The Unprecedented COVID-19 Crisis Will Require A Multipronged Policy Response
Given the multiplicity of shocks associated with the COVID-19 crisis, there needs to be a well-designed multipronged policy response of an unprecedented scale to prevent the cracks in the Indian economy from widening.
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There is a broad consensus that the crisis induced by the COVID-19 pandemic will be particularly severe, with the IMF forecasting the global economy to contract by 3% in 2020. The crisis will also be very unique in economic terms. When we look at the economic crisis of the past, they have been typically caused by either a real shock (a demand or supply-side shock), policy errors, or financial stress. For instance, the oil embargo in 1973 and spike in crude oil prices resulted in a supply shock and stagflation in oil-importing countries. As for policy errors, muted fiscal responses and flawed monetary policies worsened the Great Depression of 1929-33, while lax regulation of banks contributed to the Global Financial Crisis in 2008-09. An instance of financial stress is the liquidity crunch in India’s shadow banking sector after the bankruptcy of IL&FS, which led to a further slowing of India’s GDP growth.
In contrast to past crisis episodes, the COVID-19 crisis is unique because it will impact the Indian economy through a combination of five different types of shocks. First, a supply shock caused by the lockdown-induced temporary withdrawal of human capital from the economy and disruptions in the supply chains. The economic losses due to the current lockdown in India until May 3rd is estimated to be USD 234.4 billion (about 8% of India’s GDP), according to Barclays. The World Bank argues that even if the COVID19 outbreak is contained, there may be subsequent rounds of localised outbreaks which may require the imposition of lockdowns sporadically all through 2020, further exacerbating the economic costs.
Second, an aggregate demand shock will be caused by reduced incomes and consumption of households. This will be partially compensated by direct transfers of cash and food to the affected households in India. While these measures will cushion consumption to some extent, overall private consumption growth in India is forecast to fall to 2% in the 2020-21 financial year, compared to 5-7% growth in previous years, according to the World Bank’s South Asia Economic Focus.
Third, the global nature of the COVID-19 pandemic implies that emerging market economies (EMEs) such as India will face a severe external trade shock. The World Trade Organisation projects that global trade could fall by 13-32% in 2020, with significant disruptions to the global manufacturing value chains. A recession is expected in the major markets for Indian exports, with Eurozone GDP forecast to fall by 7.5% and the United States by 5.9% in 2020, as per the IMF.
Fourth, EMEs such as India are also facing an external financial shock. A sharp rise in risk aversion in global financial markets has resulted in a withdrawal of foreign capital from EMEs to safe havens such as US Treasury bonds, and subsequent depreciation of EME currencies. SEBI estimates that foreign portfolio investors withdrew Rs. 1.27 trillion between March 1st and April 17th. The depreciation of the INR will put pressure on the balance sheets of Indian corporates that had borrowed from international markets amid abundant global liquidity and low-interest rates.
Fifth, if the crisis deepens, it could also induce a corporate balance sheet shock due to a steep decline in cash flows and operating profits related to COVID-19 disruptions, which may result in debt defaults and bankruptcies. Such a shock to corporate balance sheets would be quickly transmitted to the banking and shadow banking sectors, which have already been under stress due to the high levels of NPAs and a liquidity crunch in the NBFC sector.
A multipronged policy response
India is stepping into the COVID-19 crisis with unresolved stress in the financial system, slowing consumption and declining private investment, unlike the Global Financial Crisis where corporate and bank balance sheets were significantly stronger coming off a rapid growth phase. Given the multiplicity of shocks associated with the COVID-19 crisis, there needs to be a well-designed multipronged policy response of an unprecedented scale to prevent the cracks in the Indian economy from widening. With an impaired monetary policy transmission channel, aggressive fiscal policies together with unconventional monetary policies are likely to be the main instruments in this crisis. This raises two questions - First, what should the response be? Second, how would the response be financed?
On the first question, in the short term, it would be prudent for the government to invest in medical infrastructure to minimise loss of life. This should be accompanied by continued direct transfers and food aid to households to cushion consumption amid the lockdowns required needed to deal with COVID-19 pandemic. The government has taken several steps, such as the Rs 1.7 trillion relief package under PM Garib Kalyan Yojana. In addition, certain sectors which are bound to be hit particularly hard by the COVID-19 crisis will need bailout packages, especially since many companies may face liquidity and solvency issues. This would prevent an exacerbation of the “twin balance sheet” problem in Indian corporates and banks that could lead to widespread layoffs and unemployment.
In the medium-term, increased government expenditure on infrastructure and construction would provide a growth impetus. These sectors are some of the largest employment creators in the country, and additionally, have a multiplier effect on many other allied sectors. It would be essential to involve major private infrastructure companies, possibly with some minimum cash flow guarantees. However, the speed of implementation will be key here. If these projects stretch for long periods, they will not be able to provide the requisite stimulus and employment opportunities. Hence, it would critical to pick projects that don’t present any major technical complexities and fast-track time-consuming processes like land acquisition.
An expansionary monetary policy, with greater reliance on unconventional instruments, will have to complement the fiscal response. In addition to rate cuts, the RBI has provided durable liquidity for banks to infuse debt capital into NBFCs through targeted long-term refinancing operations (TLTROs). It has also created special refinancing facilities for loans made to small industries, agriculture, and housing. While these timely steps are welcome, certain sectors with high employment potential and strategic complementarities should be provided substantial additional financing in the coming quarters. For instance, the MSME sector, which accounts for about 120 million jobs and has been hit by demonetisation, GST implementation and NBFC crisis, is a prime candidate for such assistance. Also, the option of allowing banks to infuse money in the corporate sector through hybrid instruments such as non-voting preferred equity could be considered, particularly for sectors with already high leverage such as aviation.
Coming to the second question, since the entire world economy is facing the COVID-19 pandemic almost simultaneously, donor money that financed recovery programs such as the Marshall Plan after the Second World War is likely to be in short supply. Additionally, with investors moving their money to safe havens, private foreign capital may not be available. Hence, much of the additional spending in India will have to be financed domestically.
It is here that one could draw inspiration from war bonds issued by the US during World War-II. The EU is also debating the issuance of Corona bonds to finance the public expenditure to revive the economies of its member states. Similarly, COVID bonds could be marketed to retail customers in India through simplified channels such as banks. Also, if a liquid secondary market is created for these bonds, they would become highly attractive investment opportunities in the current scenario. Moreover, NRIs can also be a potential additional market for such bonds. Introduction of bearer bonds could also be considered. Although bearer bonds raise concerns over the traceability of ownership, the idea may be worth considering given the current situation since they would enable the government to raise additional financial resources.
Given the possibility that higher government debt and rise in sovereign yields may crowd out private investment, large-scale purchases of COVID bonds by the RBI (similar to the US quantitative easing programs post the global financial crisis) could be considered. While raising additional debt, the government needs to ensure the productive use of these funds to mitigate the risk of future inflation.
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