The guest commentary below was written by Daniel Lacalle.
Many countries have decided to lock down entire cities and shutdown airspace to contain the spread of coronavirus. This decision may create a massive crisis drowned in liquidity.
Governments and central banks are committed to do whatever it takes in terms of demand-side policies, spending and increasing liquidity as much as needed to avoid a 2008-style crisis. However, these measures, which were already ineffective for years, will be even less successful this time.
To start with, global policymakers made the mistake of implementing aggressive easing policies in a period of growth, which left them without effective tools to address the financial turmoil. When central banks cut rates and inject billions of liquidity in a period of growth and risk appetite, an urgent reaction due to a black swan scenario like coronavirus finds them with no tool that makes a significant impact.
What impact will the ECB have with a 120 billion euro per month asset purchase when it has already bought almost 20% of eurozone governments’ debt in its misguided monthly 20 billion euro purchase and deposit rates are negative? None. Sovereign debt in the eurozone already trades with a negative yield, and buying corporate bonds of zombie multinationals did not help the eurozone economy nor will it help now.
Adding a monetary facility for SMEs only helps those who are indebted now, it does nothing for those small and medium companies that were prudent all throughout these years and now face a collapse in sales and accumulating fixed costs.
The Spanish government launched an urgent economic program of tax relief that, when you read the text, only applies to companies with sales below 6 million euros and maximum relief of 30,000 euro. Nothing. The vast majority of self-employed workers and small companies that face a lockdown that can last for months are not going to receive the slightest respite. In Italy, only the already indebted will see some relief. This is exactly the same all over Europe. Governments are implementing aggressive demand measures when the problem is not a demand issue and ignoring the real risks.
For most small companies and self-employed workers globally, a month of closure is a ruin. Two months is a catastrophe that leads to a domino of bankruptcies and layoffs.
The key factor is that the lockdown and economic crisis ahead comes on top of a very weak 2019 and 2018 for small companies, which are almost 90% of the corporate fabric in most developed nations.
Working capital kills more companies than the Government, but when the two factors come together, the risks of falling into a severe crisis are enormous.
What is death by working capital? Revenues plummet, rising unpaid or delayed payment invoices, while at the same time fixed costs accumulate and taxes continue to drown businesses. Most companies have very little liquidity. According to Moody’s the large quoted companies have increased cash, but even at large multinationals -excluding tech giants and a few exceptions-, net cash balance sheet does not cover one year of working capital requirements, particularly in the eurozone. However, an average small company usually has enough cash to survive a maximum of two months of difficulties. Hardly enough to survive a complete shutdown and a pandemic crisis.
In 2019 there were already worrying signals. In the US, small businesses were struggling despite economic growth and low unemployment. Thousands of stores closed in 2019, and the statistics of Business Formation suggested a significant weakness ahead. In most countries, the average cash maintained by an SME does not reach to cover three months of costs, and that is being very optimistic.
In the eurozone, the other problem is the high cost of hiring. Labor tax costs have increased 20% in the past two years in Spain, with 13% unemployment already, many taxes have to be paid in advance for invoices that, in the best case, will be paid months later, and fixed costs choke some companies that were mostly loss-making.
Delaying the payment of some taxes for six months does not mitigate the effect of a sales collapse or the already challenging situation that existed before any epidemic, in 2019.
The result of death by working capital is that the business fabric is rapidly destroyed and, with it, employment. Meanwhile, governments and already heavily indebted companies will receive ample liquidity and endless refinancing.
One of the reasons why Europe destroys so much employment is because it destroys companies faster than anyone else by resorting to large headline measures that do not solve the problems of job creators and ignore the problem of working capital and the size of its business fabric.
Governments will launch massive headline expense programs that strengthen neither the small nor the big companies. The small ones do not receive any real relief, and the large ones are only kept alive with a lifeline, zombified.
An epidemic crisis is not solved by increasing deficits and increasing spending in white elephants, with useless rate cuts that have no effect on SMEs with no debt suffering a sudden cash wipe-out, but even less by purchasing bonds from states that are already financing themselves at negative real rates.
GDP will be artificially lifted, but that does not work. It is easy to lift GDP with debt spending, it is very difficult to maintain the business fabric of a country in the face of a supply problem.
When governments and central banks deny supply-side measures to a supply problem and put in place large demand-side policies they benefit only those who were already privileged – the government and already-indebted sectors.
Small companies that behaved prudently throughout the so-called recovery face a double virus. The health pandemic and the interventionist epidemic.
It is almost impossible t to maintain the business fabric of a nation in the face of a supply crisis by rejecting supply measures yet adding even more demand policies.
An epidemic shock is not solved with deficit increases, current spending, and low rates. Demand for credit was already weak despite negative real rates.
The massive demand measures that will be announced in the coming days will generate a double negative: On the one hand, excess capacity in the zombie sectors and deficit spending will increase, credit is absorbed by governments and those companies that already had large debts. On the other hand, the lockdown and epidemic measures force a general closure of the economy that is not solved by building roads and infrastructure or forming congress committees. The sectors that are already indebted and the Government benefit from the measures, the rest of us are hurt by the fall of the economy and the subsequent increase in taxes.
The reader might say that more government spending will also help SMEs and citizens. However, reality and history show that any relief measure does not even start to cover the loss of employment and productive parts of the economy. Think about this, if increasing government spending and deficits were the solution to a crisis, Europe would have recovered faster and stronger than any other economy in 2009 when it launched its enormous Jobs and Growth stimulus plan.
An epidemic shock is solved with supply measures, not demand policies:
. Cutting taxes during the crisis period, eliminating social contributions in labor taxes to avoid the bleeding of employment. Lower the corporate tax in all sectors by 50% in exchange for employment strengthening plans.
. Governments are already financing themselves at negative real rates. Enable, as banks are already doing, lines for working capital at zero rates. Banks do it with their clients, the government can do it with SMEs that do not have debt or financial contracts.
. Eliminating all the obstacles to job creation and burdens for the little investment that arrives. A project cannot be delayed for months and even years under normal conditions and even less in a period of crisis.
The reader will tell me that all of this must be done in normal conditions and not just because of an epidemic, and we agree. However, we are surrounded by some politicians who think this is a fantastic opportunity to destroy the small business fabric, advance in the nationalization of the economy and make employers and employees even more dependent on state aid.
The proof that these enormous “whatever it takes” measures will fail has been evident for years. These measures only help those who are already in debt. The ones who suffer the most are the ones who have been cautious in recent years but now face tax bills, zero support, and collapsing sales.
We will see, again, the bailout of the reckless and the burden to the prudent.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor note by economist Daniel Lacalle. He previously worked at PIMCO and was a portfolio manager at Ecofin Global Oil & Gas Fund and Citadel. Lacalle is CIO of Tressis Gestion and author of Life In The Financial Markets, The Energy World Is Flat and the most recent Escape from the Central Bank Trap.
