The Propagation of Shocks Linked to Coronavirus Through Production Networks

Many wonder what the impact of the Covid-19 coronavirus epidemic will be on the global economy in general, and the French economy in particular. It will be several semesters before international trade data are available for researchers to assess the economic impact of this virus. In the meantime, our research on an unexpected shock that has developed in a completely different context[1] allows us to have ideas for answers on the potential spread, severity and longevity of the shock associated with this pandemic.

Tribune of Tomasz K. Michalski and Evren Ors, Associate Professors, HEC Paris.

The globalization of the economy is, among other things, equivalent to increased or even much increased dependence on international supply chains in the industrial sector. Most of these international trades are intermediate commodity transactions from intra-industrial transactions on which the European and French industries depend. French industrial production is very interconnected with other EU economies: often the same goods cross multiple borders, adding value at each stage of production (hence the worries of Brexit, could severely disrupt the flow of products, especially if an agreement is not reached by the end of December 2020). It should be remembered that more than 20 billion euros a year of these imports to France come from China, South Korea and Italy.

In this context, the major disruptions, related to the very large quarantines in the major industrial production basins in South-East Asia but also in northern Italy, caused by the coronavirus will necessarily have negative effects on French industrial production. In the end, the shocks generated can be quantified as price increases of these intermediate products that are specific to a particular production line. This equates, in the short term, to very few alternative opportunities, locally or internationally, for these imported products. In addition, our research shows that the impacts of such a shock can last up to three years.

In our research, we show, on the basis of an unexpected change in regulation (which is equivalent to a so-called “quasi-natural” experimentation) in Turkey, that even small shocks from the supply side (in our case, a surprise increase of 3 % of the cost of imports for some companies) may be passed on by firms that serve as suppliers to other companies.

We show that the rate of impact of such a shock is similar to that of rates found in other contexts (e.g., U.S.): – 1% increase in cost decreases on average by just over 1% of sales. Second, it is likely that companies with low inventories (either because of so-called “just-in-time” production processes or because of liquidity constraints) will increase the shock further. Third, the shock is also transmitted by suppliers: the increase in costs by suppliers of the affected companies leads to a similar transmission downstream. Fourth, we show that financially constrained businesses will be the most affected and will not only pass on the shock, but will probably amplify it. These effects can be felt within a year of the initial shock, but they can persist for at least three years.

The shock we are currently seeing is much broader and broader than the one we have studied, although its economic effects cannot be quantified at this time. But it is clear that there is an increased risk of cascading defaults, the disappearance of businesses (and jobs) and high losses for private companies and possibly for the banking system.

It goes without saying that over time, all of this will extend to the service sector and to final demand. What we could see is a strong supply shock that is both inflationary and could lead to lower productivity—with the likelihood of causing “stagflation.”

Supplier networks between companies can be difficult to recreate in the short term, especially in times of crisis, which can lead to a significant slowdown in economic activity. It is therefore important to plan for temporary measures to soften the effects of coronavirus shock. Relaxing official deadlines on late payments between companies can be a response that would help, even if this measure alone would not be up to the challenges to overcome in the coming months. Facilitating access to liquidity by importing companies would also be welcome, but its application remains difficult at the national level. It would probably be useful to have some kind of credit mediator between companies like the one created between banks and SMEs after 2008 to counter defaults.

In the face of coronavirus, governments are taking drastic measures (such as quarantine of populations) to avoid the adverse effects of this virus on the health of populations at risk and to prevent the spread of the epidemic at the national level. A series of economic measures to mitigate the effects of this disease on the short and medium term on the French economy are equally necessary. As with any other disease, it is better to prevent an epidemic as much as possible than to have to cure entire populations. Failure to act quickly can present a significant risk for the French economy as a whole, but also for the European recovery, which is struggling to anchor itself.

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