The unprecedented economic crisis triggered by the Covid-19 pandemic has resulted in calls for drastic actions on part of the government and RBI. In this post, Sengupta and Vardhan content that these actions often entail – explicitly or indirectly – undermining or even overriding established frameworks and institutions of policymaking. In their view, this approach is ineffective and unsustainable, and can be dangerous for India’s medium- to long-term growth prospects.
We are living in exceptional times. Most major countries of the world are struggling to deal with an unprecedented economic and health crisis triggered by the outbreak of Covid-19 and India is no exception. At the time of writing, the total number of confirmed Covid-19 cases in India stands at close to a staggering 10 million with over 140,000 deaths and average daily new cases of more than 30,000. The pandemic has been raging in the country for nearly nine months now without any definitive end in sight and the economic fallout has been devastating.
Fiscal and monetary policy response to Covid-19
To deal with the adverse consequences of the pandemic, the Indian government announced a nationwide lockdown on 24 March 2020, which at the time was considered one of the most stringent lockdowns in the world. The strict lockdown continued till about June. Since then the government has been announcing phased relaxations every month but the pre-lockdown level of economic activity has not resumed in most sectors.
In the April-June quarter, gross domestic product (GDP) shrank by 24% making India one of the worst-performing major economies of the world. It is likely that even the remaining quarters of 2020-21 will witness a GDP decline on a year-on-year basis, even if there is some pick-up in growth due to the lockdown relaxations and release of pent-up consumer demand. In response to the economic crisis, the government as well as the Reserve Bank of India (RBI) have implemented several policy actions aimed at providing relief to large sections of the population. Yet, given the nature of the crisis, the severity of the shock, and the precarious condition of the Indian economy in the pre-Covid period, there is no clear or well-defined path to growth recovery in the medium-term.
All major components of aggregate demand – consumption, investment, and exports – have been severely impacted by the shock; there is very little room for fiscal stimulus given the strained financial position of the central as well as state governments, monetary policy is largely ineffective in context of the broken financial sector, and the prolonged lockdown has caused massive supply-side disruptions.
However, the real risk of the pandemic is not the immediate disruption in economic activity that the country has been experiencing, or the lack of policy space to revive growth in the short-term. The real risk is that our immediate response to the economic impact of the pandemic will end up damaging the longstanding institutional frameworks thereby thwarting the future growth prospects of the economy.
The unprecedented crisis has resulted in calls for drastic actions on part of the government and the RBI. These actions often entail, either explicitly or indirectly, undermining or even overriding established frameworks and institutions of policymaking. The argument put forward in favour of such demands is that these frameworks and institutions were designed for normal times, and hence should not act as constraints on policy actions in the extraordinary times that we are living in.
We argue in this post that ignoring rules and frameworks is neither effective nor sustainable and in fact can be dangerous in the context of India’s medium- to long-term growth prospects, because it will undermine institutions.
Impact of the pandemic on Indian institutions
Over the last couple of decades, some key frameworks and institutional mechanisms were put in place to guide policy actions. The salient ones include the Fiscal Responsibility and Budgetary Management (FRBM) Act, 2003, amendment to the RBI Act that led to the creation of the inflation-targeting framework in 2016, enactment of the Insolvency and Bankruptcy Code (IBC) in the same year, and implementation of the Goods and Services Tax (GST) in 2017. These were much-needed institutional reforms designed to address specific structural challenges of the economy such as imposing fiscal discipline, assigning a well-defined objective to the RBI’s monetary policy conduct, creating a comprehensive resolution framework for non-financial businesses, and simplifying the indirect tax system in the country.
The common objective underlying these reforms was to shift from discretion-based operative procedures to more rule-based frameworks in guiding policy actions. Arguably, these constituted important steps in the right direction in taking India forward as a modern, market-oriented economy in an increasingly connected global landscape.
However, since the outbreak of the pandemic, the general inclination seems to have been to disregard the importance of these institutions and to bypass them for the sake of short-term benefits.
For instance, the projected fiscal deficit of the central government for 2020-21 is in the range of 12-15% of GDP, far above the 3% of GDP mandated by the FRBM. That said, there has been an attempt to maintain some fiscal discipline. The central government has so far refrained from announcing a big fiscal stimulus package despite the severe economic consequences of the pandemic. Rather, the large deficit is arising inevitably, because the shrinking economy has led to a drastic reduction in tax as well as non-tax revenues.
Much more worrisome is the fact that the government does not seem to have a medium-term strategy for returning to the path of fiscal consolidation. The NK Singh-led 15th Finance Commission report that was submitted in November 2020 also does not outline a fiscal roadmap for the next few years citing uncertainty due to the pandemic. In any case going by past records, even if the report had recommended a fiscal consolidation plan it is unlikely that the government would have adhered to the stipulated targets. After all, an earlier NK Singh report, given to the government in January 2017, had proposed a strategy for reducing the government debt to less than 60% of GDP. But it was not followed – not even in the 2017 Union Budget.
Instead, government debt has been allowed to increase, initially beyond 70% of GDP, this year surely above 80% of GDP, and in subsequent years potentially above 90% of GDP unless prompt action is taken to wind back the fiscal deficit over the next few years.1
In the meantime, fiscal problems have started to undermine the independence of monetary policy. For instance, the RBI’s targeted long term repo operations are nothing but using the repo facility, which is a monetary policy instrument, to refinance bank lending to specific sectors of the economy. This kind of directed (rather than market-based) lending is not monetary policy. It is fiscal policy, and should have been conducted in a transparent manner, as part of the Union Budget, as mandated by the FRBM framework.
More generally, the actions taken by the RBI since the outbreak of the pandemic have raised questions about the importance attached by the policymakers to the inflation targeting framework adopted in 2016. During the lockdown period, the decisions of the monetary policy committee (MPC) on the interest rate were not guided by future forecasts of growth and inflation, which are meant to be the essence of decision-making in an inflation targeting regime. In October 2020, when the tenure of the previous MPC members ended, the government could not appoint a new MPC on time, as a result of which a much-awaited monetary policy meeting had to be postponed by the RBI.
Even more seriously, despite the fact that inflation has exceeded the target for more than three quarters in a row (consumer price index inflation has been greater than 6%), the RBI has not yet offered an explanation to the Parliament in the form of a letter, as is mandated by the law. Nor has the MPC outlined a plan to bring down inflation to acceptable levels. Instead, the newly appointed MPC, in its October meeting decided to ‘look through’ inflation and maintain the current level of interest rates into early next year.
These actions have the cumulative effect of hurting the credibility of the inflation-targeting framework. Consider, in particular, the implications if inflation remains at its current high levels, rather than falling as the RBI hopes. The RBI will then be caught between a rock and a hard place. If it belatedly decides to raise interest rates, then it would be violating its commitment to maintain them at current levels. If it instead chooses to maintain rates, it would be violating its commitment to fight inflation. Either way, the RBI’s credibility will be damaged.
The Insolvency and Bankruptcy Code (IBC) was implemented in 2016 to help address the twin balance sheet crisis in the banking and private corporate sectors. At the start of the lockdown period, the government suspended the IBC. In the initial months of the pandemic this could have been justified because it was important to provide a calm period wherein the extent of the economic losses could be figured out without taking cash-strapped companies to the bankruptcy courts. But the country is now nine months into the lockdown and the IBC has still not been restored to deal with fresh insolvency cases, nor is it certain when it might come back.
Instead the RBI has initiated a restructuring scheme, which will primarily provide forbearance2 to the banking sector and in all likelihood, merely postpone the problem of stressed assets to the future, without resolving it. Not using a resolution framework which was put in place to precisely help solve the problem at hand, dents the credibility of IBC as an institution.
In context of the GST, the recent saga that played out in the 41st and 42nd meetings of the GST Council in October 2020, with regard to compensation payment to the states exposed two problems. First, confidence in the framework of the GST, specifically the commitment of the Centre to compensate the states when tax collections fall short, has been badly damaged. And second, the failure of collective decision-making by the central and state governments has eroded the faith in ‘cooperative federalism’, that is, the notion that the Centre and states can work together harmoniously to solve the country’s problems.
The picture becomes more worrisome if one considers the orders passed by the various courts of the land in the last few months. For example, the high courts and even the Supreme Court have questioned concepts such as compounding of interest, lenders’ ability to liquidate collateral, and creditors’ and bank regulator’s prerogative to declare a loan as ‘non-performing’. In issuing such orders, the courts have claimed the pandemic is an extraordinary situation that demands extraordinary action. There is some truth to this. But in making this argument, the courts have undermined some of the most basic and foundational concepts of the economy, which cannot easily be restored when the situation returns to normal.
Recovery from the pandemic
The current crisis presents not only threats, but also opportunities, especially the opportunity to press forward with many structural reforms that will help build new institutions. For example, the government has shown great determination and resolve in pushing through some reforms such as in the agricultural sector. The crisis has highlighted the need to move forward with reforms in many other areas – labour laws, personal bankruptcy law, etc. Significant preparatory work has been done in several critical areas – the Indian Finance Code developed and submitted by the Financial Services Legislative Reforms Committee in 2013, the Direct Tax Code, a revised version of which was submitted to the Finance Minister in 2019, the Financial Resolution and Depository Institutions Act 2015, to name a few. What is now required is the legislative intent to enact these.
At the same time, it will also be important to strengthen the existing institutions. The impulse to undermine policy frameworks and institutions and to suspend basic principles of the economic and financial system through judicial orders presents a kind of risk to our economy, which is much greater than the loss of GDP and the stress faced by the firms and the households.
It has taken decades of hard work and consensus-building to create these important institutions and frameworks – the FRBM, inflation targeting, the IBC, and the GST. Now, hasty actions are creating a risk that this hard work will be undone, dealing a long-lasting blow from which these relatively new institutions might never recover. At some point of time, the pandemic will recede and the economy will recover but the damage to the credibility of these institutions will be long-lasting. Post-independence Indian history teaches us that institutions once damaged are difficult, sometimes impossible to rebuild.
It is true that the extraordinary challenges posed by the pandemic will require extraordinary response. However, it does not automatically imply undermining or ignoring our institutional set-up. Specifically, the response should follow due process that must ensure:
- maximum permissible flexibility in the existing framework is used before alterations of the framework are considered;
- due process is followed including stakeholder consultations, disclosures, creation of oversight, etc.;
- the overruling of the framework is accompanied by sunset clauses3 with a clear path back to normalcy, with timelines and milestones;
- clear accountability is established for the resumption of normalcy.
We cannot use the excuse of the pandemic to do away with rules and frameworks without due process. Our policy response must preserve the established institutions and frameworks and at the same time, push forth with long-awaited reforms. Else, this will turn out to be a ‘waste’ of this crisis.
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- See https://www.prsindia.org/report-summaries/report-15th-finance-commission-fy-2020-21
- These debt-to-GDP projections are based on authors’ analysis.
- Forbearance refers to the temporary postponement of mortgage payments granted by a lender or creditor.
- Sunset clauses require that certain provisions or laws expire at a certain predetermined date unless reauthorised by the concerned personnel.