COVID-19 related economic scarring

The IMF’s WEO April 2021 includes a chapter on the possible persistent effects of the pandemic on economic activities (scarring). It notes that the emerging markets and low-income countries are expected to face greater scarring due to their limited policy space to launch relief measures for struggling households and firms. It argues that the crisis could result in substantial and persistent damage to supply potential and extend scarring due to diminishing labor force participation, bankruptcies, and disruption of production networks. The longer the recession, the more likely the effects will be permanent, especially in countries with the prevalence of small firms and shallow capital markets. Persistent supply disruptions could result from the loss of economic ties in production and distribution networks as job destruction and firm bankruptcies increase— these tend to lower productivity growth and slowdown capital accumulation. These could dampen investment and employment, and cripple productivity growth for an extended period of time. 

The IMF states that although financial instabilities have been largely avoided this time and the spillovers of the pandemic’s initial impact on high contact-intensive service sectors are limited, the scale of the impact could still represent a large shock to the economy. It estimates that the global output in 2024 could be 3% lower than the anticipated pre-pandemic output. However, the degree of scarring varies by country. Policymakers could limit scarring by providing support to the most-affected sectors and workers while the pandemic is ongoing. To address long-term GDP losses, countries need to focus on remedial policies for the setback to human capital accumulation, boost investment, and support reallocation of workers and firms (retraining, reskilling, and insolvency procedures).

The COVID-19 pandemic resulted in a combination of supply and demand shocks. Pandemic-induced lockdowns reduced effective productive capacity as some firms were forced to close or operate at below capacity than usual times, and some had to reorganize production on account of physical distancing between workers, which in turn lowered productivity. The initial supply shocks spilled over to other sectors through production networks. Meanwhile, demand decreased due to reduced mobility and as precautionary savings increased amidst heightened uncertainty. The initial supply shock also led to a decline in demand as workers earned either less or were laid off outright, which decreased private savings.  

After recessions or health shocks in the past, technology adoption, employment, and capital accumulation suffered, leading to extended period of economic slowdown. For instance, unemployment continued to remain high and lowered labor force as discouraged workers exited the labor market. Extended period of unemployment affects skills deterioration, delays labor market entry for young workers, negatively affects educational achievement in the long-term (especially, parental job losses adversely affect children’s schooling and future labor market outcomes)— all affecting human capital accumulation. Similarly, recessions also dampen investment, slowing down physical capital accumulation, which affects productivity though slower technology adoption. Also, business bankruptcies permanently affect productivity due to the loss of firm-specific know-how. Decline in research and development, and increase in resource misallocation also affect productivity permanently. 

The pandemic has already caused some form of supply-side scarring from lower productive capacity and demand-side persistent preference shits. The report three particular features of the crisis on scarring:

1. Although lower than after the global financial crisis in 2008, the prospects for scarring from COVID-19 are substantial. This time there is relative financial stability following the COVID-19 shock thanks to large-scale fiscal and monetary measures. Previously, financial crisis resulted in deep recessions, which then led to persistent output losses. However, this time financial stress could easily build up as loan defaults increases after debt service moratoriums and several regulatory forbearances are phased out. These affect productivity, and efficiency of labor and capital inputs. 

Lower-skilled workers have seen a disproportionately large decline in employment and business exits of small businesses are increasing. 

2. Some sectors have not recovered after productivity shocks in the past and that the spillovers from COVID-19 shocks are still sizable (despite high-contact sectors are less central to production networks). Scars become persistent due to lower productivity growth and slower capital accumulation. 

Note that scarring in the labor market may be larger than in previous recessions because of permanent shrinkage of some high-contact sectors. For instance, some student in low-income countries may not be fully able to switch to virtual learning and this could have devastating implications on human capital accumulation. Similarly, physical capital shrinkage could also amplify scarring because of sector-specific idle capital in the case of high-contact sectors, and large corporate debt buildup that lowers investment by more leveraged firms. 

The pandemic related disruptions to upstream (from customers to focal sector of interest) and downstream (from suppliers to focal sector of interest) production networks could have knock-on effects on productivity of connected firms. Productivity could also suffer if small businesses close down in high-contact sectors but large companies strengthen their market power. The increased digitization and innovation in production and delivery processes could offset some of the adverse productivity shocks though. 

The report finds that adverse productivity shock (supply shock) in own sector results in 5% lower total gross value added for up to five years after the shock. Government spending shock is not statistically significant on total GVA. For spillover shocks, downstream effects are dominant, highlighting the importance of supply shocks arising from COVID-19. The ‘own effect’ is larger for high-contact sectors such as wholesale and retail trade, hotels and restaurants, entertainment and personal services, transportation, education, healthcare, and construction.  

3. Global losses are smaller than during the global financial crisis largely due to unprecedented policy support and contained financial stability risks. That said, medium-term output losses from the shock are still sizable, but they exhibit significant variation across economies and regions. The IMF estimates that the COVID-19 shock will lower world output by 3% in 2024 compared to the pre-pandemic projections (over the same period, output losses were 10% in the case of global financial crisis). However, emerging and developing economies will likely have deeper scars than advanced economies, thanks partly due to the larger pandemic-related fiscal responses in the latter and faster access to vaccines. Particularly, economies more dependent on travel and tourism, and those with larger service sectors, are expected to experience more persistent losses.  

Medium-term scarring is contingent on: (i) the path of the pandemic and associated containment measures, (ii) impact of the pandemic shock on high-contact sectors, (iii) adaptation capability of firms and workers to a lower-contact working environment and lower-contact transaction, and (iv) the effectiveness of policy response to limit economic damage.  

Depending on the level of fiscal space, the IMF recommends countries to 

• Reverse setbacks to human capital accumulation and encourage employment by ensuring adequate resources for healthcare, early childhood development programs, education, worker retraining and investment in digital literacy, expansion of social safety nets, and support for displace workers.
• Support productivity by allowing exit of nonviable firms, active labor market policies (help workers transition between jobs by retraining, public employment services, public work schemes, wage subsidies, and support for self-employment/micro-entrepreneurs), and facilitate resource reallocation (to improve labor mobility and reduce product market rigidities). Other measures include promotion of competition, innovation and technology adoption. 
• Boost investment in infrastructure, particularly green infrastructure to help crowd-in private investment. Repairing corporate balance sheet to reduce debt overhand will also promote investment. Improved bankruptcy and debt restructuring mechanisms help to reallocate productive capital. 

Divergent recovery and policy options

In the latest edition of World Economic Outlook (WEO, April 2021), the IMF states that without the extraordinary fiscal and monetary policies, the pandemic would have resulted in an economic contraction three times larger than the current estimates. 

GDP growth

The IMF is projecting the global economy to grow at 6% in 2021, up from an estimated contraction of 3.3% in 2020, and moderate to 4.4% in 2022. These revised projections are higher than earlier estimates owing to the favorable effect of easing of lockdowns, adapting to new ways of working, substantial fiscal support in advanced economies, and an anticipated vaccine-led recovery in the second half of 2021. The IMF projects global growth to moderate to 3.3% over the medium term as the damage to supply chains scars output capacity and aging in advanced economies slows down labor force growth.

Inflation

Inflation in advanced economies is projected to rise to 1.4% in 2021, up from 0.4% in 2020, and 1.9% in 2023. In EMDEs, inflation is projected to remain stable at around 3% from 2021-2023, up from 2.8% in 2020.

The IMF expects price volatility to be short lived and that inflation will return to its long-term average as remaining slack subsides gradually and commodity-driven base effects fade away. Commodity prices, particularly oil, are expected to firm up in the months ahead. But, overall subdued inflation outlook reflects labor market conditions as well, especially subdued wage growth and weak worker bargaining power that are compounded by high unemployment, underemployment, and lower labor force participation rates. 

The IMF notes that unless output gaps become positive and very large for an extended period of time, and monetary policy does not react to rising inflation expectations, inflation is unlikely to increase much. It also does not expect monetary policy to be used primarily to keep government borrowing costs low at the expense of price stability as most economies have independent central banks. 

External sector

On external sector, the IMF projected global trade to accelerate to 8.4% due to the rebound in merchandise goods. But, cross-border services trade (travel and tourism) is expected to remain subdued. 

Divergent effects

The output losses have been divergent. The most affected are the economies that rely on tourism and commodity exports and those with limited fiscal space to respond to the crisis. Many countries entered the crisis without much fiscal space and the ability to mount an effective healthcare policy response. The WEO states that economic situation now (and eventual recovery) is influenced by factors such as the proportion of ‘teleworkable’ jobs, share of employment in small and medium enterprises, capital market deepening, size of informal sector, and quality of and access to digital infrastructure. 

The economic recovery since the second half of 2020 has been led by strong demand for products suitable for working from home and pent-up demand for durable goods such as automobiles. Industrial output is now at pre-pandemic level, but contact-intensive services activities have remained depressed. Likewise, although merchandise trade is back to the pre-pandemic levels, cross-border trade in services remains subdued.  

Unemployment and underemployment remain at elevated level. Labor force participation rate has dropped despite wage and jobs retention programs in many countries. The report notes that youth, women, less educated workers, and informally employed are hardest hit by the pandemic. Poverty (additional 95 million people) and income inequality are likely to increase. The unequal setback to schooling could further exacerbate inequality. 

Asset markets have been surging, thanks to policy stimulus and expectations of a vaccine-driven normalization. However, the IMF notes that the divergence between valuations and broader economic prospects raise financial stability risks. 

GDP loss

The IMF projects the average annual loss in per capita GDP over 2020–24, relative to pre-pandemic forecasts, to be 5.7% in low-income countries and 4.7% in emerging markets. In advanced economies the losses are expected to be 2.3%. Unlike the global financial crisis in 2008, the substantial policy support in response to the pandemic has averted a financial crisis, and medium-term losses are expected to be lower than in 2008 (about 3% lower). However, the emerging markets and low-income countries are expected to face greater scarring owing to their limited policy space. 

Fiscal authorities provided relief to households and firms in the form of transfers, wage subsidies, liquidity support, expansion of safety net such as unemployment insurance and nutrition assistance. Financial regulators facilitated credit provision by easing classification guidelines for nonperforming loans, relaxing provisioning requirements for banks, reducing risk weights on bankruptcy proceedings, and flexibility regarding bank capital requirements. 

The IMF estimates that policy actions such as automatic stabilizers, discretionary measures, and financial sector measures contributed about six percentage points to global growth in 2020. 

Economic outlook

There is considerable uncertainty over the economic outlook though. The WEO notes that it is contingent on the path of the health crisis including vaccine effectiveness against new variants, the effectiveness of policy actions to limit persistent economic damage (scarring), the evolution of financial conditions and commodity prices, and the adjustment capacity of the economy. 

Vaccine procurement and distribution are uneven with broad vaccine availability in advanced economies and some emerging market economies. Since vaccine deployment will be staggered across regions, spread of new variants forcing occasional and localized lockdowns is possible. However, the IMF notes that these may not constrain economic activities like in the initial lockdowns because they will be more targeted and that people and firms have adapted to remote work. 

The size of fiscal package will also drive the nature of recovery. The fiscal package unveiled by the US government will boost growth in the US in 2021 and provide sizable positive spillovers to its trading partners, the WEO states. The IMF expects debt service costs to remain manageable across advanced economies because their debt profile is largely dominated by long-term and sometimes negative-yielding bonds. However, it notes that EMDEs will have limited fiscal support now, but as revenue mobilization improves with pickup in economic activities and crisis-related expenditures unwind, they will have lower fiscal deficits than now. But high debt service costs are expected in EMDEs. 

The crisis could still result in substantial and persistent damage to supply potential and extend scarring due to diminishing labor force participation, bankruptcies, and disruption of production networks. It argues that the longer the recession, the more likely that the effects will be permanent, especially in EMDEs where the prevalence of relatively small firms and shallow capital markets could dampen investment and employment for an extended period of time. These may cripple productivity growth too. 

The IMF expects monetary policy to remain accommodative and tighten only gradually as recovery takes hold. It also expects oil prices to increase as OPEC+ producers curb supply. The strong rebound in PRC will put upward pressure on metal prices. Food prices are also expected to increase in 2021. 

Policy response

Against this backdrop, the IMF recommends policymakers to prioritize policies prudently including strengthening social protection with wider eligibility for unemployment to cover the self-employed and informally employed; adequate resource for healthcare, early childhood development programs, education, and vocation training; and investment in green infrastructure to accelerate the transition to lower carbon dependence. Policy support should be flexible such as shifting lifelines, reallocations, and linked to improvements in activity, but they should safeguard social spending and avoid inefficient spending outlays. Anchoring short-term support in credible medium-term frameworks is key. Economies facing high debt burden should consider creating fiscal space through increased revenue mobilization and reduced wasteful subsidies.

It recommends policy responses to be tailored to the stage of the pandemic, strength of the recovery, and structural characteristics of the economy. As the pandemic continues, policies should focus on prioritizing the healthcare spending, providing well-targeted fiscal support, and maintaining accommodative monetary policy. As recovery progresses, policymakers should limit long-term economic scarring by broadening productive capacity and increasing incentives for an efficient allocation of productive resources. 

Differences in consumption aggregates and poverty estimates in South Asia

In a paper published in the latest edition of Asian Development Review (Vol.38. No.1), Islam, Newhouse and Yanex-Pagans study how differences in the construction of consumption aggregate in South Asian countries contribute to total error (arising out of nonsampling error and the error in the process of determining the international poverty line) in international extreme poverty measurement. Methodology and questionnaire for household survey differ among the countries, contributing to total error of the subsequent international extreme poverty line obtained for each country. They examine how sampling and survey design; spatial deflation to account for cost-of-living differences and intertemporal deflation; and construction of nominal consumption aggregate contribute to total error. 

Some factors that affect total error are incomplete coverage of the country’s population, errors in measuring consumption data, errors in calculating the poverty line, use of the consumer price index (CPI) to deflate prices in a manner that may not be consistent with the consumption patterns of the poor, and geographic differences in prices.

On sampling and survey design, the paper examines (i) sampling design, (ii) monetary welfare measure, (iii) food consumption questionnaire and data collection methods, (iv) self-production and meals outside home, (v) nonfood durables, (vi) durables, (vii) housing expenditures, and (viii) health and education expenditures. 

Among these, there exists significant differences in the way food consumption data are collected, especially the number of food items in the consumption questionnaire. Inclusion of more food items tend to increase levels of reported consumption, leading to lower reported poverty rate. While Pakistan has the lowest number of food items (69) listed in the survey, Sri Lanka has the highest (227). Bangladesh has 141, Bhutan 130, India 143, Maldives 92, and Nepal 74. For nonfood items, Afghanistan has the lowest number of items (38) and Maldives has the highest number of items (483). India has 338 and Nepal 95. 

Consumption data are collected either using diary method (households record all consumption data over a certain period in a notebook) and/or recall method (households list what they consumed over a specific past reference period). Length of consumption recall is also different. Lowering the recall period have increased reported consumption by households, which resulted in poverty rates falling by half in India. The authors note that “this simple change in the method of collecting data “lifted” 175 million Indians out of poverty”. 

The South Asian countries also have different questionnaires for the value of consumption of self-produced food and meals from outside home. For instance, Bangladesh, Pakistan and Sri Lanka do not account for food expenditures on meals outside the household as a part of their consumption aggregate. Note that consumption of food eaten outside the home is shown to raise extreme poverty rate. Similarly, Maldives and Pakistan do not account for consumer durables, and in Afghanistan and Nepal it is imputed. In the case of housing, all countries except Maldives include actual rent for urban and rural areas. They also include imputed rent except for (India and Maldives). All countries include health and education expenditure (except for Nepal in the case of health expenditure). 

Spatial deflation is used to adjust cost-of-living differences, which lowers the possibility of overestimation of poverty in rural areas and underestimation in urban areas (since an urban household needs to spend more to maintain the same standard of living as that of a rural household). Use of appropriate regional price indexes is important in this regard, but this could be challenging to construct. All South Asian countries do spatial deflation when they calculate their national poverty estimates, but when calculating international extreme poverty rates, the World Bank spatially deflates consumption aggregates in Bhutan and Nepal only. Bhutan uses survey-based price index to deflate prices, but Nepal and Bangladesh use an implicit spatial price index to deflate prices. The authors show that using spatial deflation is important in the case of international extreme poverty estimates, especially given the fact that without spatial deflation urban areas have less poverty and rural areas have more poverty. They recommend collecting regional price data for different durable and nondurable goods, and services. They also suggest collecting rental cost of housing at regional level so that imputation for rental rate of owner-occupied housing could be done suitably. 

A third source of total error is the way standardized consumption aggregates are computed compared to the national consumption aggregates. Here, standardized consumption aggregate refers to the one obtained from the standardized consumption datasets created by the World Bank. It basically reclassifies expenditure items into the various categories used in the International Comparison Program (ICP). However, note that the method of data collection and questionnaire design affect standardization. The authors show slightly different average per capita consumption using the standardized and the national consumption aggregates. Not much difference, but in the case of India there is notable difference because of imputed rents for home owners. Also, standardization decreases housing expenditure in Nepal, Bhutan and Sri Lanka. 

The authors shows that standardization of consumption aggregate also changes share of particular item on total consumption expenditure. In Nepal, while food items account for 57% of national consumption expenditure, the standardized value is a bit less at 53%. Standardization reduces the share of food expenditure in consumption aggregate in all South Asian countries except Sri Lanka. 

The standardization of consumption aggregates increases poverty rate in Bangladesh, Bhutan Pakistan, and Sri Lanka. However, they authors show that it decreases the international extreme poverty rate in India, Maldives and Nepal.  

Energy sector prospect in Nepal

In an excellent article about energy sector in Nepal in New Business Age, Rupak D Sharma argues that given the large generation capacity in pipeline and the prospect of supply outstripping demand, there is no choice but to export electricity (to India and perhaps Bangladesh) in the short-term and then work to increase per capita electricity consumption over the medium-term. Above all, escalating cost of production needs to be controlled.

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[...]A total of 15 new projects built by the private sector added 135.39 MW of electricity to the national grid in the last fiscal year. Two projects of NEA, 60MW Upper Trisuli 3A Hydroelectric Project and 14MW Kulekhani III Hydroelectric Project, also came into operation that year. The energy sector is expected to see an addition of over 800 MW of electricity in this fiscal year alone if the 456MW Upper Tamakoshi Hydroelectric Project comes online. What’s more, 131 additional private sector-led projects with a combined capacity of 3,157.19 MW are under construction. And another 112 private sector-led projects with a combined capacity of 2,124.77 MW are in different stages of development, according to NEA’s latest annual report.

[...]Nepal’s energy generation cost has significantly gone up over the years due to a hike in project development cost. A few years ago, the cost of building a hydroelectric project used to hover around Rs 150 million per MW. The cost has now surged by 33 percent to Rs 200 million per MW. This has made electricity expensive, raising the spectre of restricting domestic consumption and making energy generated in Nepal uncompetitive in the foreign market.

[...]In a typical hydropower project, construction materials, such as cement, steel and aggregates, command a weight of about 40 percent in the total development cost, according to Pradhanang. Labour costs make a contribution of around 20 percent to the total cost, while soft costs, such as engineering design and management, command a weight of 25 percent. The share of the cost of electromechanical items in total project development cost stands at about 15 percent.

Over the years, labour costs have surged as most of the youths have left the country for labour destinations in the Gulf, Malaysia and other countries across the globe, creating a shortage of workers. At the same time, prices of construction materials, such as cement, steel and aggregates, have steadily gone up. Each kg of TMT 500D steel now costs Rs 95, as against Rs 75 two years ago. In India, the same product can be bought for INR 34-47 (Rs 54.4-75.2) per kg in the retail market. Cement is also a lot cheaper in India, where a 50-kg bag of OPC can be fetched for INR 300-350 (Rs 480 to Rs 560). The same quality and quantity of cement costs Rs 700 in Nepal, up from Rs 650 in early 2019.

[...]NEA will be in a position to export 25 to 30 MW of electricity round the clock in the next three months, according to NEA Managing Director Hitendra Dev Shakya. By the upcoming rainy season, that capacity will rise to 450 MW. The portion of surplus energy will continue to rise in the coming years, as NEA has already signed agreements to purchase 5,978.13 MW of electricity from 341 private developers, which is four times the current installed capacity. Nepal will not be able to consume all this electricity in the short run, as its electricity demand currently stands at around 1,500 MW; and it will take several more years to increase domestic consumption. This indicates lots of energy will go to waste if it is not exported.

[...]the Indian government in 2021 issued a procedure for cross-border imports and exports of electricity. The procedure, which has been welcomed by Nepal’s private sector power producers, has finally paved the way for government entities and the domestic private sector to export power to India. [...]Yet one question that many ask is whether India needs Nepal’s electricity as its supply has exceeded demand for over two decades. India currently has an installed capacity of approximately 375,325 MW whereas its peak electricity demand stands at 184,033 MW. Nonetheless, India may want to buy Nepal’s electricity as it generates over 60 percent of its energy through thermal sources such as coal, which are not clean. Since India is looking to migrate to clean sources of energy, Nepal may find a small market to sell its electricity. Lately, there are also talks of selling Nepal’s electricity in the Indian spot power market, where prices are relatively higher.

[...]NEA has reached a conclusion that there is no alternative to exporting power in the short run as the domestic market is not in a position to rapidly enhance its electricity consumption. But in the long run Nepal will have to enhance its energy consumption capacity, as electricity is a raw material and if value is added to it to generate other products the country will be able to generate higher returns.

[...]Even if NEA defaults on 1,000 MW of payments, Rs 140 billion in bank credit will be at the risk of going sour, considering per MW construction cost of Rs 200 million and 70 percent debt facility that banks provide. This amount is over 2.5 times the net profit of all commercial banks in the last fiscal year. Such a huge scale of credit default will not only hit the banking sector, but the entire stock market and the economy.

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