Currency

• Changes in indirect tax rates can have a visible impact on consumer prices.
• This assumes the full and immediate pass-through of changes in indirect taxes to consumer prices and therefore, on balance, tends to overstate the effects of tax changes.
• [1] Based on this measure, the contribution from changes in indirect taxes to euro area HICP inflation has been, on average, 0.2 percentage points, but was much stronger during periods when tax rates increased, such as in 2007 and between 2011 and 2014 (see Chart A).
• Chart A HICP and HICP at constant tax rates (annual percentage changes; percentage point contributions)

• However, in response to the coronavirus (COVID-19) pandemic, several euro area countries have reduced indirect tax rates on a scale not seen before in the euro area.
• In addition to temporary reductions in broad-based value added taxes (VAT) in Germany and Ireland, many other euro area countries have recently introduced targeted reductions in indirect taxes (see Chart B).
• [2] Assuming full and immediate pass-through, Eurostats HICP at constant tax rates implies that the reduction in VAT in Germany would have a downward impact on euro area HICP inflation in July 2020 of around 0.6 percentage points.
• [3] Chart B Impact of changes in indirect taxes on HICP inflation (percentage point contributions based on difference between HICP and HICP at constant tax rates)

• The actual impact of the recent reductions in indirect taxes on inflation is surrounded by considerable uncertainty.
• First, historically there are few examples of cuts in indirect tax rates in euro area countries that could shed light on the likely degree of pass-through.
• Lastly, the lions share of the current reduction in indirect taxes results from the VAT rate cut in Germany, which is only temporary (and very rare in euro area countries), and might thus generate unusual anticipation effects.
• [6],[7] The pass-through of recent reductions in indirect taxes is likely to vary across sectors and to be overall incomplete.
• The reductions in indirect tax rates in euro area countries shape the inflation profile for 2020 and 2021 in the September 2020 ECB staff projections.
• Understanding the impact of indirect taxes on the inflation profile and outlook is relevant for the communication of monetary policy.
• Chart C Impact of changes in indirect taxes on HICPX inflation projections (annual percentage changes; percentage point contributions)

• In the euro area, the deep integration of firms within regional supply chains as well as strong demand ties acts as a magnifying mechanism.
• This article quantifies the propagation and impact of adverse shocks originating in the euro area on euro area GDP, foreign trade and trade balances.
• The negative spillover effects are most severe for open countries and those most intertwined in regional production networks.

1 Introduction

• This article employs multi-regional input-output tables to evaluate the transmission via foreign trade of adverse shocks generated by lockdowns and containment measures across the euro area.
• The latter are only indirectly affected as a result of effects on the inputs of the sector directly affected by suppression measures.
• Our methodology accommodates the analysis of a variety of shocks, in particular, single country, multi-country, sector specific and foreign trade specific shocks.
• The abovementioned properties are particularly relevant given the strong interdependence of euro area economies and this articles focus on shocks originating in the euro area.
• In this context, analyses based on methodologies that fail to consider euro area interconnectedness are likely to underestimate the effective impact of the COVID-19 shock.
• Section 5 concludes by reviewing the main takeaways from our analysis and discusses the potential structural economic changes triggered by COVID-19.

2 Data and methodology

• The article takes data from the Multi-Regional Input-Output (MRIO) databaseof the Asian Development Bank (ADB) that reconstructs national and international flows between country-sector pairs and sectoral final demand.
• The database encompasses all euro area economies and a broad set of other countries.
• Compared with alternative sources, it also provides more recent information up to 2018 (see Box 1 for a detailed description of the database and our methodology).
• [2] The analysis uses a static representation of the economic linkages across sectors and countries to evaluate the economic effects on individual industries of virus-suppression policies.
• The entire manufacturing industry, except for food, beverages, tobacco and pharmaceuticals, has been significantly affected by COVID-19 containment measures.
• Let zis denote the elements of the respective matrices, where s, t {1,,N} denote the exporting and the importing sector respectively.
• We apply sectoral supply shocks to rows and demand shocks to columns.
• Shocks are calibrated based on internal and external analyses of the repercussions of countries containment measures.
• Depending on the scenario, a shock (s)can be single-country or multi-country and model production disruptions or final demand shocks.
• [4] In a second stage, indirect shocks are applied to model the supply chain adjustment to the shock in the first stage.
• The analyses rest on some key assumptions and have certain limitations, such as:
  • they strip out the price effects of implemented policies;
  • they provide no information on the implications of and interaction with significant monetary policy measures, although the effects of implemented fiscal and monetary policies indirectly influence the exercises to the extent that they modify the forecasts of aggregate output developments in 2020;
  • moreover, since they are static, the assessments ignore potential permanent changes in the structure of economies that may ensue from reshoring or the diversification of essential production processes and changes in lifestyle, time allocation across activities, consumption preferences and daily needs.
  • In our framework, as long as the relative magnitude of sectoral innovations is preserved, the final effects of a given shock are proportional to the original shock.
  • In this way, our assessments can be adapted to analyse the effects of milder or more severe trajectories that the pandemic might take.
  • Thus, the industry experiencing the sharpest contraction in production takes the value of 100 and shocks in other sectors are indexed to it.
  • We calibrate the shocks based on sectoral information available on the effects of suppression measures and on analyses from internal experts as well as external sources.
  • Possible trade diversion effects are ignored as their appearance may be delayed and our analysis focuses on 2020.

3 Transmission channels

• [8] In this section, we discuss the various channels that are at play when this occurs and how shocks originate in country-sectors and spill over to the rest of the world, amplified by foreign trade.
• Domestic production shocks applied to the ICIOT are transmitted to upstream and downstream trading partners and further up and down the chain to partners of trading partners via export and import channels.
• Intuitively, by halting domestic production, lockdown measures are conducive to shortages of intermediate goods produced domestically that enter foreign production processes via trading partners (known as the export channel).
• These shortages generate negative supply shocks for companies located downstream in the chain.
• At the same time, they reduce the demand for foreign intermediates entering domestic production processes (known as the import channel).
• We, however, only model the first two steps, the reduction in imports and foreign production and the foreign intermediates demand shock.
• To illustrate the transmission mechanism, let us consider shop closures and, more specifically, look at the case of a bar forced to lock down.

4 Euro area-wide repercussions of containment measures in the five largest economies

• [9] Using the transmission channels explained above, we assess spillovers from the lockdowns, temporary closures, restrictions on movement and other containment measures adopted by the five largest euro area economies (Germany, France, Italy, Spain and the Netherlands) since early March 2020.
• The sectoral distribution of production shocks reflects the expected differential impact of containment measures across industries.
• The initial aggregate GDP shocks to the five largest euro area economies in 2020 correspond to the projections for euro area economies in the June 2020 BMPE.
• Table 1 Shock calibration: indices of sectoral output shocks due to containment measures by main sector of activity
• There is very substantial transmission of domestic shocks in the five largest euro area economies to aggregate activity in the rest of the area.
• Based on the current structure of euro area countries and their interdependencies, our assumptions and the sectoral calibration above, the impact of a shock similar to the COVID-19 suppression measures applied to the five largest euro area economies would be amplified by 15-28%.
• Lost output results in a reduction in income if the original shock is not countered through policy measures.
• The main finding of this exercise is that the degree of interconnectedness influences the amplification of the initial shocks.
• Chart 1 Transmission of single-country shocks to the five largest euro area economies through supply and demand linkages (left-hand scale: percentage; right-hand scale: multiples)
• Euro area foreign trade contracts by more than aggregate activity and lockdown measures lead to GVC retrenchments.
• COVID-19-induced shocks have caused a deterioration in the net trade positions of euro area Member States.
• Net trade has contracted in all of the five largest euro area economies, substantially contributing to the transmission of the initial domestic shock to GDP.
• Table 2 Most affected countries and sectors in the euro area
• Box 2 The euro area regional production network The euro area is a unique example of a regional production network.
• GVC linkages in the region reflect an intricate supply web with more than one hub, comprising production, shipping and financial centres.
• This box describes the euro area production network and discusses how it has changed, focusing in particular on the period after the GFC.
• This distinction is key when disentangling trade within a production network from GVC trade with other production networks.
• Chart A GVC exports by main euro area trading partner/region (as a percentage of total bilateral exports)
• The European production network remains the engine behind aggregate activity in the euro area.
• In 2018, three-quarters of the intermediates exported by euro area countries within the European Union were destined for further processing and re-exporting; two-thirds reached another euro area member.
• Supply chains in the euro area continued to develop amid a decline in GVCs share of total global exports since before the GFC.
• While the global trade slowdown did not spare euro area trade, the euro area actually strengthened its position as a leader in GVCs relative to other regions after the GFC.
• Chart B Change in euro area GVC exports, shallow and deep linkages (2018-2008) (as a percentage of total bilateral exports)
• Integration within the euro area is clustered around a few economies (Germany and the Netherlands in particular).
• Based on the bilateral flows in intermediates crossing at least two borders, the five largest euro area economies are primarily integrated with the Netherlands, which acts as the euro area delivery and arrival point for exports and imports from the rest of the world.
• Eastern enlargement of the euro area and improvements in stressed countries explain the success of its regional supply chains after the GFC.
• [15] A significant contribution also comes from countries like Spain, Portugal and Greece that improved their participation in regional GVCs relative to their pre-GFC values.

5 Conclusion

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