key: cord-0985264-sljyqq2m
authors: Caggiano, Giovanni; Castelnuovo, Efrem; Kima, Richard
title: The global effects of Covid-19-induced uncertainty()
date: 2020-07-07
journal: Econ Lett
DOI: 10.1016/j.econlet.2020.109392
sha: ee2a216ec4a9ac99c208967e2446e24614868345
doc_id: 985264
cord_uid: sljyqq2m

We estimate a VAR with world-level variables to simulate the effects of the Covid-19 outbreak-related uncertainty shock. We find a peak (cumulative over one year) negative response of world output of 1.6% (14%).

The Covid-19 outbreak has injected a huge amount of uncertainty in our lives. Worldleading immunologist Anthony Fauci (among many others) has written scienti…c articles on how to try "navigating the uncharted" from a medical and health standpoint, stressing how much we do not know yet on the coronavirus causing Covid-19 (see, e.g., Fauci, Lane, and Red…eld (2020) ). 1 Unsurprisingly, a forward looking proxy like the VIX has immediately captured the extent of the Covid-19-induced uncertainty, as shown in Figure 1 . As pointed out by Baker, Bloom, Davis, Kost, Sammon, and Viratyosin (2020) , the peak value of …nancial volatility recorded in March 2020 is the highest in recent history, Great Recession included. This is bad news, because spikes in …nancial uncertainty have been associated to drops in real activity (see, among others, Bloom (2009), Caggiano, Castelnuovo, and Groshenny (2014) , Leduc and Liu (2016) , Basu and Bundick (2017) , Caggiano, Castelnuovo, and Pellegrino (2017) , Ludvigson, Ma, and Ng (2019) , Caggiano, Castelnuovo, and Nodari (2019) , and Cascaldi-Garcia and Galvão (2020)). Given the globality of the Covid-19-induced uncertainty shock, what does this imply for world output for the months to come?

This paper addresses this question by estimating a VAR featuring a proxy for global uncertainty (the VIX) and two state-of-the-art measures of global conditions, i.e., the global …nancial cycle index proposed by Miranda-Agrippino and Rey (2020b), and the world industrial production index produced by Baumeister and Hamilton (2019 shock, which might magnify the latter's direct e¤ect on output (Alfaro, Bloom, and Lin (2019) , Caggiano and Castelnuovo (2019) ). Finally, the monthly world industrial production measure produced by Baumeister and Hamilton (2019) , which refers to OECD countries plus six non-OECD players (Brazil, China, India, Indonesia, Russian Federation, South Africa) and covers 79% of the IMF World Economic Outlook estimate of global GDP, enables us to: i) sharpen our identi…cation of the causal e¤ects going from uncertainty to output, an e¤ort which would be more challenging when dealing with lower-frequency data (e.g., real GDP); ii) investigate the macroeconomic impact of the Covid-19-induced uncertainty shock at a global level.

We …nd a jump in uncertainty as large as the one occurred in March 2020 to induce a peak response of world output of about 1.6%, and a 14% cumulative loss in world industrial production over one year, with a value as high as 22% falling within the 90% con…dence interval. 3 This …nding o¤ers clear support to the unprecedented policy interventions put in place by Governments and central banks in most countries to limit the recessionary e¤ects of the Covid-19 shock. 4

The paper is structured as follows. Section 2 describes the data and the empirical framework. Section 3 reports the empirical results about the economic impact of the Covid-19 related uncertainty shock. Section 4 concludes.

Data. We consider the three-variable system X t = [V IX t ; GF C t ; 100 log(W IP t )] 0 , where VIX is our proxy for global …nancial uncertainty, GFC is the global …nancial cycle estimated by Miranda-Agrippino and Rey (2020b), and WIP stands for the level of world industrial production computed by Baumeister and Hamilton (2019) . The VIX is a real-time market-based volatility index derived from the price inputs of the S&P 500 index options and calculated by the Chicago Board Options Exchange. It represents the market's expectation of 30-day forward-looking volatility, and it is often used as a proxy for …nancial uncertainty in the applied macroeconomics literature (Castelnuovo (2019)). The GFC is constructed by extracting a factor from a large dataset of world asset prices, corporate bond prices and commodity prices that explains over 20% of the variance in the data. As such, it represents a measure of global …nancial cycles.

The WIP index is constructed as a weighted average of OECD + 6 (Brazil, China, India, Indonesia, Russia, and South Africa) country-level industrial production indexes. (2019) VAR model. The reduced-form …nite-order VAR representation reads:

where A j are matrices of coe¢ cients, and t is the vector of residuals whose variancecovariance is . The VAR features equation-speci…c constants and linear trends. Our baseline model features p = 6 lags. The reduced-form VAR is estimated via OLS. Identi…cation is achieved by Cholesky-decomposing the variance-covariance matrix of the VAR residuals, = P P 0 , where P is the unique lower-triangular Cholesky factor with non-negative diagonal elements. Following Leduc and Liu (2016) , Caggiano, Castelnuovo, and Groshenny (2014) , and Basu and Bundick (2017) (among others), we order the uncertainty proxy …rst in our VAR. This is done to allow uncertainty to have an immediate on-impact e¤ect on …nancial conditions and real activity, e¤ect that has actually materialized right after the arrival of the Covid-19 pandemic. This ordering is also consistent with the …ndings on exogeneity of …nancial uncertainty indicators recently put forth by Ludvigson, Ma, and Ng (2019) and Angelini, Bacchiocchi, Caggiano, and Fanelli (2019) , and with the empirical evidence that points to …nancial uncertainty as a driver of the business cycle proposed by Baker, Bloom, and Terry (2020) .

Calibration of the size of the COVID-19-induced uncertainty shock. To calibrate the size of the uncertainty shock due to the Covid-19 outbreak we look at the di¤erence between the value of the VIX at its peak in mid March 2020 (on March 16, the VIX reached its record high level, jumping at 82.69) and its value exactly one month before, on February 16, 2020. The choice of the time span for computing the increase in the VIX is due to the monthly frequency of the data we model in this study.

In mid-March 2020, the VIX stood at a level 5.6 times higher than in the previous month. How much of this increase can be attributed to the Covid-19 outbreak? Baker, Bloom, Davis, Kost, Sammon, and Viratyosin (2020) look at the measure of economic policy uncertainty (EPU) developed by Baker, Bloom, and Davis (2016) and calculate the proportion of newspapers articles that, in March 2020, mentioned Covid-19 along with the other keywords used to calculate the EPU index. They …nd that Covid-19 was mentioned in at least 90% of articles. We then attribute 90% of the observed jump in the VIX to the Covid-19 outbreak. 7 This returns a scaling factor of 5.6 0.9 = 5.04, which is the one we apply to the uncertainty shock in our VAR exercise.

IRFs. Figure 2 reports the impulse response functions of the VIX, GFC, and WIP to a 5-standard deviation uncertainty shock, along with 90% asymptotic con…dence bands. The response of the VIX is quite persistent, and it goes back to the pre-shock level one year after the shock. We believe the evolution of the VIX to be sensible, in light of the uncertainties that are likely to stay in place in the months following the Covid-19 shock (e.g., duration and characteristics of the lockdowns; e¤ectiveness and availability of the medical tests; discovery, availability, and e¤ectiveness of a vaccine; timing, size, features, and impact of the monetary and …scal policy interventions; and so on). The reaction of global output is negative, persistent, and signi…cant. The peak (negative) reaction, which takes place after four months, reads -1.56%. The negative response of output is consistent with the predictions of the real option theory in presence of non-convex adjustment costs, which implies that agents should optimally "wait-andsee", pause their investments in productive activities and purchases in durable goods, and wait until uncertainty is not there anymore. The response of GFC is also negative, persistent, and signi…cant, with the deterioration of …nancial conditions predicted to be in place for 12 months. The negative response of global …nancial markets, joint with that of world output, is consistent with the …nance-uncertainty multiplier hypothesis put forth by Alfaro, Bloom, and Lin (2019) , who conjecture that …nancial stress due to uncertainty shocks might magnify the direct e¤ects of uncertainty on output.

These …gures imply that the cumulative output loss over one year, i.e., the total deviation of world industrial production from the trend it would have followed in absence 7 The underlying assumption here is that we can map information related to EPU to the VIX. The correlation between EPU and VIX in the January 1990-March 2020 sample is positive (0.46) and signi…cant.

Journal Pre-proof of the Covid-19-induced uncertainty shock, is estimated to be -14%. There is ample uncertainty surrounding our estimate, with values from -6.17% to -21.82% within the 90% con…dence bands. The impressive magnitude of the estimated world output loss echoes that on the US economy by Ludvigson, Ma, and Ng (2020) , who estimate a cumulative loss of 12.75% in US industrial production over a 10-month horizon; and Pellegrino, Ravenna, and Züllig (2020) , who investigate the interaction between …nancial uncertainty shocks and consumer con…dence in an Interacted VAR à la Pellegrino (2018 Pellegrino ( , 2020 ) estimated on Euro Area data. Building di¤erent scenarios conditional on di¤erent paths of Covid-19-induced uncertainty shocks, they …nd a year-over-year peak loss for industrial production of about 15% in September 2020 and 19% in December 2020, with a rebound to pre-crisis level predicted to occur between May and August 2021.

Robustness. We consider alternative lag structures (3 and 12 lags) for our baseline VAR; a bivariate VAR with VIX and WIP only; a di¤erent ordering with WIP before the …nancial block; a VARX with US monetary policy shocks; and a VARX with the oil supply shocks. The latter three exercises are justi…ed as follows. Assuming exogeneity of the …nancial block to movements in the business cycle is always debatable. We then check what happens if we allow for a contemporaneous impact of output shocks on …nancial indicators. Miranda-Agrippino and Rey (2020b) …nd US monetary policy shocks to be a driver of their GFC index (for a related analysis, see Miranda-Agrippino and Rey (2020a)). Pellegrino (2018 Pellegrino ( , 2020 shows that monetary policy shocks can induce ‡uctuations in uncertainty. 8 Our baseline VAR does not feature US monetary policy shocks, an omission that calls for a check which also embeds estimates of such shocks. A similar justi…cation is behind our exercise with the estimated series of oil supply shocks provided by Baumeister and Hamilton (2019) . They show that oil supply shocks are important drivers of their measure of world industrial production. Again, our baseline VAR does not embed information on oil supply disturbances. The choice of treating these two shocks as exogenous variables in our robustness checks is due to their nature (i.e., they are meant to be exogenous). 9 Figure 3 collects the responses of output estimated with the di¤erent speci…cations of the VAR framework we work with.

Our checks con…rm the solidity of the indications coming from our baseline exercise.

Finally, to avoid imposing questionable zero-restrictions for the identi…cation of uncertainty shocks, we also consider a set identi…cation approach based on two di¤erent types of restrictions: i) standard sign restrictions on the three shocks, which require that: a) positive …nancial uncertainty shocks be contractionary and worsen global …nancial conditions; b) positive …rst moment …nancial shocks be expansionary and reduce …nancial uncertainty; c) positive output shocks improve …nancial conditions and reduce uncertainty; ii) an event restriction similar to the one imposed for the identi…cation of …nancial uncertainty shocks by Ludvigson, Ma, and Ng (2019) , which requires that the realization of the …nancial uncertainty shock in October 2008 (the acceleration of the global …nancial crisis) be a large one (larger than the 75th percentile of the empirical distribution conditional on all the models consistent with the estimated covariance matrix of the estimated VAR residuals). Figure 3 also reports the responses conditional on this exercise, which -following in spirit Ludvigson, Ma, and Ng (2019) -are those associated to the "maxG" model selected (out of those that meet our restrictions) by maximizing the value of the inequalities imposed by our constraints (conditional on an equally-weighted quadratic norm). 10 Our empirical …ndings are robust to this alternative identi…cation strategy.

We estimate the response of world output to an uncertainty shock of size comparable to that attributed to the Covid-19 outbreak. We predict a peak response of world industrial production of about 1.6%, and a cumulative output loss over one year of about 14%. Our analysis focuses on the world output e¤ects of the Covid-19-induced uncertainty shock only. Hence, our estimate of the total loss due to the current pandemic is likely to be a conservative one.

Financial support from the Australian Research Council via the Discovery Grant DP160102281 and Discovery Grant DP190102802 is gratefully acknowledged. months. Models other than the baseline: "12 lags" = trivariate model with 12 lags; "3 lags" = trivariate model with 3 lags; "BiVAR" = bivariate model with VIX and WIP only; "WIP …rst" = model with WIP ordered before …nancial indicators; "Mon. pol. shocks" = VARX with Miranda-Agrippino and Rey's (2020) US monetary policy shocks as exogenous variable; "Oil shocks" = VARX with Baumeister and Hamilton's (2019) oil supply shocks as exogenous variable; "Set identi…cation" = uncertainty shock identi…ed with a combination of sign and event restrictions, model selected on the basis of a metric built on our constraints. Sample of the analysis with monetary policy shocks: 1990M1-2010M2 due to the availability of Miranda-Agrippino and Rey's (2020) series of shocks.

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The global e¤ects of Covid-19-induced uncertainty

We estimate a VAR with world-level variables to simulate the e¤ects of the Covid-19 outbreak-related uncertainty shockWe identify uncertainty shocks either with zero restrictions or with a novel combination of sign and narrative restrictionsWe …nd a peak (cumulative over one year) negative response of world industrial production of 1.6% (14%)Our …nding o¤ers support to the massive policy interventions put in place worldwide to tackle the recessionary e¤ects of the Covid-19 shock J o u r n a l P r e -p r o o f