Central Bank Quarterly Bulletin 4, 2020

A guest post by Enda Keenan from the Central Bank, highlighting some of the key messages from Bank’s latest Quarterly Bulletin.

Today the Bank published its fourth and final Quarterly Bulletin for 2020. The report contains a detailed overview of developments in the economy since the publication of last Bulletin in July as well as our latest macroeconomic forecasts out to 2022.

The forecast for GDP growth has been revised upwards to -0.4 per cent in 2020 reflecting more positive developments in consumption, strong export performance and an enhanced level of fiscal support arising from the July stimulus package. Growth prospects for next year and 2022 are more subdued compared to the previous Bulletin due to the implications of a WTO Brexit. As outlined Box A, a disruptive transition to a WTO trading relationship would frontload associated output and employment losses. In this baseline scenario, the growth rate of the Irish economy is 2 percentage points lower in 2021 relative to a Free Trade Agreement due to the introduction of tariff and non-tariff barriers. The ILO unemployment rate is projected to average 5.3 per cent for this year, rising to 8 per cent in 2021 following the closure of income-support schemes at the end of the first quarter (Box D in the Bulletin discusses the challenges that arise for measuring unemployment in the time of COVID-19).

Since re-opening from a period of lockdown, the recovery of the Irish economy has been uneven as levels of domestically focussed economic activity remain well below pre-pandemic levels. In particular, consumer-facing services sectors, such as tourism, hospitality and retail services, which are also more labour-intensive, have been slower to recover contributing to a projected decline in underlying domestic demand of 7.1 per cent this year. The strong performance of exports, which are expected to decline by just 0.3 percent in 2020, is the main factor driving an upward revision in the baseline projection for GDP. Box C details the relative resilience of high-value exports such as computer services and pharmaceuticals during a period of declining trade-weighted world demand.

The Central Bank’s Business Cycle Indicator (BCI), a monthly summary indicator of overall economic conditions estimated from a larger dataset of high-frequency releases, fell sharply during the months of March and April reaching a historical low (Figure 1). The latest estimates show that economic conditions continued to improve into July and August, but the rate of recovery has slowed down. Despite the improvement over the four months to August, the overall level of the BCI remains substantially below that observed prior to the emergence of the COVID-19 crisis.

Figure 1: Business Cycle Indicator (BCI) for Ireland’s Economy

The outlook remains highly uncertain, depending not only on the economic consequences of COVID-19 and its containment, but also on the nature of the trading relationship between the EU and the UK. Recognising this uncertainty, Box E analyses the impact of a ‘severe’ COVID-19 scenario as an alternative to the baseline forecasts in which there is a strong resurgence of the pandemic, leading to the restoration of widespread and stringent containment measures for a more prolonged period. Underlying domestic demand is projected to fall by 8.5 per cent in 2020 in this case with a continued contraction of -1.3 per cent into 2021. While the economy does not begin to recover until 2022, underlying domestic demand remains 6 percentage points below 2019 levels. In the ‘severe’ scenario, the unemployment rate rises to 12.5 per cent in 2021 before moderating to 10.1 per cent the following year.

The bulletin also contains analysis on the latest income tax developments and measurement difficulties for the unemployment rate arising from COVID-19.

SME finances, the pandemic, and the design of enterprise support policies

A guest post by Fergal McCann (Central Bank of Ireland) on SME finances and firm supports during the pandemic.

The Central Bank has published a Financial Stability Note, written by Derek Lambert, Fergal McCann, John McQuinn, Samantha Myers and Fang Yao, entitled “SME finances, the pandemic, and the design of enterprise support policies”. The Note estimates the likely losses that are being experienced in the SME sector over from March 2020 to year end, introduces a model of SME financial distress which can be used to evaluate the effect of announced SME support policies, and discusses policy implementation issues in the current climate.

Aggregate revenue shortfalls
We begin by updating an aggregate model of SME revenue shortfalls. McGeever, McQuinn and Myers (‘MMM’, 2020) used a first variant of this model to estimate three-month initial liquidity needs for SMEs of €2.4bn to €5.7bn. We update this model to account for reported reductions in wage and non-wage costs, using both PUP/TWSS take-up rates and CSO surveys on the business impact of COVID-19. Firstly, we show that, using observed data, our estimates for Q2 are at the very high end of the MMM estimates, suggesting the effect of the COVID-19 shock is about as severe as we were willing to project back in March/April when the initial MMM work was being carried out. Revenue shortfalls for 2020 are estimated between €10.3bn and €11.7bn across the SME sector, which are of course subject to significant uncertainty, both due to the uncertain outlook and the use of firms’ survey responses during the pandemic.

We highlight in the paper that such aggregate revenue shortfall estimates are not necessarily estimates of the size of required government support. These shortfalls already account for wage cost reductions through the TWSS. In aggregate, these shortfalls can be met by a combination of utilisation of pre-existing cash reserves, draw-down of existing credit commitments, new borrowing, additional cost reductions or loss-sharing, or if necessary governmental non-wage grants, reliefs and guaranteed loans. In this vein, we also model that across the board non-personnel cost reductions of 30 per cent could have large effects in reducing the overall shortfalls, suggestive of the importance of burden-sharing and cost efficiencies, along with fiscal support, in addressing the crisis.

Protection or liquidation
We outline considerations for designing policy responses to SME financial distress. Some enterprises entered the COVID-19 shock with unsustainable business models and during a typical downturn the closure of such companies can be seen as part of the overall process of economic restructuring and dynamism. However, identification of such firms is difficult given the nature of the COVID-19 shock.

There is a risk that, if traditional financial signals were being used, widespread liquidation could arise in the short run. We also point out that there are employee, supplier and customer relationships tied up in all firms, with relationship-specific capital on the line as firms are liquidated. Blanchard, Philippon and Pisani-Ferry (2020) summarises much of our thinking in this area:

“In normal times, policies should help the reallocation process, letting some firms fail and others expand, and helping the reallocation of workers across sectors. These are not normal times, however: many firms may fail because they are insolvent even if they are viable. Given the very high uncertainty, banks may be reluctant to advance credit. Unemployment is extremely high, making it difficult for laid off workers to find other jobs. For these reasons we think that protection (of workers) and preservation (of firms) should be given a higher priority than in normal times.”

Despite the above, we of course acknowledge that those designing SME supports must do whatever feasible to use taxpayer funds as efficiently as possible, given the nature of deficit dynamics during the pandemic. Targeting is difficult, especially in the current climate, but it is not fiscally or economically sustainable for supports to be provided without regard to viability, particularly as the likely duration of the pandemic period elongates.        

Firm supports: loans, grants or equity?
Outside of the over €5bn that will be used to support wages through the TWSS and EWSS, there is a 60/40 split between debt and grants in the announced SME support packages. If tax warehousing is accounted for as a debt, this rises to 70/30. We point out that the amounts announced are committed funds – in the case of debt-based supports in particular, final take-up rates are unknown.

We highlight the risk that debt-based supports may have weak demand from firms wary of borrowing, may lead to debt overhang issues over the medium term and face implementation issues when channelled through lenders. However, debt-based supports benefit from lenders’ access to information and incentives to screen credit risk, in cases where banks retain appropriate levels of risk (such as the 80-20 split embedded in the Irish Credit Guarantee Scheme).

Direct fiscal supports, such as grants or tax or rate waivers, provide liquidity and support the economy but raise issues regarding costs, targeting and moral hazard. Relative to a guaranteed loan, where costs only arise as defaults occur, grant funding is far more expensive up-front for the taxpayer. One potential option to address this drawback is for the State is to provide equity-like or “conditional grant” injections to SMEs which involve an element of clawback or potential return, lowering the cost of intervention relative to a direct grant. In this light, the proposal of Boot et al. (2020) is worthy of further consideration, where higher future tax rates are agreed in exchange for up-front aid.

A model of financial distress
Finally we present key results from a forthcoming model of SME financial distress (McCann and Yao, 2020). The financial distress (FD) indicator is based on SMEs’ capacity to meet losses through cash holdings, or to service interest expenses during the shock. We calibrate 2018-2019 data on SME balance sheets to the revenue and cost reductions reported by SMEs in 2020, and use the model to assess the role of various policy support options.

Relative to a no-policy scenario, we implement firms’ lowering of wage costs, both through TWSS wage supports and the transition of employees to the Pandemic Unemployment Payment (PUP), as well as non-wage policies worth €7.5bn, capturing the role of the credit guarantee, other lending, tax warehousing and enterprise grant policies. When the full package of policies announced in 2020 are included in the model, distress rates fall from 18.7 to 15.8 per cent (or 25.9 to 14.9 per cent when weighting firms by their debt balances outstanding).

Why does a cohort of SMEs remain in financial distress (FD) after policy supports are modelled? There are a number of factors at play. Firstly, the schemes’ total availability of €7.5bn means there is an aggregate maximum on the number of SMEs that can access funds. Secondly, specific schemes have specific maximum amounts, which in the cases of those experiencing the most severe financial effects of the pandemic, may not suffice to alleviate FD. Thirdly, the schemes have reasonably wide eligibility criteria, often related to firms experiencing a fall in revenues of a certain amount. This means that many firms that were never at risk of entering FD by our definition are just as entitled to draw down funds as firms experiencing the greatest losses. This issue of widespread access to funding was a necessary feature of scheme designs across the globe in response to the pandemic.

The latter finding on debt-weighted distress suggests that support schemes will have more beneficial financial stability effects than are visible when looking at a simple share of enterprises falling into financial distress. The greater efficacy of policy in lowering debt-weighted distress relates to the tendency of larger SMEs to have larger debts, implying that these firms draw down larger amounts of total scheme funds available, as well as to the concentration of SME debt among affected sectors such as the accommodation, food, wholesale and retail sectors. The table below reports the impact of the sequential addition of specific policy supports, highlighting that the effects of lowering wage bills through PUP and TWSS are larger than the effect of other supports.

Scenario Financial
Distress (%),
by firm count
Financial
Distress (%),
by debt balance
No Policy 18.7 25.9
+ Income and Wage Supports 16.4 18.9
+ Grants 16.0 18.3
+ Tax Warehouse 15.9 17.4
+ Credit 15.8 14.9

Finally we show that, relative to currently calibrated support policy, a hypothetical “viability-based” grant system that targets firms based directly on the size of their operating losses, supporting firms closest to viability first, would reduce distress rates to about half the levels modelled under currently-designed policy (comparing the middle and right hand side sections of Figure 1). Such a hypothetical system would prioritise solely the minimization of the financial distress rate, for a given fiscal outlay, and is therefore not intended as a specific recommendation but rather to illustrate the effect of current supports relative to a benchmark model. In practice of course, policy must take on board sector-specific, regional and longer-run considerations that go beyond solely the minimization of financial distress rates.

Source: Model-based estimates from McCann and Yao (2020). Notes: “Targeted Grants” replicate payroll supports modelling from the “Current Supports” scenario, but replace the grant, credit and tax components with a €7.5bn grant that provides support to firms in order of their viability (with firms closest to exiting financial distress receiving support first). By construction, the debt-weighted exercise relates only to firms with debt balances above zero in the 2018-19 data

Conclusions and wider policy issues
The model suggests that existing policy supports are likely to have mitigated SME financial distress in some cases, but challenges will remain for a relatively large group of SMEs. From a policy perspective many of the firms modelled as being in financial distress may be viable over the medium term – the identification of FD does not imply enterprise liquidation. This points to the importance of a dual approach to policy for SMEs, where targeted and effective financial support is required in the first instance, but a focus is also placed on the system-wide capacity to restructure the liabilities of potentially-viable firms. This latter step will ensure that the set of firms with the greatest prospects of survival over the medium term are given a chance to trade through the current challenges posed by the pandemic. The Central Bank is a key stakeholder in this process, with oversight of lenders’ approach to loan restructuring as SMEs’ payment breaks begin to expire. The Central Bank’s approach to this process was outlined by Deputy Governor Ed Sibley on Monday September 28th and can be accessed here.

References
McCann, Fergal and F. Yao (2020, forthcoming), Modelling financial distress in SME sectors during the Covid-19 pandemic – from liquidity to solvency, Central Bank of Ireland, Mimeo. McGeever, Niall, John McQuinn, and Samantha Myers (2020). SME liquidity needs during the COVID-19 shock. Central Bank of Ireland Financial Stability Note, 2020 No. 2


NIE 2019

The CSO have published the National Income and Expenditure Accounts for 2019 including modified Gross National Income (GNI*). They can be accessed here. The Q1 2020 Quarterly National Accounts in International Accounts are available at the same link. The International Accounts include an estimate of the modified Current Acount, CA*.

Two information notes were also published: one on the impact on COVID-19 on the Quarterly National Accounts and one on estimates of overseas tourism expenditure across various CSO publications. Again available at the above link.

Central Bank Quarterly Bulletin 3 2020

Guest post by Stephen Byrne, Central Bank of Ireland

Today the Bank published its third Quarterly Bulletin of the year. The report contains a detailed overview of developments in the economy since the publication of last Bulletin in early April as well as our latest macroeconomic forecasts out to 2022.

Given the scale of uncertainty surrounding the economic impact of Covid-19, two different scenarios for the economic outlook are outlined in the Bulletin (see featured image above).

In the “baseline” scenario, the economy reopens in line with the Government’s phased plan, allowing for a rebound in economic activity in the second half of the year. Some containment measures would remain in place meaning that activity would be constrained in some sectors for a longer period. Beyond the initial rebound, recovery is expected to be gradual, in line with a slow unwinding of precautionary behaviour as the effects of the shock on consumers and businesses lingers. The unemployment rate is set to decline from its second quarter peak of about 25 per cent as the year progresses and is projected be around half that level by the end of this year, before averaging just over 9 per cent next year and 7 per cent in 2022.

The baseline scenario sees output recovering to its pre-crisis level by 2022. However, the level of activity will be significantly below where it would have been had the economy grown in line with expectations before the outbreak of the pandemic.

In the “severe” scenario, the strict lockdown period is assumed to have a more damaging impact on economic activity and is not successful in effectively containing the virus. Stringent containment measures would remain in place, or would be re-instated, albeit not as severe as before, based on an assumption that there would be a resurgence of the virus at some point over the next year. In this scenario, there is a subdued economic recovery with a larger permanent loss of output. Unemployment remains higher for longer in this scenario and would average just below 17 per cent in 2020, while consumer spending is projected to fall by around 14 per cent and GDP by over 13 per cent this year. In this scenario, the projected recovery in growth in 2021 and 2022 would not offset the loss of output this year, leaving the level of GDP in 2022 about 5 per cent below its pre-crisis level.

Both of these scenarios assume that a Free trade agreement in goods between the UK and the EU, with no tariffs and quotas on goods, takes effect in January 2021. If such an agreement is not reached, then the EU and the UK would move to trading on WTO terms from January 2021. Box D of the Bulletin discusses the implications of such an outcome.

The bulletin also contains analysis of the impact of Covid-19 on debt dynamics and sustainability, as well as a detailed examination of the regional labour market impacts of the pandemic.

Finally, an accompanying signed article explores alternative long-term recovery paths for the economy and assesses the impact of fiscal and monetary policy supports. The Article considers how hysteresis – or scarring ­­– effects could influence the pace and nature of the recovery. The paper shows that, as a highly open economy, Ireland benefits from the positive effects of monetary and fiscal policy measures implemented abroad. The assessment of the combined effects of domestic and international policy supports indicates that the actions will help to meaningfully reduce the scale of the output loss in Ireland from the pandemic.

Measuring national income in the time of COVID

National accounts are useful.  Yes, they have their limitations, and, particularly in the case of Ireland, can be subject to distortions but they are useful.

One of those uses is measuring changes in living standards.  If the growth of the inflation-adjusted measure of national income exceeds the growth rate of the population then it is likely that living standards are rising, at least on average.  This is usually taken as the real growth rate of per capita GDP (or another variant).

For Ireland, this averaged around one per cent per annum for the first three decades post independence, it rose by an average of three per cent per annum over the next thirty years and has averaged around five per cent per annum in the period since the late 1980s which is where it was before the current crisis hit.  These are useful summaries of our economic performance, though as is well known, such long-term averages do belie some significant volatility that Irish growth rates have exhibited.

2020 seems set to add to that volatility but let’s consider two things that are likely to muddy the link between the change in real per capita national income (as measured by, say,  GNI*), and the impact of the crisis on living standards:

  • Food consumption and the exclusion of domestic household production from national income;
  • Education and the cost-based approach to including public production in national income.

Food Consumption

Restaurants have been closed for dining in since March.  The CSO’s Monthly Services Index shows that the turnover value of services in Restaurants, Event Catering and Other Food Service Activities was over 50 per cent lower in April than in the same month last year.  The contribution to value added and national income from restaurants will be significantly lower this year.

However, this does not mean we are eating less or even consuming fewer food-related services.  The composition has changed.  The CSO’s Retail Sales Index shows that our retail purchases from Food Businesses were 17 per cent higher in April than in the same month last year.  The food we are not consuming in restaurants and other outlets has been replaced by food we are buying in shops.

In the national accounts, both the food and labour inputs are counted when measuring the value added of restaurants.  For food we buy in the shops the domestic labour input used to turn that food into a meal is omitted from national income, but it still contributes to our living standards.

There’s no doubt there’s more to restaurants than the food we eat and the cooking and cleaning services provided to us.  That is why we are willing to pay more for dining in.  But we are still eating the meal we would have had in the restaurant or cafeteria so someone is still doing the cooking and someone is still doing the cleaning.  It still adds to our living standards, it’s just that it has switched from market production to household production.

The drop in living standards implied by the fall in value added from restaurants in the national accounts won’t be as large as the figures suggest.  We have been forced to move to something that does not have its value added included in the national accounts (nor generate as much Value Added Tax for the government which is also counted as value added when measured at market prices.)

And, separately, the employees who would have been paid from that lost value added have had a large part of their income replaced with government transfers.

Public Education 

For market-provided services the value added is essentially the value of the output produced less than cost of intermediate consumption. 

The value of market output is estimated using the prices people for it.  After intermediate consumption has been subtracted from total revenue, value added is divided between labour through compensation of employees, government through taxes on products, and capital through gross operating surplus.  Net operating surplus remains after a deduction for the consumption of fixed capital (depreciation).  The additional value added that goes to users above the price paid (consumer surplus) is not measured. 

Still, value added is a useful concept and represents a large share of the living standards and welfare benefits of the goods and services we produce and consume in market settings.

This does not hold for publicly-produced services such as education.  These are paid for from general taxation.  We do not have prices and revenues to provide an estimate of the value people place on these services (nor how much they would be willing to buy).  Market prices might be absent but they do contribute to living standards.

The value added for public services in national accounts is essentially the sum of compensation of employees and depreciation, that is, it is the cost not the benefit that is included. 

The value added of education is simply put at the pay bill for teachers and the cost of maintained school buildings.  No benefit above that is included in national income aggregates.

Schools have been closed since the middle of March.  Just like restaurants there has been a switch to domestic production.  Yes, some online supports have been provided but the value of this is unquestionably lower (just as we are only willing to pay lower prices for takeaway meals).  The shift to home-schooling has had a huge impact on living standards.

However, the value added of publicly-provided education services will be largely unaffected.  The fact that the school children aren’t in school doesn’t matter for national accounts; all that matters is that teachers get paid.

Conclusion

The provisional Quarterly National Accounts for Q1 2020 show that constant price gross value added in Distribution, Transport, Hotels and Restaurants was down 10 per cent compared to the first quarter of 2020.  This reflects the forced closure of most of these services towards the end of the quarter.

On the other hand the gross value added in Public Admin, Education and Health was up four per cent compared to the same period a year ago.  This is despite the fact that schools were closed from the 12th of March.

This isn’t necessarily an argument to change the way national accounts are compiled.  Should household production be included in national income? Maybe.  Should the added value of public services be more than pay and depreciation costs? Maybe. For the time being we’ll be satisfied with an understanding of what the figures as currently compiled actually mean.

The drop in value added from restaurants doesn’t mean that we are not eating.  The stability in value added from education doesn’t mean that our kids are being taught.  National accounts are useful and the changes in the aggregates can be a useful proxy for changes in living standards. But not always.