IMF warns of economic ‘scarring’ effects from pandemic crisis

The International Monetary Fund (IMF) warns of the danger of ‘scarring effects’ from the pandemic crisis that could slow economic growth right across the EU for the next three to five years.

In a paper published on December 18, the IMF warns that the prolonged health crisis could lead to “a slower recovery which would depress investment and increase private and public sector vulnerabilities.”

There is danger of “significant labour market hysteresis” as well – meaning that the effects of the pandemic crisis would pressure the labour market long after the crisis itself had ended, presumably with the arrival of the vaccines.

“Taken together, these ‘scarring effects’ could weigh on the growth potential of the euro area,” the paper notes.

Further support for business will be needed

The IMF paper emphasises that the pandemic’s resurgence requires further national fiscal support, and warned against its premature withdrawal. Any further deterioration in the outlook would require additional fiscal support, the paper says.

“Fiscal policy will need to continue providing broad-based support during the second wave. Once the pandemic wanes, however, policy will have to manage the transition from necessary lifelines to facilitating a durable recovery. Priorities include investing in climate change mitigation and digitalization, while addressing likely increases in inequality and poverty.”

The IMF places strong emphasis on the Next Generation EU recovery funds, and praises the Commission for achieving this.

“These funds can help finance the investments needed to respond to climate change, though achieving the EU’s emission reduction goals will require a broader set of measures. Importantly, a positive experience with Next Generation EU could help build political support for a permanent central fiscal capacity.”

Support must go to viable firms and workers

The paper does also warn that protracted support will not lead to a healthy recovery.

“Structural policies should focus on facilitating reallocation of resources to expanding firms and sectors, limiting scarring, and protecting the vulnerable. A combination of adjusting job retention schemes, strengthening social safety nets, promoting job search, enhancing training programmes, and providing carefully targeted hiring subsidies will likely be necessary to achieve these multiple objectives.”

The emphasis is on supporting firms and projects in “viable sectors.”

“Directors agreed that, as the recovery takes hold, policies should facilitate labour and capital reallocation toward viable firms and sectors. Public support to firms should be selective and ideally provided only to otherwise viable firms whose operations are impaired by health risks or social-distancing restrictions.

To limit the cost to the taxpayer and to incentivise the necessary reallocation, such support should be given on a temporary basis with appropriate private-sector risk sharing and be gradually withdrawn as the recovery is firmly established.”

Support for labour should follow essentially the same paradigms.

“Nevertheless, as the restrictions on economic activities are gradually lifted, job protection will need to be gradually phased out and  complemented by policies to support workers and facilitate reallocation towards expanding firms and sectors.

Specifically, means-tested social assistance programs should be strengthened to ease passage into work while maintaining sufficient support. Job retention schemes will need to be adjusted, including by introducing clear phasing-out mechanisms, and promoting training to reskill and upskill.

Strengthening incentives for job search that encourage workers to register for

employment services, and reducing hiring costs for viable firms (e.g., by providing carefully targeted hiring subsidies) would also play an important role in promoting labour mobility.”

Banks face heavy pressures

Recently, as governments tightened mobility restrictions in response to the second wave, market sentiment has deteriorated, the paper says.

“Incipient tightening of credit conditions in the third quarter of 2020, and early signs of slowing credit growth indicate that rising risk aversion has become more binding on banks’ willingness to lend.”

A slower recovery could result in sizable capital shortfalls in the banking sector.

“Subdued economic activity due to delayed reopening would exacerbate pervasive liquidity problems and increase debt overhang, especially in vulnerable sectors. This would result in potentially much larger bank credit losses. In turn, banks’ diminishing capacity to lend would likely weigh on financing for consumption and investment at the time when it would be needed most. Rising fiscal vulnerabilities in countries that are most affected by crisis could strengthen the sovereign-bank nexus, raising the cost of borrowing and limiting credit availability.

Some banks might be able to raise new capital at manageable costs, while others would need their viability carefully assessed.”

Supportive financial sector measures, including restrictions to dividend payouts and share buybacks, should be maintained until the recovery is well underway, the paper concludes, while capital and liquidity buffers should be rebuilt gradually to ensure banks’ continued capacity to extend credit.”

Borrower support, mainly aimed at staving off liquidity shortfalls, would need to remain available until the recovery is underway.