Team Australia is in a top spot, so why are ‘animal spirits’ for investment still missing?

Australia’s economic, health and political institutions have come together like never before and executed a response to the current pandemic that is among the best in the world.

It means that while many challenges remain to be solved, relatively speaking Australia is in a great position to recover quickly and outperform global peers, not just in the short term but for years to come. While a number of studies have looked at comparisons between health outcomes and GDP, EY’s new Global COVID-19 Economic Index looks at GDP, employment as well as a key differentiator: combined balance sheet strength across household, government, central banks, non-financial corporates and financial institutions.

The resulting EY Global COVID-19 Economic Index of 25 countries, provides a more nuanced assessment of the success of a nation’s policies with respect to the economy. What we found is that Australia is in great shape, one of the top performers, when viewed against many comparable developed economies. Disappointingly this strong global position has failed to lower the risk premia for investment, meaning business remains more cautious than the data indicates it needs to be when it comes to committing to investment plans. Importantly, greater investment not only would broaden the base for recovery but provide a channel to build a more productive, future-ready Australia. 

Why balance sheets matter to the recovery

Academic literature points to the health of a country’s balance sheets as being an important determinant of sustained economic recovery. Recessions often lead to a worsening of an economy’s balance sheets as governments, businesses and households dip into their savings or take on more debt to support the economy or maintain their spending. Once the worst of the downturn is over these governments, businesses and households tend to shift to focus on repairing their balance sheets, which can hold back the economic recovery in the longer term. 

Household balance sheets provide a solid indicator of how households are likely to respond to external economic crises and perhaps more importantly to stimulus measures, as the balance sheet underpins how wealthy households feel and impacts the decision to spend or build precautionary savings. This wealth effect that households feel, is the most well understood of the balance sheet concepts. For example, the Reserve Bank of Australia finds “When wealth increases, Australian households consume more. … The positive relationship between consumption and wealth is particularly robust for housing wealth and has been stable over time.” [1]

A similar psychology can be applied to non-financial businesses and small and medium sized firms. Businesses with strong balance sheets tend to feel more secure in taking risks, increasing debt and investing – all important activities for a growing economy.

Financial institutions, and their balance sheets, play a particularly important role as facilitators of the flow of credit through the economy. The Global Financial Crisis highlighted the importance of this. When financial institutions have strong balance sheets, they are more able to lend which can lift household spending and business investment but also, as we witnessed in 2020, to provide deferrals in a time of economic crisis. Loan and mortgage deferrals were an integral part of Team Australia’s building of a ‘bridge to the other side’. Rent deferrals similarly.

Viewed as a whole, private sector debt is an important overlay on the health of government balance sheets. As the IMF points out, private sector debt poses additional risk to highly indebted governments. “As public finances are further stretched during the pandemic, elevated private debt levels before the pandemic can leave governments with less room to manoeuvre in promoting a healthy and robust recovery.”[2]

The balance sheets of government – state and federal – as well as the central bank are also crucially important, and the cornerstone of a country’s ability to use fiscal and monetary firepower to respond to an economic crisis. Relatively low government debt not only provides ‘fiscal room’ to spend on stimulus but also underpins relatively low cost, easily absorbed debt profiles, and is integral to maintaining a favourable sovereign credit rating. For central banks, the balance sheet is a key factor in the size of the unconventional policy response. In Australia’s case, the Reserve Bank’s balance sheet was particularly strong opening the way for quantitative easing, yield curve control and the term funding facility.

Using publicly available data, the EY Global COVID-19 Economic Index has captured the current state of five balance sheets for each country*, as well as economic activity (using GDP and employment markers) and compared that with COVID-19 mortality rates per capita**. An EY Global COVID-19 Economic Index score of 100 indicates a country has had an average economic performance. Above or below 100 indicates outperformance or underperformance relative to the rest of the countries.

This analysis of relative performance though the COVID-19 crisis is intended to capture the fundamentals of an economy that will be needed for ongoing outperformance as economies recover.

What we found

Very few countries have been able to achieve both positive economic and health outcomes – indicating how difficult it is for countries to get the balance right. New Zealand, Australia, Denmark and South Korea have fared particularly well.

It is no coincidence the countries who have done well had fiscal space to support the economy with at least two sectors in a solid financial position prior to COVID-19; populations that have shown to be relatively compliant to regulation; and are often, geographically islands or peninsulas (meaning closed international borders are more effective).

Australia ranks third behind New Zealand and South Korea with the lowest number of deaths per capita and third behind New Zealand and Ireland on the EY Global COVID-19 Economic Index. Looking more closely at the economic factors, Australia ranks 11^th out of 25 for government net debt to GDP, second for central bank assets to GDP (behind the Czech Republic), 13^th for household net wealth, 19^th for financial regulatory capital to risk-weighted assets, and fourth for the net wealth of non-financial corporates. Australia also ranked highly for GDP (4^th) and employment (6^th).

Our analysis shows that good health outcomes are not a guarantee of good economic outcomes, although it does increase the likelihood of that. Conversely poor health outcomes do correlate with a higher dispersal of economic outcomes, because it forces countries to rely more heavily on balance sheet supports to achieve positive outcomes. 

For example, Spain and Poland have achieved similar health outcomes but their economic positions have led to very different recovery prospects. Spain ranks lowest in our Index which is largely explained by the poor outcomes for GDP and employment, down 9.1 per cent and 3.1 per cent respectively on pre-COVID levels. But it also entered the crisis ranking among the worst performers on government balance sheets and central bank balance sheets and below average on household and corporate balance sheets, meaning it had little room to manoeuvre a better economic outcome. Poland on the other hand has seen above average GDP outcomes (-2.8 per cent), very strong employment outcomes (-0.3 per cent) and ranks relatively well across its’ balance sheets.

Other countries have a dispersion in balance sheet outcomes, which affects that country’s ranking. For example, Norway’s government balance sheet ranks first, because Norway has a very large sovereign wealth fund - due to its access to the North Sea Oil reserves - which outweighs its public debt. However, it’s central bank and household balance sheets rank last, meaning its’ recovery pathway may be constrained.

Interestingly Ireland has had relatively high deaths from COVID-19 but has outperformed South Korea and Germany, among others, in its economic outcomes. Ireland’s EY Global COVID-19 Economic Index was boosted by a strong GDP outcome which sits at odds to its employment outcome, which is amongst the poorest assessed, down 2.3 per cent since the pandemic started. Looking at the detail, the strength of GDP reflected a collapse in imports, which is a sign of a very weak domestic economy. This is a good example of how using GDP alone to assess economic performance through COVID-19 is too narrow. Ireland benefits from strong balance sheets for non-financial corporates and financial institutions but has very weak balance sheets for households and government.