Chart 1

Our economic scenario is intertwined with public health measures to contain the coronavirus

At the root of the recession in Europe is a public health emergency—the coronavirus pandemic. That's why we (continue to) see the key driver of our economic forecast as countries' actions to slow the spread of the virus. Most countries have extended these measures and are foreseeing a gradual loosening of social distancing. Those are the two key reasons S&P Global Ratings now forecasts a deeper recession than we did just about three weeks ago.

We now assume eight weeks of lockdowns on average (up from six previously) and a much more gradual reopening. Each country might adopt a different approach. Austria is returning to normal in two-week phases, by starting to open small shops this week. Similarly, Germany is allowing small shops to reopen today, two weeks before allowing some children to go back to school. Thus, we base our forecasts on two-week phases, but acknowledge the EU has recommended a month-by-month approach. Where we have no information, we assume countries might start by reopening small shops, then bigger shops, and finally schools and leisure activities, but don't expect large gatherings to be authorized before August--as has been announced in Germany recently. Additionally, we assume some social-distancing measures will have to stay in place until a viable treatment or vaccine are found, which could be mid-2021. As a result, restaurants and social activities are unlikely to run at full capacity until then, and restrictions on travel are likely to stay in place. This would limit, among other things, a rebound in tourism, especially considering that the EU expects its external borders to reopen as a final phase.

Another set of factors informing our more pessimistic outlook is linked to a worsening external environment. We now expect global growth to shrink by 2.4% this year versus an increase of 0.4% previously. Notably for Europe, we now forecast a deeper recession in the U.S., the main destination for the region's exports. Also, lower world oil prices, if they last, might dampen external demand in OPEC and Russia, which together account for more than 7% of European goods exports--half as much as the U.S. This will undermine some of the benefits Europe is deriving from the lower inflation associated with lower oil prices and means that the eurozone recovery will take longer than we had initially expected.

Services-led economies are set to suffer more from this crisis

We believe how economies perform in coming months will depend on:

• How restrictive the lockdowns are. These are presently the biggest brakes on economies. In Europe, Italy has the strictest lockdowns with nonessential activities shut the longest, while Germany has relatively looser restrictions. We estimate that one month of lockdown in France costs approximately 3% of annual GDP, while for Italy it is closer to 3.5% (see chart 2).
• How reliant a country is on services. Services-led economies will see a stronger hit, especially those that rely more on tourism because this sector will be under lockdown the longest (see chart 3).
• How much fiscal support a country extends. Bigger fiscal support should lead to a swifter recovery. To date, Germany has unveiled the biggest fiscal bazooka (see chart 4 and "Credit FAQ: Sovereign Ratings And The Effects Of The COVID-19 Pandemic," published on April 16, 2020).

Chart 2

Chart 3

The economic impact is mainly due to a drop in household consumption, which has been severely restricted by government measures, in particular lockdowns, to contain the spread of the virus (see "COVID-19: The Steepening Cost To The Eurozone And U.K. Economies," published on March 26, 2020). However, the effects on economic activity are not proportionate: The longer restrictive measures are in place and the longer the public health outlook remains unclear, the more disproportionately the economy will suffer. For example, higher uncertainty and longer constraints to economic activity mean more businesses will likely fail, leading to higher rises in unemployment, more losses of wealth and capital, and therefore a slower recovery.

In our view, the partial unemployment schemes unveiled across Europe will limit the rise in unemployment. However, they are likely to protect workers differently depending on the sector. Manufacturing and higher-skilled workers are set to be better protected by these schemes than lower-skilled, temporary, or seasonal workers from the tourism industry, who will more likely become unemployed. This is why we expect the unemployment rate to rise more sharply in Spain than in harder-hit Italy (chart 4).

Chart 4

Since we last published toward the end of March, we're seeing a further increase in fiscal and monetary support:

• The European Central Bank has eased its collateral standards, therefore enlarging the universe of assets banks can use to refinance themselves as well as which assets they can purchase under asset purchase programmes. These measures have been part of the ECB's toolkit since 2008.
• The EU has laid out a three-layer safety net for workers, companies, and member states by agreeing on €100 billion from the European Commission to support national short-time work schemes; €200 billion from the European Investment Bank to guarantee lending to small and midsize enterprises that are particularly hit by the lockdowns; and up to €240 billion in credit lines from the European bailout fund, the European Stability Mechanism or ESM. That is available to each ESM member state, with looser conditionality but limited to 2% of national GDP, to support health care and other expenditures focused on cures for and the prevention of COVID-19.
• The Bank of England is now buying U.K. government bonds directly from the Treasury, bypassing markets and therefore ensuring low-cost financing of U.K. fiscal support to the economy.

The EU fiscal response is not only much larger than during the financial and eurozone crisis, amounting to about 4.8% of eurozone GDP, it also contains some new elements. First, for countries that need it, the EU budget is helping fund their partial unemployment schemes without any "capital key" contribution. This works like a kind of unemployment reinsurance and as such can help reduce fiscal inequality across countries. Second, through the ESM credit line, eurozone countries have agreed to mutualize the costs of financing, temporarily using the EU signature to fund national health care spending. Admittedly, the ESM is unlikely to be used much as long as the ECB's bond buying programme is effective at keeping governments' borrowing costs down. So far, yields on European government bonds have been range bound and relatively low (see chart 6). Between March 19 and April 9, the ECB's balance sheet had already expanded by more than 4% of GDP. That said, the question of financing the EU package remains unclear. A potential EU recovery fund is up for discussion in the next few weeks that could be better suited to the current economic shock.

Chart 5

Chart 6

Looking ahead and under the assumptions above, we expect the eurozone economy will have recovered only two-thirds of its losses by 2021, and to return to trend growth only in 2023. We also expect some losses in potential output in terms of capital accumulation and maybe even human capital, linked to lower investment and school closures. There is still uncertainty about the long-term outlook for productivity. On the one hand, every crisis can spark a Schumpeterian process of creative destruction that leads to productivity gains. This time around, apart from quicker technological adoption as we all work from home, we could also see a shift to greener production systems, especially if resources to finance the recovery seek to respect the EU Green Deal's objectives—for example, a potential EU recovery fund. On the other hand, the crisis might unleash or dampen other forces that might weigh on productivity such as slower globalization, a higher savings rate as consumers expect higher taxes to pay down debt, and a bigger role of the state in the market economy. Countries are stipulating conditions to bailed-out companies, such as limits to mergers and acquisitions or share buybacks, which may impinge on their ability to invest.

Against this backdrop, we forecast the eurozone economy be roughly 1.4% smaller in 2023 than we had expected before the pandemic began (see charts 7 and 8).

Chart 7

Chart 8

Table 1

We see mostly downsides to our forecast:

The pandemic could evolve differently than we currently assume. If the virus resurges, this could involve possibly longer lockdowns or interruptions in loosening the social-distancing measures.

Financing conditions could worsen. Interest rates are now significantly lower than during the eurozone crisis--an average 370 basis points lower for the four largest European economies. Higher financing costs would probably shake the riskier, currently more fragile areas of the financial markets, such as the equity markets and the speculative-grade bond market. This might cause more companies to default and jeopardize the recovery.

Europe's external environment could worsen further if the economic impact of the pandemic is more pronounced in the U.S. or Asia, Europe's main trading partners.

On the upside, an enhanced fiscal response at the EU level, such as through a common eurozone recovery fund, would provide a positive signal for the viability of the eurozone and could help speed up the economic recovery in Europe.

Table 2

Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.