Potential Impact of the Coronavirus Pandemic on British Economy

EPC | 14 Jun 2020

During the first quarter of 2020, the British economy shrank by 2%, the largest downturn since the 2008 financial crisis. This is despite the fact that the UK only began to implement lockdown measures on March 23, towards the end of the quarter. The UK’s GDP is expected to shrink by 25–25% in the second quarter as a result of lockdown measures implemented in April and May. British Prime Minister Boris Johnson announced that most businesses would gradually be allowed to reopen during the first half of June.

The UK government is trying to mitigate the impact of the coronavirus crisis on the labor market and unemployment rates. Unemployment sat at 3.9% at the start of the year, equivalent to 1.35 million people (an increase of 0.1% over the previous year, following a period of uncertainty and instability in the British economy owing to the delay in the UK’s withdrawal from the European Union). However, predictions issued by the Office for Budget Responsibility, an independent research institute funded by the UK government, indicate that the unemployment rate is likely to double to around 8%, equivalent to around 3 million people, by the end of the second quarter of 2020. Some analysts have predicted that, by the end of the year, around 6 million Britons will have lost their jobs. These percentages do not include employees or workers covered by the government’s job protection and income compensation scheme.

The cost of the UK government’s efforts to combat the impact of the pandemic is expected to reach £123 billion, thereby pushing government borrowing for 2020 up to around £298 billion (of which £127 billion is needed to cover lost government revenue, particularly that lost from taxes, and £119 billion will go towards direct government subsidies to support the economy). This is equivalent to 15.2% of the total British economy, the highest borrowing rate since the Second World War.

The government is also providing an estimated £330 billion in guarantees for loans and grants for the private sector, equivalent to 17% of GDP.

The government is expected to cover the costs of its current borrowing by raising taxes and increasing austerity measures, meaning long-term suffering for the British economy.

Current government measures to protect and support the British economy and the cost of those measures

  • Supporting the labor market and combating expected pandemic-driven unemployment

Since the start of the crisis, the UK government has set up several schemes to protect jobs and the labor market, including the following:

Job retention scheme (furlough): This scheme costs the Treasury £10–12 billion per month. The aim is to discourage employers in sectors affected by the lockdown from dismissing employees as business slumps during the crisis, by offering to pay a proportion of their employees’ salaries in order to alleviate their financial burden. So far, the scheme has covered the wages of around 8.4 million employees who have been forced to stop work, reduce their hours to part-time, or work from home owing to health conditions or whose jobs have been threatened as a result of the loss of business and the lockdown measures. Under the scheme, the government pays 80% of employees’ wages, up to £2,500 per month. The government is also covering employers’ mandatory contributions to social security and retirement funds. While the government initially announced that the scheme would run until the end of July, it has since decided to extend the scheme until the end of October, albeit with some recent amendments: companies and business owners will have to cover their own social security contributions, and, as of September, they will be responsible for paying 10% of the wages of employees who are unable to return to work or who need to work from home as a result of health conditions that would make them vulnerable to virus. From October, that percentage will rise to 20%, and government contributions will drop to 60%.

The aim of the scheme is to combat the devastating effects that the lockdown has had on the labor market, prevent a sharp rise in unemployment, strengthen the social safety net, and protect companies’ human resources, the loss of which would deal a major blow to the economy in the long term, as companies would be forced to take time to rehire and train staff in the post-lockdown recovery period, which would have consequences for their productivity.

Self-employment income support scheme: Some 2.3 million individuals have applied for support through this scheme. For the first three months of lockdown, the government compensated self-employed workers for 80% of their average profits, up to a maximum of £7,500 for the three months, costing the government around £7 billion. The government has announced that it will extend the scheme for a further three months, during which it will pay self-employed workers 70% of their average profits, up to £6,750 in total. This is expected to cost the government around £6 billion.

  • Economic support for small- and medium-sized enterprises (SMEs)

The UK government has been particularly concerned about protecting SMEs during the crisis. It has set up several schemes to provide economic and financial support for SMEs and to reduce the likelihood of bankruptcy, closure, staff restructuring, or dismissals. At least 60% of the government’s bailout plans and programs have been aimed at SMEs:

  • The UK government considers SMEs and individual corporations to be the real economy of the UK, the health of which depends primarily on the productivity of goods and services that directly affect individuals and export levels, rather than on financial speculation, the banking sector, and the parallel economy.
  • These businesses have been suffering since the start of the British political crisis that followed the referendum on the UK’s exit from the European Union (known as Brexit). As a result of the uncertainty that prevailed in the British economy between 2018 and 2019 and the resulting devaluation in the pound sterling, many such businesses have been forced into bankruptcy.
  • As SMEs usually bear the brunt of recessions, the government has attempted to reduce the burden on SMEs as quickly as possible during the current unprecedented crisis.

As well as providing support for SMEs through its scheme to protect the labor market and prevent unemployment during the coronavirus crisis, the government has a number of other bailout programs aimed at SMEs:

  • Deferred payment scheme: In March, the Bank of England’s Monetary Policy Committee set up a program of support packages for SMEs, backed by government bonds financed by the issuance of central bank reserves. The scheme will last for 12 months and will provide funding for up to four years (and up to six years in some cases) for banks and lenders, covering at least 10% of any loan offered by the bank or lender to the UK business sector, especially to SMEs, provided that the interest rate on the loan is equal to or close to the central bank interest rate (around 0.1%). The scheme is intended to shift the impact of low interest rates onto the productive real economy, thereby lessening the burden on banks and lenders. The scheme is also designed to provide banks and lenders participating in the scheme with a cost-effective source of lending, thereby encouraging them to release cash into the real economy to enable it to continue operating during the current economic turmoil. The Bank of England expects to provide around £100 billion in funding to the private sector through this scheme.
  • Coronavirus Business Interruption Loan Scheme: This scheme provides support for SMEs with annual returns of less than £45 million. Through the scheme, companies can access up to £5 million, either in the form of a long-term loan or asset finance facilities (up to six years) or in the form of an overdraft or invoice finance facilities (up to three years). The scheme provides loans through 60 banks and private banking institutions via the government-owned British Business Bank. The government guarantees 80% of the value of loans granted to SMEs through the scheme, as well as covering the interest and fees owed by SMEs in receipt of such loans for the first year, in order to encourage lenders to continue lending to SMEs.
  • Micro loan scheme: In cooperation with banks and private banking institutions, the UK government has introduced a program of 100% government-backed micro loans for SMEs, ranging from £2,000 to £50,000, with an interest rate of 2.5%.
  • Entrepreneur support scheme: Through this scheme, the government is providing £1.25 billion in support for innovative projects run by companies in the technology and life sciences sectors that are not eligible for funding under other coronavirus financial schemes.
  • Future Fund: Through this scheme, the government and private banks are providing £500 million in support, through the British Business Bank, for small fast-growing companies not listed on the London Stock Exchange that have been affected by the coronavirus crisis. To be eligible, a company must have raised at least £250,000 in equity investment from third-party investors in the past five years. Eligible companies can apply for a loan of between £125,000 and £5 million.
  • Continuity grants and loans: The government is providing £750 million in grants and loans for SMEs that conduct research and development, of which £90 million will be issued as continuity grants ranging from £25,000 to £250,000 for companies at risk of closure due to a lack of funding for research during the coronavirus crisis. In addition, £210 million will be provided as loans for companies with ongoing research projects that are struggling to find continuous sources of funding as a result of the crisis, while the rest of the funds will be issued as financial loans to companies working on new research projects.
  • Grants for some small businesses: Around 700,000 small businesses that are not required to pay commercial property rental tax are eligible for grants of up to £20,000 to cover operating expenses such as rent. The scheme also includes cash grants of up to £25,000 for eligible businesses in the retail, tourism, entertainment, and restaurant sectors that meet certain specifications.
  • Sick leave compensation for employees of SMEs: This scheme will provide up to £2 billion for businesses that have a maximum of 250 employees. The government will pay employees’ salaries for up to 14 days of sick leave, excluding employees who are self-isolating with coronavirus. Some 2 million employees of SMEs are expected to benefit from the scheme.
  • Economic support for large enterprises

The Bank of England has launched a scheme to make financial facilities available to large companies through the purchase of their short-term debt (known as commercial papers), as a way of rapidly providing such companies — which are financially strong but have suffered from liquidity and cash flow problems during the crisis — with operating capital, so that they can pay their employees’ salaries and their suppliers. Companies in the banking and financial sectors are not eligible for the scheme.

As of May 12, 12 banks and lenders have participated in the scheme, under which companies with annual revenue of more than £45 million are eligible to receive loans of up to £25 million, while companies with annual revenue of more than £215 million can apply for loans of up to 25% of the company’s annual returns, up to a maximum of £200 million.

  • Economic support for strategically important businesses

The UK government has announced the launch of a bailout plan named “Project Birch”, in which it will use government funding to protect businesses that are strategically important to the British economy, such as those operating in the steel, aviation, and auto industries. Although the government announced that, in principle, special loans may be granted to such companies only once all other options have been exhausted, including other loan bailout schemes, observers have noted that the government may purchase shares in such companies “as a form of nationalization” to save them from collapse, if required.

One of the companies currently engaged in talks with the UK government is Virgin Atlantic, which has requested a bailout of £500 million as business has been affected by the suspension of flights. Loganair is in similar talks. Tata Steel has requested £500 million to save it from bankruptcy, and Jaguar has also filed a request for assistance under the scheme. In addition, the scheme will cover energy suppliers that are experiencing low demand for energy from factories and businesses, as well as the delayed payment of domestic energy bills as a result of job losses and rising unemployment. The scheme faces a number of obstacles, however:

  • The government must determine which companies are essential to the British economy and set criteria to identify which companies should be prioritized and how much they should be given. The government has not yet announced any specific criteria for this scheme, unlike its other support schemes. For example, it is not yet known whether the importance of the sector in which a company operates, the size of its workforce, or the volume of its exports will play a role in determining whether it is deemed strategically important. While the government has said that it will proceed on a case-by-case basis, experts fear that political interference and lobbying groups will influence which companies are given priority and how much funding they are granted.
  • Some companies, such as Virgin Atlantic and Tata Steel, have been accused of trying to use government support schemes and taxpayer money to rescue them from the financial difficulties that they were facing even before the coronavirus crisis, just as some commercial banks were accused of using taxpayer money to save them during the 2008 financial crisis even though their failure was due to mismanagement.
  • Many conservative politicians and free-market supporters are opposed to the idea that the UK may end up nationalizing struggling companies, as this would be a radical shift away from the liberal policy on which the British economy is based.
  • It will also be difficult for private companies to accept government interference in their decisions in the event that the government has acquired a significant stake in the company. Companies will want the assistance provided under the scheme to take the form of loans and grants, rather than the purchase of shares, but lenders’ risk assessments may make this impossible. Conversely, lenders may want to impose conditions that allow them to monitor how recipient companies are managed, which will likely lead to long and complex negotiations.
  • Trade unions in the UK are worried that negotiations will drag on and that there will be a delay in the provision of sufficient financial support to prevent these companies from laying off tens of thousands of workers, especially as the British economy is expected to suffer its worst contraction as a result of lockdown measures at the end of the second quarter (the end of June).
  • If the government is forced to purchase shares in strategically important companies, it is expected to sell the shares once the crisis is over and its bailout plans have been wrapped up. The government has yet to announce how it will exit these partnerships, however. The opposition Labour Party has voiced fears that the exit period will give companies the opportunity to repurchase their shares and combine them with the financial benefits that they have already received from taxpayer funds.
  • Support for charities and foundations: The government is providing a total of £750 million in grants to organizations that have been affected by a slump in donations during the crisis, such as shelters and centers for victims of domestic violence.
  • Support for public health services and other government services: As of the end of May, the government had provided £16 billion in support for the health sector and other government services (such as local councils) that have been providing services to limit the spread of the virus.

Financial measures and monetary policy during the coronavirus pandemic

Lowering the interest rate:

On March 10, the Bank of England’s Monetary Policy Committee decided to slash the interest rate by 50% to 0.25%. Less than two weeks later, it reduced the rate even further to 0.1%, the lowest in British history. Having reached the conclusion that the government bond market was declining under the current economic conditions, both in the UK and around the world, the Committee decided to reduce the interest rate in order to support the economy and increase consumer confidence by providing funding and facilitating cash flow to businesses and individuals. However, lowering the interest rate may make private banks and lenders less willing to provide loans to businesses, especially SMEs, given the high level of risk. The government has sought to counteract this issue through the SME support schemes outlined below.

Buying bonds:

  • The Bank of England has announced that it will purchase an additional £200 billion in government bonds and non-financial investment-grade corporate bonds, bringing the total value of bonds held by the bank to £645 billion. This purchase will be funded through the issuance of central bank reserves (i.e. printing additional British currency from the bank’s available reserves).
  • The UK government has decided to double the size of its purchase scheme for non-financial investment-grade corporate bonds. It first launched the scheme in August 2016, with an initial sum of £10 billion, in order to stabilize the British economy following the Brexit referendum. The value of the scheme was recently doubled to £20 billion, and the purchases are funded by the Bank of England.

The Office of Budget Responsibility has revised its forecast for the UK’s net public debt for 2020 to £298 billion, making it the highest level of government borrowing as a proportion of GDP since the Second World War.

Taxes:

  • The payment of value-added tax (VAT) owed on business transactions between March 20 and the end of June — valued at around £30 billion — has been deferred in order to provide additional cash flow for businesses.
  • The payment of self-assessment taxes due by self-employed workers in July 2020 (estimated at around £13 billion) has been postponed until January 2021.
  • Businesses have also been given a break on rental tax for commercial properties, estimated at around £11 billion.

Will these government measures save the UK economy?

• Unemployment rates have continued to rise despite the government’s unprecedented program of bailouts. More than 2 million applications for unemployment support have been filed, and the unemployment rate has risen from 3.9% at the start of the year to 5.7% currently. Were it not for the measures taken by the government, the unemployment rate is expected to have risen much higher. The coronavirus crisis has had a unique impact on the British labor market. Between March and the end of May, the daily number of applications for unemployment support as a result of the crisis was three times higher than that during the height of the global financial crisis. This is just one of the signs that the current crisis is having a far greater effect on the British economy than the global financial crisis.

The Office of Budget Responsibility has predicted that the unemployment rate will double to around 8% by the end of the year, while a number of analysts are predicting that it will rise to 16%. The credit rating agency Fitch Ratings has developed three scenarios for the unemployment rate in the UK as a result of the coronavirus pandemic: the first is the most optimistic, giving an unemployment rate of 11%, whereas the second scenario predicts that unemployment will rise to 20% and the third that it will rise to 28%.

These predictions do not include employees and workers covered by the government’s job protection and income compensation scheme, nor do they account for the potential loss of jobs in the event that the UK leave the EU without an agreement.

• Most government and independent experts predict that the coronavirus crisis will have a far greater impact on GDP than the global financial crisis ever did. During the first quarter of 2020, the British economy shrank by 2%, the largest downturn since the 2008 financial crisis, despite the fact that the UK only began to implement lockdown measures on March 23, towards the end of the quarter. The UK’s GDP is expected to shrink by 25–25% in the second quarter as a result of lockdown measures enforced in April and May.

Fitch Ratings has developed three scenarios for GDP downturn in 2020. In the most optimistic scenario, the economy shrinks by 7.3%, whereas the other two scenarios predict a contraction of either 16.3% or 25.1%.

• Consumer confidence dropped dramatically during the lockdown period to levels last seen during the peak of the global financial crisis, owing to fears over job security and a drop in household incomes. This loss of confidence is expected to negatively affect UK businesses as consumers choose to save rather than spend and as individuals’ daily economic activities change. The car manufacturing sector — considered a vital sector of the British economy — is expected to be particularly affected. Consumer confidence is likely to depend on the government’s success in containing the epidemic.

• Weekly commercial data for the UK shows a gradual decrease in the volume of cargo shipping arriving at seaports and a severe drop in air freight. At the end of April 2020, airfreight had decreased by 62% over April 2019, not only as a result of the impact of lockdown measures on the UK business sector, but also as a result of the closure of other countries’ airspace and the decrease in global trade. The World Trade Organization estimates that global trade has reduced by 13–32% during the current crisis, compared with the 12% drop experienced at the height of the global financial crisis. The decrease in global trade will also have a negative impact on the UK’s economic productivity, following changes in supply and demand.

• Thus far, the UK’s Debt Management Office, which is part of the Treasury, has managed to raise £80 billion through bond auctions without disturbing market demand. Indicators show that demand for these bonds remain strong.

• At this time, it is difficult to assess the impact of the grant and loan schemes announced by the government to support businesses. Nonetheless, these schemes are expected to prevent many SMEs from falling into bankruptcy, and economists believe that the schemes may shield many businesses from the economic shock of the UK leaving the EU without an agreement. During a session of Parliamentary questions, however, UK Chancellor Rishi Sunak admitted that the loan scheme would not be able to save all businesses from bankruptcy.

• Any agreement made with any of the UK’s strategically important companies is expected to provoke opposition and political controversy, given the large sums involved. Furthermore, the government has yet to announce what criteria will be used to determine the level of support, and what guarantees will be put in place to ensure that any such support is used to save the company and that, where a loan has been provided, the company’s leadership do not profit from shares in the company. The government has also yet to announce what its exit plan will be for withdrawing from companies in which it has been forced to purchase a stake.

• The UK is expected to suffer further economic troubles if it withdraws from the EU without an agreement, leading to economic contraction, lower consumer confidence, and a drop in monthly spending. This would be yet another blow to businesses and may even further push up the risk of lending, even where backed by government guarantees, especially if the value of the sterling declines dramatically.

Comparison of the impact of the coronavirus crisis, the global financial crisis, and the UK’s withdrawal from the EU without an agreement

• The current crisis has brought a sudden end to the UK government’s policy of non-interference in the economy, pursued since former Prime Minister Margaret Thatcher first came to power, with the exception of the small-scale government interventions that took place during the 2007–2008 global financial crisis. While the UK government has prepared plans to address any economic disruption that may arise as a result of the UK’s withdrawal from the EU without an agreement, the coronavirus crisis has called for an entirely different type of government intervention, for the following reasons:

  • The government has been forced to intervene on a large scale across all economic sectors of the country, while previous interventions have been limited to specific sectors.
  • Lockdown measures have posed a more serious and immediate threat to the income of millions of Britons than any previous economic recession. Neither the government nor businesses have been able to provide a transitional period, as is customary during an economic recession.

• Although both the global financial crisis and the coronavirus crisis has a global reach, the impact of the coronavirus crisis on each country’s economy has varied according to how widespread the virus is in the country and how the government has responded. Countries have therefore varied in their approach to the pandemic and in the policies adopted for each sector. The UK government has therefore been unable to make reliable predictions to guide its economic management policies during the next stage. The government has focused on absorbing the immediate impact of the crisis and providing an immediate response, rather than on developing long-term strategies to mitigate its impact. The Bank of England, for example, has been keen to maintain the stability of the financial and currency market by buying bonds, which has helped protect the sterling against significant devaluation. There are, however, serious concerns about the impact that such purchases will have on the UK’s public debt burden and on taxpayers’ purchasing power in the long run, including for basic services such as water and electricity.

• One of the problems facing economic policymakers in the UK is that, while the crisis has created a “new climate”, its existence will be temporary. How economic policymakers need to respond during the initial stage of the crisis and how they need to respond during the post-crisis period of economic recovery and rebuilding will differ dramatically. This will pose an obstacle for the UK, given the rigidity of the British financial system in general and its tendency towards conservatism. It will also be difficult to predict what the medium-term effects of the pandemic will be, given the extreme uncertainty experienced by the British economy as a result of both the UK’s withdrawal from the EU and the coronavirus pandemic. This is reflected in the initial forecasts produced by various UK government departments and agencies regarding the impact of the pandemic on GDP, which predict an economic downturn of anywhere between 5% and 14%. This large disparity will make it difficult for decision-makers to design suitable policies to combat the downturn. Experts believe that, given the difficulty of identifying what the best decision would be under such circumstances, the government will be forced to settle instead for whichever policy seems the least damaging.

Expectations

• The economic and health impact of the pandemic will likely sway voters during future elections, particularly as the Conservative Party is facing numerous allegations of negligence. This will be compounded by the rise of the new Labour Party leader Sir Keir Starmer, as the party begins to overcome the difficult legacy of its former leader Jeremy Corbyn.

• The UK’s economic situation post-pandemic is expected to play a more critical factor than ever before in guiding the government’s foreign policy, as the government will make reviving the economy a national priority.

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