Macroeconomics

The Covid-19 shock: Learnings from the past, addressing the present - III

  • Blog Post Date 07 June, 2020
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In the previous part of the series, Dr Pronab Sen provided estimates of the economic damage on account of the ongoing crisis, and the expected trajectory of the economy over the next three years. In this part, he presents a pathway to recovery, focusing on the survival phase. In the immediate context while the lockdown is in place, the two principal imperatives should be survival of those who have lost livelihoods, and of production capacities in non-essentials sectors. An approximate estimate of the additional fiscal support required during this three-month period is Rs. 2 trillion.

 

Pathway to recovery

Given the magnitudes involved, the central government really has no option but to intervene massively, fast and on a sustained basis. However, both the quantum and the time-phasing of fiscal interventions have to be thought through carefully since any error on either count can have large unintended consequences. It is useful to think of the recovery process in three distinct phases – survival, revival, and recovery.

The survival phase

In the immediate context, while the lockdown is in place, there should be two principal concerns. The first imperative is survival of those who have either lost or seen serious erosion of their incomes thereby compromising their ability to access adequate amounts of essentials. This not only ensures survival of such people, but also ensures that there is no crash in the prices of essentials, which would seriously compromise the economic health of the sectors producing such goods and services. This is particularly important for agriculture, which has been in serious distress for the last six years. There are fears that high levels of income support may trigger off food inflation as had happened in 2009-10. This is a completely misplaced fear since 2009-10 saw the worst drought in 35 years, while this year has had a bumper harvest. The far greater probability is that without adequate income support, farm prices will decline.1

The PM Garib Kalyan Yojana (PM-GKY) announced on 25 March 2020 is meant to address this issue along with measures being taken up by state governments. The amounts involved so far are both meagre and largely misdirected.2 The question then is: how large should this package be, and towards whom should it be directed?

To begin with, it should be noted that agriculture is the least affected of all the sectors of the economy and does not really need support for farmers to survive. The crucial element here is to ensure that farm prices do not crash and wipe out the gains from a very healthy harvest. This will depend mainly on two things: (a) supply chain glitches are resolved immediately, which is an administrative issue and does not require much by way of financial support; and (b) demand for agricultural products is not allowed to fall because of lack of income among the consuming classes, particularly the poor who are the main consumers. This then puts the onus back on income support for those who have lost jobs.

There is, however, one component of agriculture which may need immediate support – producers of non-food (cash) crops, such as cotton, jute, tobacco, etc. Since the user industries are locked down, these products may not get sold immediately and may see price erosion. Some income support for such farmers makes sense. If the agricultural sector is kept afloat, the rest of the rural economy will also, by and large, survive.3 There will of course be residual damage, but much of this can be managed through a significant up-scaling of MNREGA; although this will come at a later phase.4

The real damage of the lockdown is in the urban and peri-urban areas of the country. Almost all of the job and livelihood losses are in these locations, although they do have implications for rural India as well since a significant proportion of the urban job/livelihood losses are of migrants. Most of them have their families back in their villages and support them through remittances from their earnings. These remittances have completely dried up now putting both the workers and their families under serious stress.

Government transfers into Jan Dhan bank accounts are not a bad way to tackle this problem given the urgency, but it involves serious levels of exclusion errors.5 However, the amounts provided under PM-GKY are risible.6 The minimum amounts that need to be deposited are Rs. 5,000 per month in rural accounts and Rs. 6,000 in urban accounts of workers who have lost their jobs.7 If we take the estimate of 120 million job losses, this involves payment of Rs. 0.12 trillion per week until employment picks up. The only problem is how to identify those who have lost jobs or are unemployed. This is an administrative issue, but is not insuperable provided the government is willing to tolerate a certain amount of inclusion errors. For the future, however, it may be desirable to implement a voluntary system of registration which will help in reaching out to such people quickly and in a targeted manner.

The second imperative is survival of production capacities in the non-essentials sectors. Given the duration of the lockdown, there is a real danger that a very high proportion may close down permanently, especially among the MSMEs (micro, small, and medium enterprises). In such a situation, the road to recovery will be very long and excruciatingly slow since it will depend upon new entrepreneurs to enter and make fresh investment.

As we learnt from the demonetisation episode, the real danger arises from their inability to service their debts. The danger is much greater now than before. In any event, the most efficient way of addressing potential damage to production entities across the board is to concentrate, or aggregate, the damage into the financial sector. The advantages of doing so are:

  1. The government simply does not have the reach to address a very large number of production entities (around 15 million).Using the FIs (financial institutions) as the front end addresses this problem.
  2. The government has no idea about the amounts that each of these entities need.This information is by and large available in the FIs.
  3. The decision as to whether the support can be a loan or given as a grant can be deferred until such time as things become clearer.

The RBI (Reserve Bank of India), which has clearly learned this lesson from the demonetisation episode, reacted quickly by allowing FIs such as banks, NBFCs and MFIs (micro finance institutions) to give a three-month moratorium on servicing of their standard loans at their discretion, and has provided significant amounts of extra liquidity to meet this requirement. Unfortunately, this is inadequate and, indeed, faulty in several ways.

First, the financial sector as a whole was risk averse to begin with, and has become even more risk averse now. It is more than likely that if the moratorium is to be decided by FIs, it may not be extended to the firms that need it the most, namely the MSMEs. This fear is not unfounded since data from a sample of banks indicate that less than 70% of the loan accounts are under moratorium, with some banks being lower than 20%. However, if FIs were truly rational, they would realise that a blanket moratorium would be more positive than a selective one, on their financial position over time. The reason is that not granting a moratorium will inevitably mean that the loan will become an NPA within the next three months, whereas if the moratorium is granted there is some probability that it will not. But risk aversion precludes such logic.

Overcoming extreme risk-aversion can be done in two ways – by issuing guarantees or by making the moratorium mandatory. Neither of these options is within the ambit of the RBI. It can only grant regulatory forbearance, which it has done. It is for the government to take it further. The government has belatedly given some guarantees in the May package, but much of the damage has probably already occurred.

Moreover, guarantees address risk aversion at the institutional level to an extent,8 but do nothing to overcome individual risk-aversion of the financial sector executives. Making the moratorium mandatory is much to be preferred since it completely de-risks both the institution and the individual since there is no discretion involved and the responsibility vests in the government.

Second, the RBI directive permits the FIs to cumulate the interest due during the moratorium period and add it to the principal, while re-computing the repayment schedule. Moreover, it is not clear whether the repayment period is being extended or not. Both these features will lead to a situation where the debt servicing costs will go up sharply at a time where neither production nor sales would have returned to their pre-lockdown levels. This will again give rise to completely avoidable NPAs.

The sensible thing to have done would be to declare the moratorium period as a “standstill”, which means in effect that this three-month period supposedly does not exist9. As a result, the loan servicing terms both in the size of the EMIs (equated monthly instalments) and the repayment period remain unchanged once the period is over. There is of course a cost – during this period the FIs will not earn interest income but will need to continue servicing their own interest payment obligations to depositors or bond holders. On the other hand, their loan books will be larger later than would otherwise be the case, which is a benefit to them. The difference can be considered for repayment by the government. In the May package, the government has extended the moratorium for three more months, and has mandated that the accrued interest be converted into a term loan repayable over the remaining six months. This takes care of some of the problem but does not really reduce the interest burden of the borrowers.

Third, the moratorium is not extended to loans taken by NBFCs and MFIs from banks. Since about 40% of the loans taken by these institutions are from banks, this is a huge burden for them which they will not be able to bear given that their reserves are far lower than those of banks. Moreover, these institutions have much greater exposure to MSMEs than banks do, and this stipulation will require them to call in their loans and not give any moratorium to their customers. This will lead to a bloodbath in the MSME sector. In the May package, the government has not corrected the problem but has opened a liquidity window for supporting NBFCs by banks through purchase of NBFC bonds. However, it is clear that smaller and weaker NBFCs will not get this support either and will be left to fend for themselves, which will then get reflected on their clients.

Already too much time has passed, but nevertheless these infirmities in the RBI order and some of the liquidity support extended by the government must be corrected immediately. However, this is not enough. In order for production units to survive until production resumes, they will need to continue payments on a number of cost items such as rents, utilities, and some part of their workers’ wages. In order to cover these, the FIs will have to give additional loans since most of the working capital would have already been used up. These amounts are not that large, and an additional 20-25% of existing working capital limits may suffice. Fortunately, the government has addressed this problem. Since the demand for term loans are going to be very subdued, the banks should be able to manage this without too much trouble.

Liquidity support apart, the single most important step that the government must take is for the central government to immediately pay off all its unpaid dues. Overdue payments by the Centre to states, tax payers, exporters and, most importantly to its suppliers and vendors, add up to somewhere around 1% of GDP or Rs. 2 trillion, which should, for the moment, relieve their stress. These payments can be made quickly since they are already committed and approved; and, therefore, do not need to go through the normal tedious government processes. The government has announced that it will pay the outstandings to its vendors in 45 days, but the quantum involved is not clear. It seems likely that it will be only a small part of its overall dues, otherwise it would have been announced with great fanfare. However, this should not be done at the cost of the expenditure programme contained in the Budget.

During this three-month period, therefore, the fiscal support needed, over and above clearing all its dues, is not large since it is essentially to ensure that the poor and the unemployed do not have to suffer needlessly. An approximate estimate of the additional fiscal support required is around Rs. 2 trillion, including Rs. 0.8 trillion contained as a part of PM-GKY. Since most of this is direct benefit transfers (DBT), it can and should be released immediately.

In the next part of the series (to be posted on Monday, 8 June), Dr Pronab Sen will discuss the revival phase – four-month period after the lockdown is lifted and normal economic activity is allowed to resume from June 2020, and the recovery phase thereafter. 

Notes:

  1. The agriculture sector is already facing this problem with mandi prices falling for a wide range of agricultural products.
  2. The PM-GKY, which amounts to about 0.8% of GDP, is a repackaging of existing schemes and some additionality. The additionality is only about 0.4% of GDP. There is as yet no estimate of the costs being borne by the states.
  3. Rural India is by and large used to periodic supply shocks from weather-related events and, therefore, coping mechanisms exist.
  4. Up-scaling will not only involve a large increase in the volume of works taken up, but also increase in the number of days of work per household from the present limit of 100 per year to at least 150. But this can happen only when the central government permits such work.
  5. There is by now considerable work in identifying alternative mechanisms which would address this problem. Ration cards and MNREGA lists in combination with Jan Dhan accounts appear to offer a better option.
  6. PM-GKY transfers Rs. 500 or Rs. 1,000 per month into Jan Dhan accounts for a three-month period.
  7. These numbers are on the basis of the poverty line.
  8. FIs will worry about the inevitable government audit that will be made consequent to such guarantees being invoked. Such audits are quite rightly feared given the past track-record.
  9. An equivalent of this exists in labour laws (and is often used by the government itself on labour matters). It is called dies non, and applies to periods of strikes where the labour does not get paid but the time does not count as a break in service.

 

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