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. 

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)

Impact of COVID-19 on the external sector

The IMF’s latest external sector report highlights the state current account balance amidst the global trade and supplies disruptions caused by the COVID-19 pandemic. The pandemic has sharply curtailed global trade, lowered commodity prices, and tightened external financing conditions. 

According to the report, the world had a current account surplus of about 2.9% of world GDP in 2019. About 40% of current account surpluses and deficits were excessive in 2019. Euro area had larger-than-warranted current account balances, but the US, the UK and Canada had lower-than-warranted current account balances. China’s external position remained unchanged and they were broadly in line with fundamentals and desirable policies. Currency movements were generally modest, but with preexisting vulnerabilities/fundamentals in EMDEs (large current account deficits, a high share of foreign currency debt, and limited international reserves or reserves adequacy). 

The IMF forecasts current account surplus narrowing by 0.3% of world GDP in 2020, thanks to large fiscal expansion but offsetting increases in private savings and lower investment (precautionary move by household and business sectors). Economies dependent on severely affected sectors such as oil and tourism, and remittances have been hit hard.  There was a sudden capital flow reversal and currency depreciations in EMDEs as financial market sentiment deteriorated during the initial days of the crisis. Unsurprisingly, global reserve currencies appreciated as investors looked for safe haven amidst the financial stress. There is some unwinding now though, reflecting exceptional monetary and fiscal policy support. 

Current account balances in 2020 will be affected by 

• Contraction in economic activity (lower output/export and import demand)
• Tightening in global financial conditions
• Lower commodity prices (oil, metals, food, raw materials)
• Contraction in tourism
• Decline in remittances 

The number of export restrictions in 2020 is higher than during the global financial crisis, but the number of import restrictions is lower. Sectors such as pharmaceutical and medical supplies, made-up textile articles, wearing apparel, rubber products, and ethyl alcohol and spirituous beverages faced the most export restrictions.  

Some EMDEs with preexisting vulnerabilities (large current account deficits, a high share of foreign currency debt, and limited international reserves) might face high risk of an external crisis (with capital flow reversals and currency pressures) if risk sentiment deteriorates. 

A second wave of the pandemic could lead to tightening of global financial conditions, narrow the scope of EMDEs to run current account deficit, further reduce current account balances of commodity exporters, and deepen the decline in global trade. Up to now, swift response of central banks (policy rate cuts, liquidity support, asset purchase programs, and swap lines offered by the US Federal Reserve) and expansionary fiscal policy have contributed to an easing in global financial conditions. EMDEs experienced sudden capital flow reversals in late February and march but then stabilized in most cases with even modest inflows in selected economies. 

Near-term priority

The near-term priority should be to provide relief and promote economic recovery. 

• Flexible exchange rates should be allowed to adjust as needed to absorb external shocks (especially a fall in commodity prices or tourism). 
• Official financing to ensure continued healthcare spending is required for those economies experiencing disruptive balance of payments pressures and without access to private external financing. 
• Tariff and non-tariff barriers to trade, especially on medical equipment and supplies, should be avoided. 
• Countries with adequate forex reserves could engage in exchange rate intervention to avoid disorderly market conditions and limit financial stress. 
• Countries with limited reserves and facing reversals of external financing, capital outflows management measures could be useful (but these should be used to substitute the warranted macroeconomic and structural policy actions).

Medium-term priorities

Preexisting economic and policy distortions may persist or worsen over the medium-term.

• Fiscal consolidation over the medium term would promote debt sustainability, reduce current account gap, and facilitate raising international reserves. Note that excess current account deficits in 2019 partly reflected larger-than-desirable fiscal deficits. 
• Productivity-enhancing reforms would benefit economies with low export competitiveness. 
• For countries with large current account surpluses after the COVID-19 pandemic, prioritizing reforms to encourage investment and discourage excessive private savings are warranted. In some instances, economies with large current account surpluses could discourage excessive precautionary savings by expanding the social safety nets. 
• For economies with some fiscal space, emphasis on greater public sector investment would be helpful to narrow excess surpluses and to stimulate economic activities. 

Outlook for 2021

The outlook for 2021 is highly uncertain. Under a scenario where a second major global outbreak occurs in early 2021 (disruptions to economic activity is assumed to be half the size of the baseline in 2020, financing tightening of about one-half of the increase in sovereign and corporate spreads since the outbreak began in EMDEs, and relatively limited tightening of sovereign premiums for advanced economies),

• Global trade is projected to decline by an addition 6%, global GDP decline by 5%, and oil prices to be higher by 12% compared to the baseline. 
• Recovery in global trade will be underpinned by the need to rebuild the capital stock (investment goes up), and higher import intensity of exports. 
• Emerging market economies will face higher borrowing costs, lower oil prices and subdued domestic demand – it will raise current account balances toward surplus. 
• Net oil exporters will face lower oil prices, which will reduce their current account balances.
• Advanced economies will face relatively limited tightening in external financing conditions and greater fiscal policy space will mean lesser import compression than among EMs, leading to lower current account balances. 
• So, capital will flow from EMs to AEs, highlighting the unequal impact of the crisis and the need for a global policy response. 
• Under a faster recovery scenario, global trade rises by 4% in 2021 compared to the baseline. 

The report notes that the historical relationship between trade and the components of GDP/aggregate demand (or import-intensity-adjusted measure of aggregate demand, which basically is a weighted average of aggregate demand components in which the weights are the import content of each component computed from national accounts input-output tables) fully explains the expected global decline in trade of goods. A part of the impact of lower economic activity on trade is felt through global value chains. After the global finance crisis circa 2009, residual factors such as rising protectionism explained part of the fall in trade in goods and services as they could not be fully explained by the fall in economic activity alone. Services trade contraction in 2020 is more severe than what could be expected based on the historical relationship between services trade and aggregate demand, suggesting the role of special factors such as travel restrictions. 

The IMF determines excessive current account balances by comparing the actual current account (stripped of cyclical and temporary factors) and the current account balance that is consistent with fundamentals and desirable policies. The resultant gap reflects policy distortions (e.g., higher current account balance than implied by fundamentals and desirable policies correspond to a positive current account gap, whose elimination is desirable over the medium-term). The IMF also considers REER that is normally consistent with the assessed current account gap. A positive REER implies an overvalued exchange rate. Other indicators that are considered are financial account balances, international investment position, reserve adequacy, and other competitiveness measures such as the unit-labor-cost-based REER and staff views on the current account gap using country-specific trade elasticities. 

On economic and financial fundamentals, and desired policies, advanced economies with higher incomes, older population, and lower growth prospects have positive current account norms. EMDEs tend to have negative current account norms because they are expected to import capital to invest and exploit their higher growth potential.

Ben Bernanke on economy recovery in the US

In an op-ed published in The New York Times, Ben Bernanke argues that the US government should not repeat the mistakes made during the Great Recession. The federal government should provide more aid to state and local governments in addition to the social protection measures for the unemployed people. This is crucial to stabilize aggregate demand and restore full employment.  

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Many other states face ominous budgetary outlooks, too, implying the need for draconian reductions in essential services to state residents and large potential job cuts. Furloughs have already begun in New Jersey. Since February, state and local governments collectively have laid off close to 1.5 million workers.

We have been here before. I was the chairman of the Federal Reserve during the global financial crisis and the subsequent Great Recession. As part of the recovery effort, Congress responded with a stimulus package of nearly $800 billion. But that package was partly offset by cuts in spending and employment by state and local governments. Like today, with sharp declines in tax revenue as the economy slowed, states and localities were constrained by balanced-budget requirements to make matching cuts in employment and spending. This fiscal headwind contributed to the high unemployment of the Great Recession, which peaked at 10 percent in late 2009. Together with a subsequent turn to austerity at the federal level, state and local budget cuts meaningfully slowed the recovery.

In the current recession, unemployment rates have been much higher than 10 percent, and even with recent job gains the Congressional Budget Office estimates that, without further action from Congress, the unemployment rate at the end of 2020 will most likely be close to 11 percent. Those numbers are particularly dire for people of color. Black, Latinx and Native American communities not only face a far greater health risk from Covid-19; they also face higher rates of unemployment than white families. States and localities are in desperate need of additional federal intervention before the bulk of the CARES Act funding expires this summer. Budget gaps like the one in New Jersey cannot be closed by austerity alone. Multiply New Jersey’s problems to reflect the experiences of 50 state governments and thousands of local governments and the result, without more help from Congress, could be a significantly worse and protracted recession.

The CARES Act allocated $150 billion to state and local governments. This new aid package must be significantly larger and provide not only assistance for state and local governments but also continued support for the unemployed, investments in public health and aid as needed to stabilize aggregate demand and restore full employment.

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Policies to help recovery in Asia and the Pacific

The IMF’s Chang Yong Rhee argues that Asia’s growth is projected to contract by 1.6% in 2020 due to weaker global conditions and more protracted lockdown measures in several emerging economies. Since Asia is heavily dependent on global supply chains, a slowdown in global economy would automatically slow the region too. Assuming that there is no second wave of infections and with the ongoing unprecedented policy stimulus to support recovery (especially private demand), the IMF projects growth to rebound to 6.6% in 2021. Still, output will be 5% lower compared to pre-COVID-19 projections. 

However, this outlook may be optimistic due to: 

1. Slower growth in trade as supply chains continue to be affected (reorienting Asia’s growth model towards domestic demand and reducing its reliance on exports may take time)
2. Protracted lockdowns (physical distancing to reduce contagion will depress economic activity)
3. Rise in inequality (past pandemics led to higher income inequality and lower employment prospects for less educated population) as informal sector workers get hit
4. Weak household and corporate balance sheets (negatively affect investor sentiment or amplify uncertainties) 

Significant fiscal and monetary policy support is helpful, but they may not last long as a potential correction of the disconnect between financial markets and the real economy could exacerbate the already high borrowing costs for many Asian economies. A close coordination between monetary and fiscal policy measures (to support liquidity and demand); resource reallocation (streamlining the restructuring and insolvency frameworks, adequately capitalized banks, and facilitation of equity injections into viable firms and risk capital for new firms); and addressing inequalities (enhancing access to health and basic services, social safety nets, informality, etc) may be some policy options to respond to the emerging crisis. 

Meanwhile, Gita Gopinath argues that “in the absence of a medical solution, the strength of economic recovery is highly uncertain and the impact on sectors and countries uneven”. Many countries are reopening amidst a surge of cases. The June edition of WEO sharply downgraded global output growth forecast to -4.9% in 2020 followed by a partial recovery with growth at 5.4% in 2021. In absolute terms, the cumulative loss to the global economy comes to be around $12 trillion over two years. Upside risks to the forecast include availability of vaccines and treatments, and additional policy support. Downside risks to the forecast include further waves of infections (which could reverse mobility and spending), and rapidly tightening financial conditions (which could trigger debt distress). Geopolitical and trade tensions could further affect growth outlook.

The crisis is affecting export-dependent economies and jeopardizing prospects for income convergence. The staggered reopening of economies has also meant that the pick-up in activity is uneven. Some sectors have seen a surge in spending due to pent-up demand (retail), but contact-intensive services remain depressed. Lower-income and semi-skilled workers are particularly affected as work from home norms do not apply fully to them. 

Fiscal and monetary policy support has helped to check the downturn to some extent. 

• Advanced economies have a larger fiscal space, so they rolled out larger fiscal packages. 
• Emerging market and developing economies are somewhat constrained by fiscal space.
• The IMF estimates that global fiscal support is over $10 trillion in addition to accommodative monetary policy measures such as interest rate cuts, liquidity injections, and asset purchases. 
• The strong backing by central banks have contributed to rebounding of equity prices, narrowing of credit spreads, stabilization of portfolio flows to emerging and developing economies, and strengthening of currencies that sharply depreciated previously. 

These support measures may have to continued in the near future too. However, the IMF recommends countries to ensure proper fiscal accounting and transparency, and to keep independence of monetary policy intact. 

• The first priority is to respond to the health crisis through building health capacity, widespread testing, tracing, isolation and practicing safe distancing. 
• Affected people should be provided with unemployment insurance, wage subsidies, cash transfers. 
• Affected businesses should be provided with tax deferrals, loans, credit guarantees, and grants. 
• Digital payments will be helpful. 

Over the medium-term, policy support should facilitate reallocation of workers to sectors with growing demand and away from shrinking sectors. This could require worker training and hiring subsidies. Policies should also be designed to repair balance sheets and address debt overhangs (requires strong insolvency frameworks, and mechanisms for restructuring and disposing of distressed debt). Economies could also increase green public investment, and expand social safety net spending. 

The international community can support developing countries through concessional financing, debt relief and grants. Emerging market and developing economies could require larger access to international liquidity (through central bank swap lines, global financial safety net, and ensuring financial market stability). Since public debt is projected to shoot up, economies will need to roll out sound fiscal frameworks for medium-term consolidation (cutting back on wasteful spending, widening tax base, minimizing tax avoidance, and progressive tax system).

Government's counter-cyclical measures are helpful in maintaining demand

Despite strict lockdowns, supply chains disruptions, sharp economic contraction, and high unemployment rate, the COVID-19 recession is not expected to as worse as an economic depression. Zachary Karabell argues that this is due to the large fiscal stimulus by government and a commitment to unlimited liquidity by the central bank. It largely applies to the US economy, but some variant of it is true for all economy. 

Specifically, two factors are at play here. First, average unemployment benefit is higher than average wage per week, meaning that consumption demand across most households is in fact relatively strong. Second, the job losses are mostly in sectors required face-to-face contact, meaning that unemployment is not economy-wise. 

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There are two reasons, one positive and one decidedly not. The positive reason is that for all the clunky ineptitude of the social safety nets created in April by Congress in the form of direct payments, small business relief and expanded unemployment benefits, those considerable amounts of money ended up buoying the depressed fortunes of tens of millions of people. In fact, given the extra $600 a week emergency supplement provided by the federal government, many people at the lower end of the wage spectrum pre-COVid have been taking home more money weekly than when they were employed. The average amount earned by the 40 million people who have received unemployment at some point since March was less than $750 a week; the average amount received under the various emergency programs? $970 a week. That helps explain why overall economic activity hasn’t declined in lock-step with unemployment or with the contraction of so many industries. Those juiced benefits are due to expire in July, however, raising the prospect that unless those are extended further the trajectory will worsen.

The other reason isn’t so benign. In terms of unemployment statistics and how we discuss work, a job is a job is a job. But in terms of wages and a living wage, all jobs are not created equal. Not even close. For many millions of jobs, the pay is barely above what constitutes the poverty line and isn’t enough to cover food and shelter for one person let alone a family. Hence the strong push in recent years to raise the minimum wage to at least $15 an hour, which many cities such as Seattle have done but which the federal government has not.

In the current crisis, the preponderance of job losses have been human service industries, ones that depend of face-to-face contact and cannot be shifted via Zoom into the digital realm. Those industries – restaurants, hospitality, travel, tourism, retail stores, events – are also amongst the lowest paid. Overall, average earnings in the U.S. are $28 an hour. But earnings for leisure and hospitality are $16 an hour and for retail $20 an hour. Those tens of millions of workers were never accounting for the same level of consumer spending or home sales or travel dollars or economic activity as the tens of millions who work in construction or manufacturing or technology or higher-end service industries such as finance and consulting or public servants like teachers and police. The result is that you can have 15-20% unemployment with 40 million people out of work at one point or another in the past months and not have a one-to-one hit to economic activity. 

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Quick thoughts on Nepal’s FY2021 budget

Here are my quick thoughts on FY2021 budget

On 28 May 2020, Finance Minister Dr. Yuba Raj Khatiwada presented FY2021 budget (mid-July 2020 to mid-July 2021) to a joint session of the federal parliament. This is the third budget of the government that commands two-thirds majority in the parliament. The budget is designed to focus on scaling up health sector spending to respond to coronavirus disease, COVID-19, and its impact on the economy and livelihoods. 

The economic disruptions caused by COVID-19 pandemic have severely affected economic activities, lives and livelihoods. This disruption is widespread. The budget for next fiscal is an opportune moment to craft an economic policy to not only respond to COVID-19’s effect, but also to rectify the long pending economic issues such as agricultural transformation, consolidation of social protection schemes (including PM employment program), rationalization of recurrent spending (especially the wasteful ones), nixing some of the politically oriented distributive spending schemes, prioritization of projects, and changes to legal, regulatory, policy and institutional frameworks to increase private sector participation. Most of these are transformative in nature and are growth-enhancing structural changes that are relatively easy to rollout during critical junctures like the one created by COVID-19.

At the outset, FY2021 budget looks like it is trying to strike a balance between responding to the economic, lives, and livelihoods disruptions caused by the COVID-19 pandemic, and continuing with the traditional party-backed signature programs and projects. Given the uncertainty and circumstances under which FY2021 budget had to be unveiled, the finance minister has done a decent job. The prioritization on healthcare spending and some support to businesses is the right one for the coming fiscal, but estimates of revenue or receipts are a bit unrealistic. That said, we should not be too fussy about a surge in fiscal deficit at this stage, but the government should at least have a credible medium-term fiscal consolidation plan. 

However, the budget has also missed one thing that is really needed at this critical juncture: a bold fiscal move and an economic package to reorient the economy towards high value-added production and higher sectoral productivity. This is the time for taking bold steps to structurally transform labor and capital markets, and institutions. This opportunities during such critical juncture do not come often. One such opportunity is to create a unified digital registry of all social protection beneficiaries so that social transfers reach the targeted beneficiaries and leakages are minimized. 

The budget is notable in five ways:

First, there is COVID-19 economic recovery package, but it is not really an extra fiscal package. Most of the already announced incentives and initiatives were subsumed in the budget. It includes NRs 100 billion refinancing facility from the central bank (initially, it was NRs 60 billion refinancing facility, which the government announced to increase to NRs 100 billion), and a separate fund of NRs50 billion to provide subsidized loans to sectors affected by COVID-19. The refinancing facility will be for one year but it can be extended by another year. The separate fund will provide loans at 5% interest to businesses that are facing difficulties in retaining workers and to secure working capital to continue business. In addition to its own contribution, the government is hoping contributions from public enterprises and development partners to the NRs 50 billion fund. The effectiveness of this facility is uncertain at this moment and a detailed standard operating procedure for its roll out is awaited. Besides these refinancing facility and new relief funds, the government argues that there is about NRs 60 billion worth of interest subsidy, utility subsidy, and tax concession. There is a plan to provide employment to 700,000 people too.

Second, the government has committed to pay mandatory contributions to SSF by both workers and employees (total 21%) in organized sector for the duration of lockdown. It has also extended contract and bank guarantees for the period of the lockdown, provided tax concessions on renewal of firms, earmarked funds for concessional working capital loans, and provided insurance cover to healthcare workers. It has also increase incentives for frontline security and healthcare workers. These were continuation of the previous measures. Similarly, social security related cash allowances have been continued. 

Third, there is an increase in allocation for healthcare sector and employment generation. But there is also a decrease in allocation for infrastructure, probably because the government had to save money for healthcare sector and employment generation. 

Fourth, the government has given continuity to constituency development fund despite the call from the opposition to cancel it altogether and use the funds for the COVID-19 response. Now, each parliamentarian is earmarked NRs 40 million, down from NRs 60 million previously. Last year, the finance minister increased allocation for parliamentarians to NRs 60 million from NRs 40 million. Due the lack of accountability and sound oversight, there are reports (even in OAG’s reports) of misappropriation of funds.  

Fifth, the finance minister has tried to maintain fiscal discipline despite the increased expenditure needs and decreased revenue mobilization. The size of the budget has been reduced compare to FY2020 budget estimate, but increased by 37.4% compared to FY2020 revised estimate. Continued lockdown and lack of pick up in economic activities will hit revenue mobilization and further jeopardize fiscal discipline. A large increase in domestic borrowing will create liquidity shortages (already squeezed by deceleration of remittances, lower capital spending, higher credit growth, and now a potentially large number of MSMEs unable to service interest and principal payments on time due to cash flow problems). This might drive interest rates up and crowd out private investment. Since a spike in fiscal deficit was expected in FY2021 given the healthcare and social security related expenditure needs and declining revenue, the government should have also outlined a fiscal consolidation plan for the medium term. A pick up in economic activities will narrow down fiscal deficit if expenditure (especially recurrent) does not rise commensurately in the coming years. 

More on these later, but first let us look at the macroeconomic specifics:

Budget outlay

The total expenditure outlay for FY2021 is NRs 1474.6 billion, which is lower than NRs 1532.9 billion budget estimate for FY2020 but 37.4% higher than the revised estimate for FY2020. The government expects to spend 91.8% of NRs 1215.1 billion allocated in FY2019 (NRs 1073.4 billion). However, given the expenditure trend so far, it is highly unlikely. Due to the lockdown and disruption to economic activities in the last two quarters of FY2020, the government expects to spend 70% of the earmarked budget for FY2020. 

FY2021 budget outlay comprises of NRs 948.9 billion as recurrent expenditures (64.4% of the total outlay), NRs352.9 billion as capital expenditures (23.9%), and NRs 172.8 billion as financial provision. 

As a share of GDP, total budget amounts to 35.9%, including just 8.6% for capital spending. As per FY2020 revised estimates, the government now expects to spend just 73.3% of planned recurrent budget and 58.6% of planned capital budget. Compared to the revised estimates, recurrent budget is up by 35.2% and capital spending by a whopping 47.6%. Without a viable implementation plan and the effect of lockdowns on labor mobility and availability of supplies, it is most likely to be underspent as before. 

FY2021 budget overview
GDP growth target (%)	7
Inflation target (%)
Budget allocation for FY2021	Rs billion	%
Projected total expenditure	1474.6
Recurrent	948.9	64.4
Capital	352.9	23.9
Financial provision	172.8	11.7
Projected total receipts	950.1
Revenue	889.6	93.6
Foreign grants	60.5	6.4
Projected budget surplus (+)/deficit (-)	-524.5
Projected deficit financing	524.5
Foreign loans	299.5	57.1
Domestic borrowing	225.0	42.9

Revenue

A total revenue target of NRs 889.6 billion (21.7% of GDP) has been set for FY2021 (or NRs 1011.8 billion if revenue sharing with subnational governments is included—24.7% of GDP). Foreign grants are expected to be NRs 60.5 billion (1.5% of GDP). Total central receipts (total revenue plus foreign grants less sharing of revenue with subnational governments) turns out to be NRs 950.1 billion (23.2% of GDP). The central government shares, based on monthly collections, 30% of VAT and internal excise duty, and 50% of royalties from natural resources with subnational governments. The revised estimate for federal revenue mobilization (including grants) in FY2020 is 27.6% of GDP. 

Compared to the revised estimate, revenue growth target for FY2021 is about 22%, which is ambitious in the first place due to the expected decline in nominal GDP. Tax buoyancy is less than one. The government has been unable to meet revenue target since FY2018.

Given that the GDP growth target itself is ambitious, and revenue administration reforms along with tinkering of import tariff on some non-essential items have its limit in increasing import-based revenue, it needs to be seen how this government plans to achieve the revenue target. 

Nepal’s revenue mobilization is already one of the highest among low-income countries and about 45% of it comes from taxes on imports. Tax revenue is projected to be around 22.3% of GDP in FY2021, down from 26.8% of GDP in FY2020. Non-tax revenue is projected to be 2.4% of GDP.

Deficit financing

Considering center’s expenditure and its share of revenue in total revenue mobilization, budget deficit turns out to be NRs 524.5 billion, which is to be financed by foreign loans equivalent to NRs 299.5 billion and domestic borrowing of NRs 225 billion. So, government’s revenue is able to fund only 60% of its projected expenditure in FY2021. The government expects foreign aid (grants and loans) to cover about a quarter of its expenditure needs. Domestic borrowing will cover 15% of its financing needs. 

This is going to exacerbate liquidity crunch in the financial market and raise interest rates. The government had a plan to raise NRs 195 billion in FY2020 and is hoping to raise almost 99% of it by mid-July 2020. 

Compared to the revised estimate for FY2020, the government is planning to increase net foreign borrowing by 88.7% to NRs 179.7 billion (4.4% of GDP) and net domestic borrowing by 77.4% to NRs 276.4 billion (6.7% of GDP). Again, without substantial improvement in budget execution capacity, it is unlikely that the government will be able to borrow the targeted amount. 

Overall, fiscal deficit is projected to be about 8% of GDP. Fiscal deficit is the difference between revenue including grants and expenditure including net lending. Primary deficit is projected to about 4.8% of GDP.

Where is recurrent budget going?

Almost 52.7% of planned recurrent budget of NRs 948.9 billion is going to subnational governments in the form of fiscal transfer (fiscal equalization, conditional, complementary and special grants) and unconditional grants. These grants are to cover both recurrent and capital spending at subnational level. The other big-ticket item is the compensation of employees, which takes up about 14.6% of total recurrent budget. The government has earmarked NRs188.7 billion (4.6% of GDP) for social security spending and NRs74.4 billion for use of goods and services, which also includes some of the pet projects of politicians and government. Use of goods and services consists of (i) rent & services; (ii) operation and maintenance of capital assets; (iii) office materials and services; (iv) consultancy and other services fee;(v) program expenses; (vi) monitoring, evaluation and travel expenses; (vii) recurrent contingencies; and (viii) miscellaneous. 

Compared to the revised estimate for FY2020, allocation for compensation of employees has decreased. It shows that the government is expecting tighter revenue conditions, forcing it to cut back on some recurrent spending. The government has already announced cutbacks on allowances for all but front line security and healthcare sector staff.  

The biggest increase within recurrent budget is for miscellaneous expenditure, followed by subsidies and social security. Interest payments are also increasing. Given the high fiscal deficit and accumulation of outstanding public debt due to the 2015 earthquake and fiscal profligacy during elections time, interest payments have been rising fast. Interest payments have more than tripled since FY2015.

Where is capital budget going?

Almost 64% of the planned capital budget of NRs 352.9 billion is going for civil works, 18.7% for constructing or purchasing buildings, and 5.2% for land acquisition. Compared to the FY2020 revised estimate, capital spending has been increased by 47.6%. Allocation for vehicle purchase within capital spending has decreased by 34.6%. In fact, spending on vehicle purchase by central government has been decreasing since FY2018 (this does not mean subnational governments have also decreased vehicles purchase under their capital budget). 

Major takeaways from FY2021 budget

First, COVID-19 has severely affected government’s finances in FY2020. The government is expected to utilize just 70% of total budget allocated for FY2020. For recurrent, capital and financial provision, it is 73.3%, 58.6% and 78.9%, respectively. Revenue mobilization too has suffered. Total central government receipts are expected to be 73% of budget estimate for FY2020. The lowest is for foreign grants, which is expected to be just 55.2% of the one expected in FY2020 budget. Similarly, foreign loans are expected to be just 35% of the estimate in FY2020 budget. 

Second, the focus is on immediate-term only with surge in healthcare sector budget and temporary employment schemes. The short-term challenge is also to prop up demand (through cash transfers, subsidy and tax concessions) and to maintain supplies of essential goods and services (graded easing of lockdown). The medium-term challenge is a sustained recovery. The latter requires preventing layoffs from both organized and unorganized sectors (wage subsidies and incentives to retain workers), and saving struggling MSMEs from collapsing (by offering subsidized credit at a very low rate, longer term refinancing schemes, infusing working capital or equity, and creating credit guarantee schemes. The budget is unclear on the recovery part, largely leaving private sector to fend the crisis for themselves. Refinancing facility and subsidized loan schemes do not take off as expected because some businesses do not have operational bank accounts and some are already not creditworthy in the eyes of the BFIs. A direct fiscal support is needed, but it is missing. 

The COVID-19 specific refinancing facility and recovery funds are not really going to be effective if businesses do not demand for it. Banks will be willing to extend further credit to creditworthy borrowers only, leaving behind the cash-strapped micro, small and medium enterprises (MSMEs). So, the utilization of refinancing facility from NRB will have few takers unless the refinancing tenure and interest rates are lower than the usual refinancing schemes. Similarly, at a time when many MSMEs are struggling with mounting debt payments and uncertainty over business operations, not many of them will be willing to take new loans to pay salary of employees. What if business never takes off as expected in the future? This will saddle them with more debt. The government should have extended even more generous loans on working capital or additional capital to sustain businesses. There are income tax exemptions for micro and small industries ranging from 25% to 75%, but most of these are operating in the informal sector and hence may not be eligible for these exemptions. Furthermore, these exemptions were already existing and now they are extended by few years. It may not be that helpful given that intake previously was already low. Unorganized sector firms and employees need an unconventional policy measure for the time being and an incentive for them to formalize eventually. Furthermore, the exemptions should be continued up to medium-term (because they cannot recover business and fix balance sheet so quickly) and if possible lower them permanently. 

Third, there is fiscal austerity of sort but not to the full extent expected. We should ideally be comparing FY2021 budget allocation with FY2020 revised estimate, not FY2020 budget estimate. The new allocations are made based on the realized or expected spending in the previous year. Compared to FY2020 revised estimate, total expenditure outlay for FY2021 is 37.4% higher. Higher allocation was warranted given the healthcare sector and social protection related spending needs. But the government could have also cut down other recurrent spending. It could also have re-prioritized spending by not including projects that are not expected to be completed over medium-term and are highly uncertain if they will ever be implemented. The larger slump in expenditure compared to center’s receipts is expected to sharply lower fiscal deficit in FY2020. However, due to higher spending and lower receipts (which itself is ambitious), fiscal deficit is expected to increase to around 8% of GDP in FY2021. Bringing this down in the coming years requires a medium-term fiscal consolidation plan. 

Fourth, revenue mobilization growth target is around 22% compared to FY2020 revised estimate. This is a bit ambitious because of two reasons: (i) there is uncertainty over the period of lockdown and what form it will take going forward, meaning that economic activities will be severely affected, and (ii) imports as well as domestic businesses are not expected to recover soon. Both of these will hit revenue mobilization. In fact, the private sector is bracing for collapse of many MSMEs, especially in the travel and tourism sector. Furthermore, an increase in foreign grants by about 90% compared to FY2020 revised estimate is also not a realistic scenario given that it was not this high (INR 60.5 billion) even during and after the 2015 earthquake. The government has been received less than 50% of the estimated grant receipts in budget since FY2015. This further increases fiscal deficit. 

Fifth, expectation of foreign aid receipts is also a bit ambitious. Foreign loans and grants are expected to be about NRs 360 billion. Apart from emergency budget support, most of the other loans are hinged on progress made in projects. With a low capital budget absorption capacity, it will be challenging to receive all the loans as expected. So far, the government has been able to receive around 40% of the expected foreign loans stipulated in budget speech. These will lead to a severe resource crunch for the government. 

Sixth, a large increase in domestic borrowing (about 77% compared to the revised or budget estimate for FY2002) will create liquidity shortages (already squeezed by deceleration of remittances, lower capital spending, higher credit growth, and now a potentially large number of MSMEs unable to service interest and principal payments on time due to cash flow problems). This might drive interest rates up and crowd out private investment. Net domestic borrowing is expected to increase to about 6% of GDP from a surplus of about 0.2% of GDP before FY2016.

Seventh, the government argues that capital spending is higher than the indicates. Generally, the grants that goes to the subnational governments are included as recurrent spending in the central government’s budget. To avoid confusion, the central government should practice an accounting system where it reports central, provincial and local government’s capital spending separately. Perhaps, FCGO can be the agency to do that. 

Eighth, there has to be more explanation for the 7% GDP growth target. Given the extended period of lockdown, uncertainty over the peak spread of COVID-19, and demand as well as supplies slump, a quick V-shaped recovery is not normal. GDP growth in FY2020 may in fact contract now because the 2.3% growth projection by CBS was done with the expectation that economic activities will pick up pace from mid-May. The disruption to labor, capital and supply chains will continue to affect output. Agricultural output will be affected because of shortage of two key inputs, labor and chemical fertilizers, despite the forecast of a normal monsoon. Industrial activities will also remain subdued despite the expected growth in electricity, gas and water sub-sector (more addition of hydropower including Upper Tamakoshi and completion of Melamchi). Construction activities will remain below average and so will mining and quarrying activities. Some manufacturing establishments may not recover at all and those able to resume production will see drastic drop in capacity utilization. On services sector, wholesale and retail trade activities will remain affected because imports will continue to be disrupted (it accounts for about 50% weight) and agricultural output will affect its transactions (accounts for about 25% weight). There is uncertainty over how quickly travel and tourism sector can recover, if at all. Similarly, air transport remains affected as well as education. So, outlook on all sectors is not encouraging. Even with a favorable base effect (FY2020 real GDP growth will likely contract), FY2021 GDP growth target of 7% is too ambitious. 

Ninth, COVID-19 has created a critical juncture for the economy. This is the time to overhaul laws, regulations and institutions so that pace and pattern of structural transformation is growth-enhancing. The government should give generous tax concessions (much more than neighboring countries) and make it easier for private sector to do business. It would help to generate non-agricultural jobs for the unemployed and returning migrant workers. It should also strengthen government mechanism and establish a technology-driven systems reforms so that public service delivery is efficient and leakages are minimized. A unified digital platform and registry for social protection would be transformation at this stage in terms to plugging fund leakages and to target beneficiaries without much bureaucratic or political hassle. These unfortunately are missing. 

Tenth, government-backed employment should only be a temporary social protection measure to fend off financial difficulties faced by the poor people. The plan to provide jobs to 700,000 people is too ambitious because there is not unified registry of unemployed workers and returning migrant workers. These are at the discretion of local governments and the work they are given are not of durable nature. Fudging of rolls is common and so is siphoning off of funds. The PM employment programme should be clubbed with the larger social protection schemes under a unified digital registry. The government expects 200,000 jobs from PMEP; 50,000 from skill training at subnational level; 75,000 from TVETs; 50,000 in private sector (subsidy for private firms employing state-trained workers); 50,000 from Youth and Small Entrepreneur Self Employment Fund, among others. The effectiveness of these programs are not that good at present.

Finallly, I have assumed FY2021 nominal GDP growth to be the same as in FY2020, although the nominal growth in FY2020 will actually be lower than the one estimated by CBS as the estimates pertain to an unrealistic assumption about the duration of the lockdown and resumption of economic activities. In that case, as a share of GDP, expenditure and revenue will be higher than indicated in this piece (as denominator NGDP value decreases).