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Source: Asia Development Bank

The pandemic is challenging policymakers across Asia. The shape of the economic recovery is uncertain but pro-active government and central bank policies can improve outcomes.

The COVID-19 pandemic caused major contractions in economic activity throughout Asia and the Pacific. Despite some green shoots, in most countries the recovery path is still unclear.

The recently published Asian Development Outlook 2020 Update provides some insights into the projected shape of recovery in developing countries in Asia. The region’s economy is forecast to contract by 0.7% in 2020 and rebound by 6.8% in 2021. The expected expansion next year is fairly consistent with the region’s average growth rate of 7% over the last 20 years, but will not be sufficient to return the economy to its pre-pandemic trend by year-end. As such, the debate on the shape of recovery has important policy implications – in particular, to gauge the size and timing of the appropriate policy responses.

What are the possible paths of recovery? To illustrate, consider an optimistic scenario where the swift arrival of effective vaccines prompts a ‘V-shaped’ recovery. In this situation, the pandemic causes an output loss but GDP quickly returns to its pre-COVID-19 trend of economic activity. An often overlooked but important fact is that, for a V-shaped recovery to occur, growth needs to overshoot its long-run mean for some time.

In a more pessimistic scenario, economic growth does not overshoot, but just returns to its long-term mean. This implies a larger output loss, as the economy follows an L-shaped recovery along a lower path for GDP parallel to its trend before COVID-19.

Other possible recovery trajectories are U-shaped or swoosh-shaped, where it takes several years before the economy converges back to its pre-pandemic trend. Projections in the Asian Development Outlook 2020 Update point to either a swoosh-shaped or L-shaped recovery for the region’s economy, with significant variation in the shape of individual economies’ recoveries.

How should regional authorities react? To devise appropriate policy responses, we need to understand the key demand or supply constraints binding growth. The shape of recovery will depend on whether the negative effects of the demand shock, such as falling consumption and investment, spill over to the supply-side and restrict the economy’s capacity to grow.

Beyond a certain point, depressed demand can damage the drivers of productivity growth. For instance, human capital depreciates as learning-by-doing declines and some workers de-skill due to persistently high unemployment. Research and development investment falls and physical capital accumulation slows down, as investment remains sluggish. In short, a temporary but deep decline in demand can lead to an L-shaped recovery (or worse) by causing persistent damage to the economy, a concept known as hysteresis. 

On the other hand, a V-shaped recovery from the pandemic poses policy challenges too. The first relates to the timing for lifting of containment measures put in place to stem the spread of the pandemic. If this is done prematurely, the economy grows faster in the very short run but the risk of a second wave (or a prolonged outbreak) increases, so that the economy may fall into a double-dip recession.

In addition, a fast recovery means that authorities should stand ready to gradually withdraw support to avoid inflationary pressures, due to short-term supply-side bottlenecks produced by the crisis. So, policymakers are faced with a delicate balancing act, which depends both on the evolution of the outbreak and on the pace of the recovery.

By and large, the policy response in Asia has largely focused on income support and liquidity provision—with measures including income transfers, credit guarantees and interest rate cuts. This was necessary and appropriate in the first phase of the crisis, when most economies imposed stringent containment regulations and the priority was to cushion COVID-19’s blow on households’ and businesses’ finances.

Even after outbreaks are brought under control and containment measures start being relaxed, policy support will still be necessary for some time—but it will not be sufficient. Active policies will be needed in the second phase of the crisis, to reduce its long-term damage and to aid the recovery.

In the labor market, the crisis is bound to make redundant many currently furloughed workers as well as create obstacles for new entrants. Training programs, assistance in the job search process, and incentives for independent workers or micro-entrepreneurs will be needed to match workers to new jobs.

To bolster job creation and growth, liquidity provision to businesses will need to be selective and aimed at favoring innovative companies and viable production activities, to help the economy shed “zombie” firms.

The COVID-19 pandemic poses significant challenges to policymakers in Asia. While the shape of recovery may be uncertain, what is clear is that pro-active government and central bank policy can help shape the recovery.

MIL OSI Global Banks