Due to the measures adopted to prevent the spread of the Coronavirus Disease 2019 (Covid-19), especially social distancing and lockdown, non-essential expenditures are being postponed. This is causing aggregate demand to collapse across the globe. Rajeswari Sengupta argues that the problem could be more acute and longer lasting in India owing to the parlous state the economy was in before Covid-19 struck, and discusses policy options to deal with the economic crisis.

We are in the middle of a global pandemic, which is inflicting two kinds of shocks on countries: a health shock and an economic shock. Right now, most of the policy focus is on the health shock, but soon it will become clear that the economy is also facing a serious problem. In this, India is not unique. All countries in the world will have to deal with the economic mess that the health shock will leave behind. But the mess may be particularly bad in India because the economy was in a weakened state when the shock hit us. And while the health shock will be temporary, the economic crisis it is triggering will affect us for a much longer period.

Macroeconomic shock

Due to the measures adopted to prevent the spread of the Coronavirus Disease 2019 (Covid-19), especially social distancing and lockdown, non-essential expenditures are being postponed. This is causing aggregate demand to collapse across the globe.

In addition to the demand reduction, there will also be widespread supply chain disruptions, as some people stay home, others go back to their villages, imports are disrupted, and foreign travel is stopped. This will negatively affect production in almost all industries.

Right now, the service sector, especially travel, tourism, and hospitality, is the worst hit. Gradually the shock will spread to manufacturing, mining, agriculture, public administration, construction – all sectors of the economy. This will adversely affect investment, employment, income, and consumption, pulling down the aggregate growth rate of the economy. We are already seeing some early numbers that highlight the severity and duration of the crisis the economy may experience going forward.

Precarious situation of India

The shock will play out in a nearly similar manner in all countries. In case of India, however, the problem could be more acute and longer lasting, owing to the parlous state the economy was in before Covid-19 struck.

1. India has a vast informal sector which is especially vulnerable to the Covid-19 shock. In the formal sector, to the extent that firms do not close down, employees will still have their jobs and receive their salaries. The informal sector works differently. It depends crucially on people’s daily demand. With a large chunk of the potential customers of the informal sector staying at home right now and withdrawing from non-essential expenditures, the survival of informal sector units will become questionable with every passing day that the health crisis and the associated lockdown drags on.

The informal sector is especially vulnerable at the current time because it is still recovering from two previous shocks: demonetisation in November 2016 when 86% of the money in the economy became unusable overnight owing to a government decree, followed by the haphasard introduction of the goods and services tax (GST) in 2017.

While demonetisation was a big enough monetary shock, it did not fundamentally disrupt demand and supply mechanisms for too long. We now know in hindsight that people found workarounds in the forms of electronic payments, informal credit, converting black money into white, using old notes etc. In the case of the current crisis, it is not a question of finding a workaround for payments: the demand is not there, the supply is not there, and hence, the underlying revenues are not there. Many firms in the informal sector will be forced to shut down, which in turn will put stress on the large microfinance sector that provides support to innumerable small and micro enterprises throughout the country.

2. Even before the crisis, there was considerable stress in the corporate sector – one half of the well-known Twin Balance Sheet (TBS) problem. The firms in the private corporate sector which have been deleveraging for the last few years in response to the TBS crisis and those with relatively deep financial pockets, will perhaps be able to tide over this episode, also depending on which sector they are operating in. A large number of firms will however struggle to survive. They have to pay rents, salaries, debts, etc. even as their revenues will steadily keep falling as people change lifestyles and cut back on expenditures.

The firms that were near insolvency will end up in the bankruptcy process, and those that were undergoing insolvency resolution process under the Insolvency and Bankruptcy Code (IBC) will most likely get pushed to liquidation, especially as the IBC procedures will slow down even further.

3. The Indian banking system is badly broken – the other half of the TBS problem. In normal circumstances, a healthy banking system makes a distinction between 'good' firms and 'bad' firms while extending credit. The former are firms whose financial prospects are strong and who can repay loans even if they do not have much revenues for say a certain period of time. The latter are firms that are on the edge who cannot repay a loan even if revenue stops for say just a week. The longer the health crisis lasts, fewer firms will be left in the former category and more firms will end up in the latter category. So the number of ‘firm deaths' will depend on how long the health crisis runs.

It will also depend on how cautious the banks are in making their viability assessments. Even before the health crisis, banks were exceptionally cautious, because their capital positions are weak. Now with such extraordinary levels of uncertainty, banks will most likely be even more careful in extending credit, resulting in many unnecessary and avoidable ‘deaths' in the private corporate sector. Moreover, even before the previous NPA crisis could be resolved, banks will be hit by a new round of NPAs as more and more financially stressed firms start defaulting on their dues. Private banks may witness an increase in defaults by consumers on unsecured loans. This will make it harder for most banks to make fresh loans.

4. Indian households were already leveraged going into the current crisis. Once unemployment goes up and income disappears, they will find it difficult to repay existing loans, let alone make new expenditures.

5. Given the state of the economy and especially the state of the financial institutions, the policy levers available to the government to deal with the economic crisis are limited. When the effects of 2008 Global Financial Crisis were felt in India, fiscal deficits were low and banks were well-capitalised, putting the authorities in a position to implement both fiscal and monetary stimulus measures.

In contrast, the State is not so well-positioned now. The fiscal deficit of the government was already high in the pre-Covid-19 period. Monetary policy has its limitations given the TBS problem in the banking and corporate sectors. In other words, the combination of demand and supply shocks will hit the Indian economy at a time when the tools to deal with the crisis are impaired.

Policies to avoid

In such circumstances, it is tempting to address the problems using piecemeal and drastic measures, such as imposing directed lending, bans, or price controls. These measures effectively supplant the market mechanism with a politically driven allocation of resources. In some cases, this might be necessary. It is possible that some industries, such as aviation, will need to be bailed out using State resources. But these cases should be few. In general, the goal should be to make the market system work more effectively, helping it rather than hindering it.

Consider, for example, the plans to impose further rules on banks, directing their lending, telling them which loans to forgive, instructing them not to classify delinquent loans as non-performing assets (NPAs) and so on. The aim of such measures is laudable. The objective is to ensure that more firms are saved. The effects however are likely to be counterproductive. To the extent that weak banks are being asked to save certain weak firms, the former will try to protect themselves by being more cautious in their lending to the stronger firms. As a result, stronger firms may be denied credit in favour of the weaker ones, the opposite of what we need to happen.

The effects of such a distortion will reverberate on the banking system itself. To the extent that bank lending portfolios become riskier – because inherent risk has increased and policies have shifted the mix towards more risky borrowers – an already weak banking system will be made more fragile. The more this fragility is disguised –because the NPA figures do not reflect the full extent of their bad loans – the more confidence in the system will get undermined and investors will suspect the worst. The cost of bank funds will increase, and these costs will get passed on to the borrowers who are already struggling financially.

In general, care must be taken to avoid measures that may have some benefits but will also have severe side-effects, which can do lasting damage to the economy and society. Most importantly, it is critical to maintain the credibility of institutions during these troubled times. It takes decades to build institutions and months to erode their capacity and credibility.

Possible policy options

Here are a few ideas that the policymakers can consider as they gear up to deal with the economic crisis.

(i) The first measure must be to protect the workers in the informal sector, who will be badly affected, and yet have little savings to tide them over the shock. This will not be easy to do, but there are two mechanisms that could be utilised: MNREGA¹ (Mahatma Gandhi National Rural Employment Guarantee Act) and Jan Dhan² accounts. To a certain extent, the MNREGA system works as an automatic stabiliser because if people need jobs they can just apply. The constraint here is that if social distancing has to be maintained due to the Covid-19 outbreak and since economic activity will get stalled, even MNREGA may not be a viable option right now. The key therefore will be to ensure that the funding is available, and in the hands of the states and panchayats, such that when the appropriate time comes and large number of workers sign up for MNREGA, the mechanism works as designed. Another option will be for the government to give large-scale direct cash transfers using the Jan Dhan accounts, and to start this right away to help the informal sector cope with the shock. The optimal design of the cash transfer programme needs to be figured out in terms of targeted recipients, amounts, and duration.

(ii) What about firms in the organised sector? As discussed above, the objective should be to make the banks somewhat less risk averse in their overall lending, while preserving their authority to distinguish between viable and non-viable firms. Perhaps the best way to do this is by providing the public sector banks with additional capital, to give them a larger cushion to fall back on in case they make lending mistakes given the prevalent uncertainty. It might be harder for private banks to raise capital from the market given that they are already experiencing declines in share prices. The government could also improve corporate cash flows by speeding up GST refunds and delaying payments of corporate taxes.

(iii) Medium, small and micro enterprises (MSMEs) will need special help, requiring a multi-pronged effort:

• The government’s first priority should be to pay the large amounts of accumulated arrears to the MSMEs, reportedly in billions of rupees. This will be an immediate infusion of cash, and encourage banks to continue to finance them.
• Interest subsidies could also be given to banks, to allow them to reduce the cost of credit for MSME loans.
• A loan guarantee fund could be set up, targeted to MSMEs that have been hit hard by the crisis and that may now be considered too risky by the banks to lend to.

(iv) All these programmes will cost money thereby raising the most important question: where will the government obtain the funds from? Fortunately, the ongoing global crisis has had a silver lining for India, in the form of considerably lower oil prices. In normal times, there would be a strong argument for allowing the benefits to go to the consumers. These are not normal times. The windfall should be taken into the budget and redirected to those most in need.

Given the extraordinary circumstances and the uncertainty about how long the health shock will last, it may also be advisable to temporarily increase the budget deficit and let the debt-to-GDP (gross domestic product) ratio go up, provided when the crisis is over, the commitment would be to bring this down and get back to the fiscal consolidation path.

The private sector investment demand is currently low, and it is unlikely to get revived soon because firms will focus on surviving, instead of making new investments. Therefore, the scope of crowding out private investment is relatively low. Moreover, in volatile times as this, when households have already incurred losses from real estate and equity investments, there could be a flight to safety to government bonds, directly or indirectly through bank deposits. At the same time foreign funding is drying up and tax revenues will fall substantially. Therefore, it will be important to think through the financing of any increase in deficit.

The appropriate design of the fiscal stimulus also needs to be carefully thought about. It may make sense to calibrate the measures right now according to the severity of the problem at hand and gradually ramp it up as the true dimension of the crisis becomes clear. This will leave room for a suitable response as and when the health shock reaches its peak as well as for other future contingencies.

(v) That leaves monetary policy. The design of inflation targeting (IT) is well suited for such crisis times. IT anchors inflation expectations, thereby giving monetary policy more room to manoeuvre during downturns. Accordingly, efforts must be put into retaining and even enhancing the credibility of this mechanism. What is required is accurate inflation forecast targeting. Given the slump in aggregate demand and fall in oil prices, consumer price index (CPI) inflation will come down, creating ample room to cut rates. Once interest rates are reduced drastically, banks will cut their lending rates sharply (even taking into account the weak transmission mechanism), thereby reducing the stress of servicing debt for corporates and households, helping them to survive the crisis.

Conclusion

Many countries around the world have already started discussing measures to support the respective economies in view of the severity and duration of the crisis. In India, this has not yet started in a systematic manner and needs to be prioritised alongside steps to deal with the health crisis.

Notes:

1. MNREGA guarantees 100 days of wage-employment in a year to a rural household whose adult members are willing to do unskilled manual work at state-level statutory minimum wages.
2. Pradhan Mantri Jan Dhan Yojana is the Indian government’s flagship financial inclusion scheme. It envisages universal access to banking facilities with at least one basic banking account for every household, financial literacy, access to credit insurance, and pension facility.