As part of our look at the consequences of the economic shock brought on by Covid-19, we focus here on policy and regulation. Our view is that we are heading for an era of higher taxes, increased sovereign debt levels and greater regulation of free markets.
In the long term, all tax rates are likely to increase in order to fund both the current emergency response and the recurring support governments may have to provide to strategically important industries and citizens.
This is the case, particularly in many emerging markets, because the fiscal and monetary policy room for manoeuvre was becoming more constrained prior to this crisis. Many emerging markets were running fiscal deficits wider than 3% and many were in policy rate-easing cycles (narrowing real interest rates). Furthermore, in some emerging markets expensive FX rates – eg on the basis of real effective exchange rate versus the last ten-year average – further constrains to what degree fiscal budgets can be expanded or policy rates can be cut without causing a loss of policy credibility or a precipitous flight of foreign capital.
More local currency government debt to finance wider fiscal deficits will continue to crowd out the private sector as commercial banks are incentivised to invest in government securities rather than extend credit. Furthermore, governments in some markets were already applying soft regulation on the returns for investors in government securities (eg the tax on T-Bill investment profits in Egypt, the restriction of Open Market Operation instruments in Nigeria) or on squeezing whatever liquidity it can from the banking sector via lending rate caps (eg Bangladesh currently and Kenya between 2016-19).
On external debt, in the emerging markets at least, we are already set down a path towards more external debt defaults and renegotiations, but with a more supportive multilateral (IMF-WB) and private investor base than might have existed prior to Covid-19.
Unprecedented central bank liquidity and direct support for corporate balance sheets in response to an unprecedented challenge likely drives an unprecedented – in recent decades – interference in the operation of free markets. The intermittent stop-start of economic activity during the management of Covid-19 (until a vaccine is widely injected) implies intermittent interference. Unbridled capitalism has proved incapable of responding to the scale of this crisis, much as it did immediately after the global financial crisis.
Figure 1: Emerging and Frontier Fiscal stimulus response to Covid-19 (% of GDP)