Fiscal policies to address COVID-19 pandemic

In its latest Fiscal Monitor (October 2020), the IMF argues for flexible fiscal measures to respond to lockdowns and tentative reopenings, and facilitation of structural transformation to a new post-pandemic economy. The report outlines a roadmap for the overall fiscal strategy to promote a strong recovery. The idea is to facilitate the transformation to a more resilient, inclusive and greener economies. The IMF recommends full transparency, good governance, and proper costing of all fiscal measures, especially given their size, exceptional nature, and speed of deployment.

Going forward, interest rates will remain low for a long time in advanced and some emerging market economies due to high levels of precautionary savings by households and limited private investment amidst the uncertainties. It means there is scope and motivation for fiscal policy (thanks to negative interest-growth differential) to remain a crucial and powerful tool for recovery. For instance, scaling up of quality public investment will boost employment and economic activities, crowd-in private investment, and absorb excess private savings without increasing borrowing costs. Some emerging market economies and low-income developing countries that face tight financing constraints may need to reprioritize expenditures, enhance efficiency of spending, and seek further official financial support and debt relief.  

On the nature of fiscal policy during and after the pandemic, the IMF recommends:

• No premature withdrawal of crucial household and business support measures
• Ensure social protection systems are targeted and able to deliver benefits to vulnerable people
• During the recovery phase, help workers find new jobs and facilitate vulnerable firms to reopen
• Support structural transformation toward the post-pandemic recovery including building resilience against future epidemics and other shocks. Policies to ensure that all people have access to basic goods (food) and services (health and education) are useful. Similarly, increasing carbon pricing and catalyzing investment in low-carbon technologies would help reduce emissions.
• When the pandemic is under control, focus on addressing the legacies of the crisis such as elevated private and public debt levels, high unemployment, and rising inequality and poverty.
• Countries with limited fiscal space should consider increasing progressive taxation and ensuring that highly profitable firms are appropriately taxed. This should be a growth-friendly and equitable adjustment.
• Develop well-resourced and better-prepared healthcare systems, expand digital transformation, and address climate change and environmental protection. 

Recovery strategy

To boost immediate-term growth, the IMF recommends transfers and public investment, which when faced with uncertainty combined with very low interest rates, weak private investment, and a gradual erosion of public capital stock over time yield a high fiscal multiplier. The fiscal response strategy depends on at what stage of the recovery a particular country is in, i.e. lockdown, partial reopening or post-pandemic phases. These generally include the following

• Lockdown phase: The objective is to save lives and livelihoods by continuing projects where safe (especially maintenance/repair).
• Start planning or reviewing portfolio of planned and active projects
• Partial reopening phase: The objective is to ensure safe reopening and to provide lifelines and targeted support. 
• Public investment could focus on job-rich projects, reassess priorities and prepare pipeline
• Maintenance works and ready for implementation projects should be the priority
• Review, reprioritize and restart feasible projects put on hold, plan for new projects or prepare pipeline of appraised projects that can be implemented in the next two years
• Post-pandemic phase: The object is to transform to a more inclusive, smart and sustainable economy. 
• Depending on fiscal space, countries could implement large, transformational projects with large long-term multiplier in healthcare, climate change adaptation and mitigation and digitization sectors.
• Strengthen project planning, budgeting, and implementation practices to improve public investment efficiency

Fiscal multiplier

The pandemic focused fiscal strategy calls for strengthened public investment management practices and governance to avoid delays, cost overruns, and disappointing project execution. Countries facing tight fiscal conditions could borrow at a low interest rates, which are expected to remain low through the medium-term. 

In advanced and emerging market economies, fiscal multiplier can be as high as 2 in two years. The IMF finds that increasing public investment by 1% of GDP in these economies would create 7 million direct jobs, and between 20 million and 33 million jobs indirectly. Similarly, GDP could grow by 2.7%, and private investment by 10%. The estimate is based on an empirical exercise covering 72 AEs and EMs with data on economic uncertainty regarding GDP forecasts (proxied by disagreements among forecasters). 

Public investment has larger short-term multipliers than public consumption, taxes or transfers. Macroeconomic conditions, institutional quality, and the quality of investment undertaken affect the size of multiplier. 

• First, higher levels of public debt could yield lower fiscal multipliers if deficit-financed investment leads to greater sovereign spreads thus higher private financing costs (essentially, crowding-out the private sector). 
• Second, if an economy faces supply constraints, then fiscal multipliers tend to be smaller (social distancing measures limit output capacity). 
• Third, uncertainty over the trajectory of the virus and the economy could affect multiplier if private spending does not react to a fiscal stimulus (due to uncertainty and precautionary savings). Alternatively, multiplier could be higher if private spending reacts positively to higher public investment amidst mounting uncertainties. 
• Fourth, weak balance sheet of firms (as they are unable to repay debt) and default risks limit their investment and hence the size of fiscal multiplier. 

Generally, multipliers tend to be larger in countries less open to trade because low propensity to import reduces leakage of the demand gains to other countries. Similarly, multipliers tend to be large in countries with fixed exchange rate regimes or where central banks are facing an effective lower bound. Also, when resources are underutilized (like in recessions), fiscal multipliers tend to be high – could be through direct public investment or through a combination of direct public investment and crowding-in of private spending through confidence boosting measures. 

Crowding-in private investment is possible in communications and transport (to respond to healthcare crisis), and construction and manufacturing (during recovery). Investment in health and education, and digital and green infrastructure can improve connectivity, economy-wide productivity, and resilience to climate change and future pandemics. Right government policies and initial investment can crowd-in private investment when faced with uncertainties.

 

Sizable fiscal support

The IMF notes that fiscal actions in response to COVID-19 amounted to $11.7 trillion (12% of global GDP) as of 11 September 2020. Half of this was additional spending or foregone revenue (such as temporary tax cuts and liquidity support including loans). In 2020, government deficits will likely surge by an average 9% and global public debt will approach 100% of GDP. Sizable discretionary support, a sharp contraction in output and an ensuing fall in revenues along with a rise in expenditure (beyond preexisitng automatic stabilizers) have increased government debt and deficits. 

Fiscal space

The ability of countries to respond to the pandemic is determined in part by their fiscal space, and by public and private debt levels. In advanced economies, massive liquidity provision and asset purchases by central banks have facilitated fiscal expansions. In some low-income countries, financing constraints have been high due to debt distress. 

Countries with limited fiscal space need to weigh in the benefits, costs and risks of additional fiscal support measures in the face of limited fiscal space. Evidence so far suggest that public health policies that quickly contain the spread of the disease also allowed for an earlier and safer reopening, restoration of confidence, and economic recovery. 

Popular fiscal support measures included the following:

• Household income support (targeted cash transfers or/and in-kind transfers, unemployment benefits/stimulus checks)
• Employment support (wage subsidies, hiring or retention subsidies)
• Tax support measures (temporary tax deferrals, social security payments, income tax cuts, progressive tax, increase in excise duty, VAT refunds, utility subsidies)
• Liquidity support (loans, guarantees, equity injections/solvency support, debt restructuring) 
• Support for innovation, green growth and digitization

Financing public spending

Some EMDEs have met increasing financing needs from borrowing internationally, drawing down buffers or extrabudgetary funds (India) or sovereign wealth funds (Chile, Russia), purchasing of government debt by central banks through quantitative easing (many AEs and some EMs), and increasing taxes (especially fuel excise tax in India and VAT rate in Saudi Arabia). Low income countries are relying on external assistance (grants or concessional loans).

Fiscal risks: Fiscal risks are high. They stem from

• A protracted economic downturn (private sector demand may remain subdued, bank balance sheets may deteriorate, high fiscal resources needed to support and retain unemployed workforce) 
• Tightening global financial conditions (rapid growth of sovereign debt and nonfinancial corporations debt expose countries to sudden change in financing conditions, especially borrowing costs, and subsequently issues with sustainability of corporate credit and sovereign debt)  
• Commodity market volatility (price fluctuations impact commodity exporters and importers differently)
• Contingent liabilities (new guarantees increase liabilities and debt vulnerabilities)

Post pandemic recovery strategy

It was published in The Kathmandu Post, 19 October 2020.

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Everything is not okay

A series of impractical and confusing recovery policies have heightened business, investment and employment uncertainties.

Owing to a prolonged combination of health, supply and demand shocks, and a botched response to containing the spread of the novel coronavirus, the pandemic is severely affecting the economy. These shocks, along with preexisting economic and governance weaknesses, have increased the likelihood of subdued economic activities well into the medium-term; that is, the ongoing economic pain may not be a temporary phenomenon. The poorest households, informal sector workers, and those working in contact-intensive services have been disproportionately affected. Consequently, both poverty and inequality are expected to increase. Furthermore, many micro, small and medium enterprises are expected to face bankruptcy, as consumer demand remains muted and supplies continue to be disrupted.

Against this backdrop, a sustained and inclusive economic recovery hinges on pragmatic stabilisation policies over the short to medium term, followed by coherent structural reforms across sectors over the medium to long term. The economic strategy should focus on propping up aggregate demand over the medium term through public spending on quality, shovel-ready projects; or through the repair and maintenance of public assets. In order to bridge the short-term financing gap amidst high fiscal stress, the government may need to rely more on policy-based external borrowing, which comes as budget support conditional on fulfilling certain committed reforms.

Not so rosy

Economic output growth in the fiscal year 2020-21 will most likely be only slightly better than in 2019-20, thanks to a base effect, which refers to a tendency of achieving an arithmetically high rate of growth when starting from a very low base. Gross domestic product (GDP) growth might actually contract in 2019-20 as labour and capital mobility were curtailed in the last quarter of 2019-20 as well. Third quarter estimates released by the Central Bureau of Statistics in September show that GDP growth plunged to 0.8 percent even though lockdowns started in the middle of the quarter. This is the slowest pace of quarterly GDP growth since the second quarter of 2015-16, when the Indian economic blockade contracted the economy. The fourth quarter GDP data for 2019-20 will probably show a contraction. Cumulative full year GDP will also likely contract due to the severe disruptions in industry and services owing to lockdowns, a shortage of inputs in the agricultural sector and a lack of effective fiscal response to prop up consumer demand. The Bureau’s 2.3 percent growth projection for 2019-20 has no relevance now. The International Monetary Fund projects the economy to grow by 0.02 percent in 2019-20 and 2.5 percent in 2020-21.

The other statistics are also not that rosy. Despite subdued demand for consumer goods, continued supplies disruptions, as well as higher logistics costs, will likely keep inflation above 6 percent. The surge in banking sector liquidity is temporary, as credit growth has slowed down significantly due to a drop in new loan applications. This is benefitting the government as it is able to borrow at a record level with lower interest rate. The current account deficit is narrowing down as imports decelerate more than exports and remittances’ deceleration is below expectation. These indicators will quickly deteriorate as businesses and household activities pick-up pace. Overall, the outlook is not at all rosy.

Effective recovery

What went wrong since the first confirmed Covid-19 positive case on January 23 and the lockdown that started on March 24 but was relaxed in September? The uncontrolled outbreak and the lack of healthcare infrastructure are now considered a basket case of bad pandemic mismanagement. The lockdowns were an opportunity to prepare necessary healthcare infrastructure—which includes the availability of personal protective equipment, hospital beds, Covid-19 care centres for those unable to stay in home isolation, an active network of contract tracers, and widespread testing, among others—to respond to the eventual rise in infections. Not only was healthcare response mismanaged, the economic response too was patchy and demoralising. A series of impractical and confusing recovery policies heightened business, investment and employment uncertainties. These need to be rectified for sustained and inclusive recovery.

The priority should be the healthcare sector. Without controlling the spread of the novel coronavirus and providing necessary medical care to the infected, a full recovery to pre-crisis output growth is a foregone conclusion.

The government should then implement effective short-term measures to support struggling households (through cash transfers and in-kind food subsidies) and businesses (with subsidised low interest loans, credit guarantee schemes, tax deferrals, moratoria on debt services, and equity injections in promising firms). This calls for both a growth-enhancing revenue policy and an expenditure policy designed to stabilise the economy in the short term, followed by structural reforms to boost long term growth potential.

However, since this entails additional fiscal burden amidst limited resources, the third priority should be a smarter fiscal strategy. For instance, expenditure should be reprioritised to address the healthcare crisis. It means investing in temporary Covid-19 care centres, increasing hospital beds and ventilators, increasing availability of affordable and hassle-free testing, and tracing potentially exposed people effectively, among others.

Similarly, to boost short-term aggregate demand, the government could prioritise shovel-ready projects that can be completed within the next two to three years, or simply focus on the maintenance of existing assets (especially water supply, irrigation canals, bridges, rural roads and highways, transmission and distribution lines, etc) and the completion of ongoing projects. It will not only give an immediate-term boost to public sector-led demand at a time when private sector demand is subdued, but will also create badly needed manual and low skilled jobs for returning migrant workers. Initiating new projects that are short of project readiness should not be the priority for the short-term. To save scarce resources, the government could think of ending subsidies on fuel and all discretionary handouts.

To generate more resources to finance short-term needs, the government could also focus on securing policy-based loans from development partners. A well-planned set of sectoral reforms with clear policy, regulatory, institutional and legal framework would serve as a basis for securing policy-based loans. The post-Covid-19 era is a defining moment to initiate consequential structural reforms similar to the ones rolled out in 1992. Public financial management reforms, such as in robust medium-term expenditure and revenue frameworks, streamlined processes across the three tiers of government, and legal cap on central and provincial fiscal deficit, are important. The digitisation of government services, integrated social protection platform for better identification and to control leakages, and core sectoral reforms in energy, water supply, roads, education and health sectors are other key areas. Another key avenue for development is an overhaul of the vocational training curriculum to provide reskilling to shrinking sectors such as travel and tourism. In business, the promotion of economic corridors to boost enterprise on the one hand, and a facility to resolve bankruptcies sooner for struggling organisations on the other would both go a long way to boost growth and recovery.