Shock scenarios: major economic downturn projected this year, banks to remain resilient
The coronavirus (COVID-19) outbreak will hit Lithuania’s economy with its hardest punch in the second and third quarters of 2020. However, if the spread of the virus is properly contained and economic stabilisation measures are put in place, economic growth could be back on track already in 2021. The first and most important step in this direction is the fiscal measures taken by the government and other institutions. The Bank of Lithuania, together with the European Central Bank (ECB) and in close cooperation with Lithuanian and foreign governments, has already introduced aid measures to mitigate the shock. Moreover, banks have sufficient buffers to ensure their operational stability.
“The economy, both on a national and global level, is currently experiencing an unprecedented shock which, in turn, requires an unprecedented response. Hence, national central banks and governments are proposing and implementing exceptional measures to support businesses and households. And if all of us – the public sector, companies and residents – join forces to overcome the virus and its adverse economic impact, we might bounce back sooner rather than later,” said Vitas Vasiliauskas, Chairman of the Board of the Bank of Lithuania.
Leading global economic indicators signal that the corporate sector has been particularly sensitive to the pandemic outbreak and the containment measures that, albeit painful, were inevitable. One of the key leading economic indicators – the euro area composite purchasing managers’ index – has hit all-time lows since it was first recorded in 1998, reflecting a significant drop in economic activity.
By now, it is already clear that the Lithuanian economy will not be left unscathed; however the duration and scope of the economic implications will depend on how quickly the spread of the virus will be contained and what measures will be implemented to fight against it. The Bank of Lithuania has prepared three economic development scenarios which entail: 1) a sudden recession followed by a longer recovery period (GDP to contract by 11.4% in 2020), i.e. a U‑shaped recession; 2) a protracted recession and recovery (GDP to decrease by 20.8% in 2020), i.e. a prolonged U-shaped recession; and 3) an abrupt recession followed by a rapid recovery (GDP to decline by 3.4% in 2020), i.e. a V-shaped recession. These scenarios differ in terms of three underlying assumptions: the size of the contraction in foreign demand, the magnitude of the domestic demand shock, and the pace of economic recovery.
The first – U-shaped recession – scenario, which is currently considered as baseline, entails that Lithuanian export volumes will decline to a similar extent as during the 2009 global financial crisis, while with a plunge in domestic demand (i.e. household consumption and investment), the country’s economy will only recover in the medium term.
Under the second scenario of a prolonged U-shaped recession, a protracted nationwide quarantine will lead to an even stronger decline in domestic demand, thus further economic development will replicate that observed during the previous crisis and its aftermath. In this case, economic growth will not be back on its upward path during the entire projection horizon. However, it must be noted that this scenario is most unlikely.
Should the third scenario of a V-shaped recession materialise, foreign demand in Lithuania is expected to contract by slightly less than 4%. However, a rapid and coordinated response to the spread of the virus will allow economic activity to return to normal already in the third quarter of 2020. This scenario is based on the assumption that the coronavirus outbreak will not last longer than two months and the government will be able to preserve most of the affected businesses and jobs.
Given that economic shock cannot be avoided, stabilisation tools have already been developed and are currently being implemented. First and foremost, the fiscal measures taken by the government and other institutions. The ECB has resorted to monetary policy measures, announcing the launch of the new pandemic emergency purchase programme (PEPP) with an overall envelope of €750 billion and facilitating borrowing conditions.
The Bank of Lithuania, in turn, reduced the countercyclical capital buffer (CCyB) requirement for banks from 1% to 0%, thus permitting them to make full use of the capital set aside for a rainy day. The release of the buffer allows banks to provide up to €1 billion in loans to businesses and residents.
Looking at the banking sector’s operating results in 2019 and the capital buffers it managed to accumulate so far, banks are well equipped to withstand even heavy losses. Last year banks earned almost €333 million in profit, while the capital adequacy ratio increased from 18.6% to 19.9%.
“Taking into consideration the possible negative implications of the spread of the virus for the Lithuanian economy, including the banking sector, we urged banks not to pay out dividends and in turn use last year’s retained earnings to strengthen their capital base,” said Vasiliauskas.
In light of the measures taken (release of the CCyB requirement), if faced with a severely adverse scenario, banks would be able to withstand a €1.2 billion loss without any external aid and prejudice to their capital requirements. Banks operating in Lithuania incurred similar losses during the 2009 crisis.