COVID-19, poverty and why rescuing industry is a good strategy

COVID-19, poverty and why rescuing industry is a good strategy

By Anders Isaksson

April 2020

This opinion piece is part of a series of articles by UNIDO's Department of Policy Research and Statistics

Key Messages:

  • Recent successful experiences in poverty reduction in developing countries will not be sustained and we might even witness setbacks in the fight against poverty, as well as increased income and wealth gaps vis-à-vis industrialized countries.
  • Developing countries fare worse than their industrialized counterparts because of lower economic margins, weaker resilience and greater overall vulnerability.
  • These conclusions are borne out of the strong relation between manufacturing, productivity and the social dimension of industrial development.
  • Governments in developing countries, together with international organizations such as UNIDO, should immediately coordinate their efforts to support industry and its speedy recovery to avoid a regression to past levels of poverty.

COVID-19 is causing deaths and serious illness around the globe. No country is being spared; countries are facing significant real economy costs as a result of containing COVID-19 and its consequences. While various measures have been taken in different countries—some countries have imposed more and harsher restrictions than others—the common denominator is that all countries are confronting drastically reduced demand for goods and services. This in effect has resulted in deglobalization in terms of shortening global value chains. What’s worse, what may be expected to be a temporary reduction in demand in industrialized countries could cause permanent damage to the manufacturing industry and productivity in developing countries, leading to a setback in recent advancements in the social dimension of industrial development, i.e. we may be seeing a significant poverty increase and worsening income inequality. To protect against regression in social development, this article argues that governments in developing countries need to do their utmost to support manufacturing industries throughout the crisis and prepare them for a speedy recovery. In the most optimistic scenario, one might envisage a change in the business model to one that is more inclusive and sustainable. However, it is unrealistic to expect governments to be able to weather the storm on their own and therefore, timely and coordinated international action is called for. UNIDO could emerge as the natural leader of such an international initiative.

Manufacturing, productivity and poverty

This short opinion piece argues that if governments in developing countries do not support their industrial sector (this article focusses on industry and in particular on the manufacturing industry. Many developing countries that have built their economies around tourism will undoubtedly be hard hit as well by COVID-19), much of the hard-earned advancements in the social dimensions of development, such as poverty reduction and reduced income inequality (poverty and income inequality are part of UNIDO’s Inclusive and Sustainable Industrial Development, ISID), run the risk of regression. (It is far easier to discuss poverty than income inequality, because the former is unequivocally bad, while it is unclear what the optimal level of income inequality is. However, it is a fair assumption that most countries have a suboptimal income distribution.) The increase in poverty and the loss of income equality will not be confined to national borders, but will also manifest itself in widening gaps vis-à-vis industrialized countries, as well as between stages of development within the developing country group. 

Arguably, the most renowned economic success story is the East Asian Miracle. This is essentially a story about well-designed industrial policy geared towards rapid industrial development, with a strong focus on technology and innovation, as well as on the export of goods. There are other more recent examples, perhaps most notably China and India which together constituted the lion’s share in terms of attaining the poverty reduction goal under the umbrella of the Millennium Development Goals (MDGs).

Developing through industrialization comes with several positive side effects, such as the establishment of a middle class and with it, a steady and consistent stream of demand for goods and services, a broad-based wealth increase and reduced income inequality (in the short term, inequality might increase as some sectors take off before others, but in the long term, we will see reduced income inequality as demand has a pull effect on the other sectors and compensation is extended to the less fortunate), skills accumulation, productivity increases through technological progress and enhanced innovation, the formation of stronger institutions, and much more. Arguably, the longer a country has been industrializing—or has been industrialized—and thus the higher the productivity of its economy, the more stable and lasting the country’s economic progress is, and the more resilient and protected its society is from slipping back into the pre-industrialization phase. Productivity growth creates the surplus that allows countries to build their social safety nets and their workers to earn a higher income. And much of that growth and its quality emanates from manufacturing-led industrialization. It follows that developing countries that are in the process of industrializing or that will see their industrialization efforts thwarted by COVID-19 will be more vulnerable and will have lower economic margins to protect against the pandemic’s consequences.

The flipside of successful manufacturing-led industrialization is that if there are disruptions to manufacturing, such as those caused by COVID-19 and the restrictions imposed on economic activity, some of the positive development effects including poverty reduction witnessed in recent decades could be reversed. This is especially true if the damage caused by the pandemic turns out to be permanent rather than transitory. The longer it takes to break free from COVID-19 restrictions, the higher the risk of permanent damage. Likewise, the lower the economic margins, the higher the risk of setbacks. Developing countries have lower economic margins and thus face greater vulnerability than their industrialized counterparts.

Hence, it is not unreasonable to argue that the [poverty] impact on developing countries will be worse than for their industrialized counterparts. For instance, disruptions to global value chains (GVCs) could be compensated by a stronger focus on regional supply chains within the OECD. Where supply does not exist, it can be created. Another example is the stronger welfare systems and social safety nets in rich countries. Lost market shares may lead to a permanent exit of developing country firms from GVCs, forcing them to focus on the much smaller domestic market. Lack of government resources to deal with increased unemployment, even if transitory, may lead to lasting effects on the labour market.

The above line of reasoning hinges on the existence of a statistical relation between, on the one hand, manufacturing per capita and poverty reduction (income inequality), and productivity and poverty reduction (income inequality), on the other. Using a combination of data from the World Bank and own calculations, the following figures illustrate that such a statistical relation does indeed exist across a broad set of countries.

While Figure 1 shows that there is a lot of heterogeneity across countries. It also clearly illustrates that a higher manufacturing share is associated with less income inequality and lower poverty. (Although I make no causal claims here, it would be surprising if causality did not run both ways, that is, that higher productivity reduces poverty, but people lifted out of poverty also contribute to productivity.)

However, let us put this in COVID-19 impact terms: a 10 per cent decrease in average manufacturing value added (MVA) per capita (about USD 176 in constant 2010 prices) is associated with an increase in income inequality of 13 per cent! Likewise, a 10 per cent decrease in the average share of MVA in GDP (a decrease of about 1.2 percentage points) is associated with a rise in poverty amounting to 2 per cent; the corresponding figure for a 10 per cent increase in average MVA per capita is 0.3 per cent. The same effect is found for (total factor) productivity and poverty, where a 10 per cent widening of the average productivity gap vis-à-vis the United States (about a 2 percentage point increase in the average gap) is associated with a 4.4 per cent rise in poverty. (Labour productivity shows a similarly negative relation, but with a larger negative slope since that measure combines the impact on production factors (e.g. labour and capital) and technology. Productivity is also negatively related to income inequality, that is, more productive countries exhibit less inequality, an effect that is most likely generated by industrial development. These relations, at various statistical strengths, hold true for various measures of poverty (e.g. USD 1.90 per day; USD 3.20 per day and USD 5.50 per day) and using daily median income instead of the Gini coefficient to measure income inequality.) These are not small effects and in line with the claim made in this article that a COVID-19-induced deterioration of productivity and industrialization will have significant negative impacts on social development.

Figure 1: Manufacturing, productivity, income inequality and poverty

PRS

Source: Gini and poverty (measured as the headcount ratio relative to the national poverty line) data are from the World Bank (2020) and manufacturing value added (MVA) data are from UNIDO (2020). Productivity data are based on the author’s own calculations and is based on a Cobb-Douglas production function.

Collapse of manufacturing, falling productivity and poverty increase

Having established that an important relation exists between manufacturing, productivity and the social dimension, this section discusses how COVID-19 could affect manufacturing and productivity. It is already well known that demand for final goods has dropped significantly. This has had effects along value and supply chains, internationally and domestically. At the far end of these chains, where value added is relatively low, we tend to find industries in developing countries. Without demand for final goods, at least two things happen that affect developing countries: firstly, if demand for intermediate goods and resources moves towards zero, firms can only stay in the market as long as they have savings or retained earnings to tap, or if their governments can support them. The duration for this is likely to be shorter in developing countries than in industrialized ones. Secondly, even if there is some demand, it has decreased, which means that the price firms in developing countries receive is lower. This, in turn, implies reduced earnings and profit and in the worst case, firms go bust. In both cases, workers will be furloughed, or, in the worst case, they lose their jobs, increasing the upward pressure on poverty.

In industrialized countries, the longer the crisis continues, and manufacturers have to adjust and prepare for recovery, the higher the probability that they will look for ways to secure their supply chains. This could result in an abandonment of pre-COVID-19 supply chains. The importance of labour costs in their decision to offshore or buy from further afield might therefore diminish — instead, the importance of receiving timely inputs might rank higher. This could cause permanent damage on the part of developing countries and many firms would find themselves permanently shut out from the market once recovery begins.

In this period of crisis, firms could redefine and adopt a different, leaner business model. Firms in industrialized countries might find investment in Industry 4.0 technologies worthwhile, while workers who have been furloughed or laid off might find it harder to come back or find a new job. This discussion is already underway amongst firms in Sweden, for instance. The same may hold true for developing countries, where labour-saving technologies could be adopted, albeit not necessarily Industry 4.0 technologies because the necessary conditions, such as digital infrastructure, skill levels and institutions, are not yet in place. Nonetheless, if firms resort to labour-saving technologies and if there are only few or no alternatives for workers, poverty will increase.

In the longer term, high unemployment and underemployment coupled with dwindling financial resources both for the private and public sector will start affecting crucial functions, such as institutional quality, education and skills, and innovation and technological progress. This will translate into lower manufacturing productivity and competitiveness and, as a consequence, lower demand over and above the initial demand reduction caused by COVID-19-related lockdowns. Unsurprisingly, this will exacerbate the impacts on income inequality and poverty. A worst-case scenario would be the emergence of a vicious circle, where poverty escalation and reductions in demand create their own dynamics.

It is worth reiterating that time is of essence here. As long as the crisis is the cause of the temporary decline in demand, there is a chance for the manufacturing sectors in developing countries to recuperate and regain their place in global production. However, should the crisis be prolonged and cause structural changes, even if only in industrialized countries, there is an increased risk that the damage to the manufacturing sectors in developing countries become a permanent feature. While temporary effects also cause damage, it is mainly the permanency of the crisis that will lead to a deterioration of manufacturing and productivity, with ensuing increased poverty and a widening of social gaps, which might prove difficult to repair.

Industrial policy and international coordination

So what can governments in developing countries do to prevent [lasting] increased poverty and income inequality? Well, there is always the option of doing nothing and letting the market sort this out on its own. This could result in a distribution of market shares that might not be favourable for developing countries for the reasons stated above. What is certain is that the new equilibrium will entail higher poverty levels.

Hence, governments in developing countries might be better off designing short-term strategies to help industries survive the temporary disruption to production, e.g. by covering the costs related to labour and rent, the introduction of liquidity-ensuring measures and debt relief, to name but a few of the many options available. (This section does not provide an exhaustive list of policy options. To that end, Hartwich, Fokeer, Isaksson and Santiago (2020) focus and discuss various policy options.) In parallel, they should also prepare recovery plans for industries’ re-participation in global production. Here it will be important to ensure that firms have access to a labour force that has the same quality of skills as before the crisis. Measures to retain workers’ skills for the duration of the crisis are therefore paramount.

An optimistic view might hold that developing countries will turn the crisis into an opportunity to radically change their business models. For instance, this could be a chance to upgrade economic systems in line with sustainable development. Policies should be designed to support the electrification of industrial processes, with electricity sourced from renewable energy sources; circularity could become a central element and further enhance resource efficiency. Likewise, policies should ensure that equal opportunities are available, irrespective of gender, that youth can quickly enter the job market before their education becomes obsolete and that opportunities for continuous skill improvement are provided.

However, in case of a prolonged crisis, governments will find it difficult to sustain their support for industry, as the adoption of a more inclusive and sustainable business model may prove financially challenging. This suggests that countries that have the means to support those that do not have them should collaborate in a bid to design an international aid package – why not in the form of a Marshall Plan type of aid? International action should be swift to prevent developing countries from falling too deep, which would only result in higher costs and protracted suffering. Aid for developing countries should not be seen as a cost but rather as an investment to suppress the disruption of world production as much as possible. And why not condition financial support on advances towards inclusive and sustainable industry? In the long term, this will prove to be well-invested money.

Someone needs to take the first bold step. Frankly speaking, I cannot think of a better organization than UNIDO, with its vast and profound knowledge and practical experience in inclusive and sustainable industrial development, to take the initiative to create and lead such an international assistance programme.

Disclaimer: The views expressed in this article are those of the authors based on their experience and on prior research and do not necessarily reflect the views of UNIDO (read more).