite low compared to that of the United States, even amid a historic decline in economic activity. This is because many European governments have implemented employment protection programs, which offer subsidies to employers for keeping workers on the payroll even when businesses are closed. In the five largest economies in Europe—Germany, France, the United Kingdom, Italy, Spain—these programs have helped 45 million workers, or about one third of the labor force. The result is that in May, the unemployment rate in eurozone was only 7.4%, up one percentage point since April, but lower than the 7.6% reported in May 2019.
The subsidies were only meant to be temporary, although many governments have extended the programs by a few more months. However, the cost is enormous and most governments expect to ultimately end these programs, with the hope that employment will quickly rise as economies recover. It is likely that there will be a spike in unemployment as these programs end later this year. Moreover, so long as the virus remains a threat, it is likely that industries in which human interaction is high won’t return to normal levels of activity. This could mean the permanent loss of many jobs. In fact, a study by insurer Allianz estimated that nine million jobs in Europe could be permanently lost due to decrease in the size of industries such as restaurants, hotels, airlines, and retail stores.
When the Trump administration came into office in 2017, it chose to renegotiate the North American Free Trade Agreement (NAFTA), claiming that the 1990s-era agreement was responsible for significant job losses in the United States. The replacement deal is the United States Mexico Canada Agreement (USMCA). In many respects, this agreement is very similar to NAFTA. However, the most important difference concerns automotive trade. The USMCA mandates that in order to be eligible for tariff-free trade within North America, at least 40% of the value of an automobile must be produced by workers earning more than US$16 per hour. When the deal was signed, only 13.5% of the value of automobiles exported from Mexico to the United States met this requirement, mainly because of components being imported from the United States and Canada. The US administration expected that the 40% provision would lead auto companies to shift final assembly to the United States, thus boosting automotive employment in key Midwestern states. The provision says that if companies fail to meet the 40% requirement, their vehicles will be subject to a 2.5% tariff when crossing the border from Mexico to the United States.
However, it has been reported that major Japanese carmakers that have invested heavily in Mexico-based supply chains have no intention of shifting production to the United States. Rather, they will either triple wages in Mexico and/or will accept tariffs. Their calculation is that this will still be cheaper than investing in a massive transfer of capacity across the border. In any event, the cost of production will go up and the carmakers expect to pass on the increased cost to US consumers in the form of higher prices.
The Center for Automotive Research estimates that because of increased tariffs, the average price of cars sold in the United States will rise between US$470 and US$2,200 per vehicle. They said the provisions of the USMCA, along with trade tensions with China, will lead to a decline in the number of units sold and a decline in US automotive employment. Meanwhile, the USMCA came into effect last week. The timing of the implementation couldn’t have been worse, given the massive disruption caused by the viral outbreak in the past few months. Automotive production and sales fell sharply since the crisis began and are only now starting to recover.
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