Thinking About Coronavirus

From every angle, the race is on to understand the impact of the coronavirus. This week, for example, has seen a proliferation of reasoned estimates about the scale of the hit to growth it will have on China and the rest of the world. I salute those economists brave enough to make those estimates and publish them: they are serving a useful purpose even though the estimates can only possibly be extrapolations based on previous experience which may or may not turn out to be relevant. I am not being sarcastic: the challenge at this point is not so much accuracy of forecasts, but rather to provide a way of thinking about the impact of the coronavirus.

There is so much we do not know. The basic factors that will govern everything else are basically this:

• how easy is it to catch it
• how bad it is when you catch it.

Inevitably, the comparisons usually made are with SARS. In the British papers at least, SARS is usually described as 'highly contagious'. This is wrong. The profile of SARS was that a) it was actually quite hard to catch it, but b) if you did, it was a very nasty, very dangerous, illness. Very early on in the SARS outbreak, I had dinner with a senior medic. At the time, there were not too many Hongkongers' with SARS, and the mortality rate was negligible. What the medic told me, however, was that although the mortality rate was very low, approximately 70% of those who caught SARS ended up surviving on hospital ventilators. 'And Hong Kong has only got a limited number of ventilators.' When the number of SARS cases outstripped the number of available ventilators, that low mortality rate was going to shoot up quite dramatically.

My wife and children were, quite literally, on the plane the next day.

So here are the possible permutations:

Option 1. Hard to catch and not too dangerous. Result - no panic.

Option 2. Hard to catch but really nasty if you get it. Result, panic but probably containable (ie, ultimately like SARS).

Option 3. Easy to catch but not too dangerous. Result, panic and a global bout of 'seasonal flu'. Maybe hundreds of thousands of deaths globally a year (flu carries off about 500,000 a year, according to WHO). Nasty, but ultimately still a 'normal' result.

Option 4. Easy to catch, and really nasty. Result: justified and contagious panic. At the limit, this is the Black Death scenario.

It seems at the moment that, judging both by the rapidity of spread in China itself, and the dramatic global efforts to curtail its spread outside China, we can observe, first, that it is easy to catch. Quite how easy I do not know, since seemingly responsible medical reports give conflicting conclusions about whether it can, or can't, be aerosolized (ie, transmitted by sneezing rather than by physical contact).

So the choice is between 3 and 4. That means that the SARS comparisons are unlikely to hold. And it means the key question is: How nasty is it?

I find myself naturally gravitating towards the 'not too bad, really' response - just as I did (wrongly) for SARS. But I recognize that in judging epidemics/pandemics, survivor bias is at work: most epidemics burn out eventually without catastrophic damage, as they mutate to less harmful variants. But of course, that's not necessarily true. And I worry about three other things: first, as with SARS, early estimates of the mortality rate may disguise how nasty the disease really is, because those who catch it early probably have the benefit of being treated by medical systems before those systems themselves are overwhelmed by sheer numbers. At the moment, the global mortality rate is apparently around 2%, but in Wuhan it is now said to be double that. And second, we do know that it was nasty enough to kill a fit young medic in his 30s, Dr Li Wenliang. And third, in China the Party seems to have put China on a full 'war' footing - and if anyone knows the true state of play, it is likely to be the Party.

None of this is reassuring. It alerts us to the possibility that we cannot at this stage rule out option 4: easy to catch, and really nasty.

But economics isn't going to be able to walk you through the consequences of Option 4. With Option 4 comes political, social and economic consequences which are unknowable and potentially very dramatic. For example, who's going to run China? Will China continue its trajectory towards being a single integrated continental economy? What will be the future of borders both to China and within China itself? What sort of interruption of globalization will occur - how severe, and how long? The ramifications are endless, and economic life will become an endless series of discoveries about assumptions we didn't realize we held.

So if we are going to think in economic terms, we should start with the assumption that we are probably faced with Option 3 - a deeply unwelcome global pandemic with a high body-count, but not with the power to fundamentally re-order the world's political economy.

In the short term, this will deliver (is delivering) both supply shocks and demand shocks. The supply shock: as China struggles to contain the virus, the distribution channels tying together its internal continental economy are likely to fray or, in some cases, be suspended entirely. With provinces (and cities?) erecting ad hoc borders, deliveries from across the nation will be interrupted, and this in turn will curtail output even at those factories which are attempting to maintain uninterrupted production. The supply shock will not, of course, be confined to China: those international companies relying on Chinese operations for either intermediate inputs or final assembly will face similar uncertainties.

If you were drawing the typical supply/demand graphs, the supply curve will shift up and to the left, and will probably develop a steeper gradient.

The demand shock is easier to sketch: as social and commercial life in China is suspended, consumer and investment demand will falter for as long as it takes to either bring the virus under control, or to accept that it is here to stay as a new fact of life (and death). The demand curve will shift down and to the left.

The result of these supply and demand shocks will be this: activity will slow even as prices rise. In other words, in the short term, the result is stagflation. Stagflation in China, and a tendency towards stagflation in the world economy.

Of the two, I think it is the supply shock which in the short to medium term is the more worrying. There are two reasons for this judgement. First, China's massive trade surplus (US$430bn last year) tells us that the rest of the world is more dependent on China for supply than for demand. Right now, Apple will be worrying far more about its lost Chinese production than its lost Chinese sales. Second, in the medium term, alternative sources of production outside China will be developed, and Says Law will determine that these new sources of supply are also new sources of demand.

The short term and medium term consequences don't end there, however. First, the supply shock will generate its own response, and that response will be a desire and a need for companies throughout all stages of the world's supply and distribution channels to carry inventory. This will be a great time for wholesalers! The need to build inventory, and then hold it, will to some extent offset the demand shock, but will amplify the supply shock. In a world developing stagflationary tendencies, this inventory impulse will provide some mitigation for the demand shock, backstopping the growth shock whilst amplifying the price shock.

(The timing of the coronavirus could not be more awkward. I found myself last week tracing the impact of inventory cycles in 2019. The broad conclusion was that the first half of 2019 included precautionary build-ups of inventory in response to the US/China trade hostilities, whilst the second half of 2019 features difficult and painful attempts to dump that now unwanted stock. My feeling was that by the beginning of 2020, the hard work of inventory clearance had just about been completed. Which means the world's suppliers walked into the coronavirus supply shock with relatively skinny inventories!)

The second medium term factor will be the need for policy responses to the disruption of economic cycles. The challenge will be different for different countries. In China, the challenge is likely to be both financial and fiscal. Disrupted production and delivery schedules will mean disrupted financial schedules, which effectively means a rise in non-performing loans and cashflow problems for China's banks. At the same time, the Chinese government will be expected to not only to lead and finance the fight against the outbreak, but also to underwrite corporate losses and at the least absorb the fiscal costs of the demand shock. Since the Chinese government's revenues/GDP ratio has been falling continuously since 2016, sinking to just above 19% in 2019, these responsibilities will only be met by borrowing.

The combined financial and fiscal challenge will put pressure on interest rates, or currency rates, or both. Since China's debt/GDP ratio is already very high (domestic credit/GDP of around 215%), China economic tolerance for interest rate rises is limited, so we should expect the currency, or China's foreign reserves, is likely to take the pressure.

More generally, we should expect China's experience to be mirrored elsewhere in the world, proportionate to the degree to which coronavirus disrupts supply and demand schedules. In each case, we should expect financial and fiscal pressures to mount, and for impact on interest rates and currencies to vary according to the degree of fiscal and financial vulnerability which is discovered.

In the longer term,  it seems obvious that if Option 3 or worse is our fate, it poses a multi-faceted challenge to globalization - challenges of supply, of demand, of capital markets and of the financial system.  The word we will be using even more than now is: 'Antifragile'.