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.
