February 2021 Study of the COVID-19 Impact on the Economy of Kazakhstan Prepared by Zhanybek Aigazin For Asian Development Bank This consultant’s report does not necessarily reflect the views of ADB or the Government concerned, and ADB and the Government cannot be held liable for its contents. Asian Development Bank Acknowledgements This report was written by Zhanybek Aigazin and prepared under a staff consultancy engagement with the Asian Development Bank to analyze the impact of the COVID- 19 crisis on Kazakhstan’s economy. Genadiy Rau, Economics Officer from Kazakhstan Resident Mission of ADB, provided overall guidance and contributed valuable comments. The report also benefited from the constructive inputs of Dias Kumarbekov, Rustam Bekishev, Yevgeniya Pak and from an overview of international experience in modeling the influence of external shocks on the macroeconomic parameters prepared by Gulmira Issimbayeva. Table of Contents Acknowledgements .......................................................................................... I Executive Summary ....................................................................................... II A. Theoretical base and practical aspects of the forecasting model .... 1 A.1 The theoretical base for the forecasting model ............................... 1 A.2 Structural and behavioral model ....................................................... 1 B. GDP by expenditure approach: Analysis of Kazakhstan’s economy from the demand side ..................................................................................... 3 B.1 Stage 1 ................................................................................................. 3 B.2 Stage 2 ................................................................................................. 5 B.3 Model conclusion from the aggregate demand side ..................... 10 C. Impact of COVID-19 on sectors of the economy: Supply-side analysis........................................................................................................... 11 C.1 Survey on the application of the Cobb-Douglas production function in international research ............................................................ 11 C.2 Basic premises and limitations of the supply-side model ............. 14 C.3 Data .................................................................................................... 15 C.4 Model building and testing ............................................................... 18 C.5 Conclusion for the supply-side model............................................. 21 D. Assumptions about the main explanatory variables for the aggregate demand and supply model ........................................................ 22 E. Modeling results: Impact of COVID-19 on aggregate supply and demand of Kazakhstan in 2020 and forecast for 2021 ............................. 24 E.1 Forecast scenarios in the framework of the aggregate demand model .......................................................................................................... 24 E.2 Modeling results: Impact of COVID-19 on Kazakhstan's aggregate demand in 2020 and forecast for 2021 ................................ 27 E.3 Modeling results: Impact of COVID-19 on Kazakhstan's aggregate supply in 2020 and forecast for 2021 ................................... 30 F. Conclusion............................................................................................ 34 Appendix A: Heteroskedasticity and multicollinearity diagnostics for equations of the demand-side model .......................................................... 36 Appendix B: Heteroskedasticity and multicollinearity diagnostics for equations of the supply-side model ............................................................ 37 Appendix C: Test for restrictions of the coefficients .................................. 38 Appendix D: Assumptions on capital and labor growth rates for the supply-side model. ........................................................................................ 39 II Executive Summary The first COVID-19 outbreak occurred in December 2019. There were more than 99 million cases of infection and more than 2 million fatalities around the world at the time of writing. Early in 2020, many countries introduced quarantine regulations, restricted international and domestic movements, placed restrictions on many businesses, and other measures that could reduce direct human contact. In Kazakhstan, the first COVID-19 infection occurred in March 2020. At present, there are more than 170 thousand cases and two thousand fatalities. Some restrictive measures are still in place in Kazakhstan. The consequences of these restrictions have a negative impact on economic activity. The second quarter of 2020 revealed a significant downturn in economic activity around the world, as well as in Kazakhstan. To assess the development of Kazakhstan's economy, this study presents the results of a macroeconomic forecast taking into account the consequences of the COVID-19 pandemic in the short- and long-term. The objectives of this study are to: 1. Review and analyze international experience in combating the economic impact of the pandemic, 2. Build a forecasting model, 3. Collect data, 4. Conduct a regression analysis, and 5. Model the impact of COVID-19 on the economy of r Kazakhstan. This report consists of two parts, i) an analysis of Kazakhstan's economy from the supply and demand side, and ii) an analysis of the impact of COVID-19 on the economy. Part one presents the theoretical foundations and practical aspects of the forecasting model, taking into account current socio-economic events in Kazakhstan based on the data for aggregate demand, aggregate supply, foreign trade and investment, the social sphere, public finance, monetary policy, and business development conditions in 2000–2019, as well as the construction of a model to assess the impact of the COVID- 19 shock on individual sectors of the economy based on the Cobb-Douglas function. The second part describes the direct impact of COVID-19 on the economy of Kazakhstan. 1 A. Theoretical base and practical aspects of the forecasting model A.1 The theoretical base for the forecasting model 1. The theoretical basis of the model is a Keynesian-Neoclassical synthesis, which offers more realistic assumptions compared to purely Keynesian theories. 2. The term ‘Keynesian-Neoclassical synthesis’ was introduced by Paul Samuelson in the mid-1950s to describe a compromise that had emerged from economic schools of thought in the United States driven by the need to develop economic theory. In particular, the Keynesian economic theory suffered from a fundamental flaw, i.e. the lack of microeconomic foundations for model building. The weakness of the neoclassical theory was the assumption of perfect competition. Economists who adopted the Keynesian-Neoclassical synthesis were able to overcome the disadvantages of each by combining the two schools of thought. 3. The main assumptions of Keynesian-Neoclassical synthesis used in this study are: I. Markets for goods and resources are markets of imperfect competition. II. Prices of goods and factors of production are not sufficiently flexible for an economy to adapt to changes in market conditions in the short-term. However, in the long-term, prices and wages eventually bring markets into balance. III. The leading force in market conditions is an aggregate demand in the short-term and an aggregate supply in the long-term. 4. The use of the Keynesian-Neoclassical synthesis as a theoretical basis makes it possible to construct a model of aggregate demand based on the main macroeconomic identity and a model from the supply side based on the Cobb-Douglas production function. At the same time, the use of the main macroeconomic identity makes it possible to connect the model of supply and demand through the identity Investment=Savings, reflecting the formation of fixed capital. A.2 Structural and behavioral model 5. Jamir (2020) projected India's GDP growth after the COVID-19 pandemic. The results show that India's GDP growth rate will decrease by 6.09%, 5.42% and 5.3% in 2020, 2021, and 2022. Quarterly GDP data for 10 years (Q1 2010–Q1 2020) was used for the short-term forecast until the end of 2021. The methodology included the ARIMA model based on an analysis of one-dimensional time series data. 6. Khan and Ahmad (2020) predicted China's economic growth for 2020–2026 in light of the COVID-19 pandemic. Annual GDP growth year-to-year data for 1961–2019 were used. Stationarity was identified in the first differentiation of the GDP growth. ARIMA (2,1,2) was chosen as the most appropriate model based on the Akaike criterion. Then, a seven-year forecast was made. 2 7. Primiceri and Tambalotti (2020) formulated several assumptions that make it possible to construct a predictive distribution for the vector of monthly macroeconomic variables based on their historical evolution without any behavioral assumptions. They assumed that exogenous shocks follow independent AR or ARMA processes, and that the endogenous equation fixes the spread of exogenous shocks on endogenous changes. 8. Kelly and Coburn (2014) calculated a macroeconomic forecast for a scenario where an Ebola virus spreads in the USA and Europe in 2014. The macroeconomic scenario analysis was performed using the Oxford Economics Global Economic Model (OEGEM). OEGEM adopts Keynesian principles in the short-term and a monetary view in the long-term. 9. In the Republic