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The coronavirus threat

Economies don't always bounce back from what look like temporary shocks. Which is why the coronavirus has caused share prices to fall so much
February 4, 2020

Will the outbreak of coronavirus have a permanent effect upon China’s economy? This question is the key to understanding last week’s stock market falls, which are being blamed upon the virus.

Undoubtedly, the virus is doing economic as well as human damage. This isn’t just because of the closing off of Wuhan and surrounding areas. There are also reports of cinemas, restaurants and public transport in other parts of the country losing trade as people stay at home for fear of contracting the virus. All this will depress GDP in the near term.

Economists, however, distinguish between transitory shocks and permanent ones. Most believe that the coronavirus outbreak is merely transitory and that demand will recover once the virus fades away and Wuhan reopens. Chetan Sehgal at Templeton Emerging Markets says the longer-term outlook for the Chinese economy is “unchanged”.

If this is the case, then the recent stock market falls are overdone: the Hang Seng index is almost 10 per cent down from its recent peak and the Nikkei 225 almost 5 per cent down, which have had knock-on effects upon western markets.

There’s an encouraging precedent for this. In 2003 shares fell after the outbreak of the Sars virus, but had begun to recover even before the World Health Organization declared the virus contained.

But this does not mean investors are daft to mark shares down so much. There is a danger that what looks like a merely transitory shock might have longer-lasting effects.

Yi Wen at the St Louis Fed has pointed out that this is perfectly possible. He has shown that declines in economic activity that we would expect to be temporary and harmless – such as post-Christmas drops in demand – do sometimes depress demand for longer periods. One reason for this lies in basic economics. If demand falls, then companies are left with spare capacity, so they don’t need to expand, and so they cancel some investment projects.

But there’s something else – a scarring effect. Nasty shocks can make us nervous even years later – hence the old saying, 'once bitten, twice shy'. For example, the financial crisis of 2008 might well have discouraged companies from borrowing and investing and encouraged them to build up cash simply because it alerted us to the facts that demand is volatile and that credit lines can be snatched away when you need them. And the 1930s depression created a fear of unemployment that persisted well into the 1960s, which is a big reason why the post-war period saw such low inflation.

The coronavirus might have a similar effect. Companies might fear that if whole regions can be isolated for weeks by a virus then it can happen again. That could make them nervous about expanding, especially outside their home towns.

This of course is only a possibility. The more likely outcome is that the Chinese economy will indeed bounce back, if necessary with the help of looser monetary policy and more public spending. Share prices, however, are not set only by central scenarios. They should also price in low probability/high impact risks. It is the latter that justify last week’s drop in share prices.

And this means that if the markets do recover – as is very possible – it will only be as a reward for taking on the risk that this economic shock might be a permanent one. Market volatility is not always a sign of irrationality.