The pandemic and the package

The government has announced a package of fiscal and monetary policy actions, and broader economic reforms to set the economy back on track after the Covid-19 lockdown. In this post, Sengupta and Vardhan argue that instead of announcing many small-ticket items that further complicate matters of targeting and delivery, the package could have been split into two main parts: partial credit guarantees and direct lending programmes for targeted micro, small, and medium enterprises; and direct benefit transfers to low-income households.

Covid-19 and actions taken to deal with the pandemic, in particular the nationwide lockdown since 24 March, have been causing severe damages for the Indian economy. In response, the government has announced a package of fiscal and monetary policy actions, and broader economic reforms. How effective will the package be in ameliorating the pains the economy has been experiencing?

The problem

The pandemic is a massive shock that hit the country at a time when the economy and the financial system were already weak. The pre-conditions will influence the economic consequences of the pandemic and the policy actions (Sengupta 2020). Some key trends of the pre-Covid-19 period were as follows:

GDP (gross domestic product) growth rate has been on a downward trajectory since 2015-16. Annual growth rate fell from 6.04% in 2018-19 to 3.89% in 2019-20, the lowest since 2002-03. Industry, which accounts for 30% of GDP, shrank by 0.58% in Q4 (fourth quarter), 2019-20.
A major driver of growth in any economy is investment by the private corporate sector. In the pre-Covid period, nominal values of private sector investment have been declining. The total outstanding investment projects between 2015-16 and 2019-20 declined by 2.4%, whereas new projects announced fell by 4%, as per data from the CMIE (Centre for Monitoring Indian Economy).
The banking sector contributes bulk of India’s commercial credit. By December 2019, the annual growth rate of non-food bank credit had fallen below 7%, the lowest in nearly six decades. The low growth in bank credit was driven by private banks lending to consumers, whereas the growth rate of net lending to businesses has been declining.
The banking sector and the bond markets have been displaying high levels of risk aversion, as discussed in Sengupta and Vardhan (2020).
The external sector of the economy has been weakening as well. The nominal value of exports of goods and services – another important driver of growth – witnessed a decline by 8.49% in Q4, 2019-20.
The fiscal deficit of the central government in 2019-20 was 4.6% of GDP – the highest since 2012-13. The government has been consistently missing its deficit targets over the last few years. The fiscal deficit for 2020-21 was pegged at 3.5% of GDP in the Union Budget. This will get breached by a wide margin. Even without any additional expenditure, the deficit would go up substantially because of decline in tax revenues and disinvestment receipts. Net tax revenues in April 2020 fell by a staggering 70% compared to April 2019. If state-level deficits are added, then the overall fiscal deficit in 2020-21 could very well exceed 10% of GDP, even without taking into account the off-balance sheet items. Financing such high levels of deficit poses a serious challenge.
In response to the growth slowdown, the Reserve Bank of India (RBI) embarked on a path of monetary expansion. Between October 2018 and December 2019, it freed up around Rs. 4 trillion of liquidity through open market operations¹, and reduced the repo rate² by 135 basis points to 5.15% – the lowest since March 2010. Yet, credit growth has not picked up, primarily due to the heightened risk aversion in the banking sector, and low credit demand from the stressed private corporate sector.

What is needed?

Against the background of a weak economy, the twin shocks of Covid-19 and lockdown are operating at two levels:

Creating supply-side disruptions
Triggering reduction in aggregate demand

The need of the hour is policy actions to deal with both supply- and demand-side problems.

The supply side has been reeling under three pre-existing shocks: (i) demonetisation of 2016, (ii) goods and services tax (GST) since 2017, and (iii) slowdown in credit growth. The pandemic is creating additional disruptions due to the following factors:

Mass exodus of migrant workers from urban areas: Many firms will not be able to find the required number of workers, and hence production will be constrained even if they do not face a demand shortage. This will be acute in sectors such as construction, logistics (last-mile delivery of goods), unskilled manufacturing, etc., where large number of migrant workers are employed.
Non-availability of financing: Finance is the backbone of business. Currently the banking sector, especially public sector banks (PSBs), are operating under high levels of risk aversion. The future prospects of borrowers have become more uncertain in the ongoing crisis. This will further affect credit availability. Bond markets have also become risk averse. Credit spreads on corporate bonds are the highest since 2009.
Restrictions on international trade: The pandemic has disrupted global supply chains. To the extent that international transport of goods is adversely affected, importing firms will face supply constraints.
Logistics issues: The lockdown has imposed restrictions on intra- and inter-state movements. This has made transportation of raw materials and finished goods difficult even within the national boundaries.

In other words, all factors of production are facing disruptions – capital, labour, and raw materials. In addition, marketing has been disrupted, retail stores are closed, and e-commerce is not operating smoothly. The relaxation of lockdown will release some pent-up demand, but the supply-side disruptions are unlikely to get resolved soon. This in turn will exacerbate the demand shortage. For example, firms have fixed expenses such as rent, wages, inventory maintenance, etc., but a large number of them are earning no revenues. If they do not receive financing to tide over this crisis, they will be forced to downsize their businesses or even shut shop. This will add to unemployment and aggravate the demand problem.

Hence, authorities need to figure out ways to offer funding to the firms who need it, to help them stay solvent.

The demand-side problem is due to the following factors:

Right now, a large number of consumers all over the country are only spending on essential commodities such as food, groceries, and medicines. Demand for nearly all non-essential goods and services has remained suppressed for nearly two months, even if consumers have the purchasing power. We call this Round 1 of the demand problem. The gradual relaxation of the lockdown that is currently underway will release some pent-up consumption demand. However, in view of the prevailing uncertainty, large parts of demand are likely to stay subdued for a long time, especially discretionary expenditures.
The Round 1 demand problem is getting aggravated due to the loss of jobs of millions of migrant workers and daily-wage earners, who have been forced to return to their native villages because of the lockdown. The formal sector too has been witnessing retrenchment of contract employees, reduction in variable pay, etc. These factors have led to a significant decline in disposable incomes. This problem will worsen over time, unless the authorities step in with adequate relief measures.
If the lockdown continues in some form or the other, and supply shocks continue unabated, there will be a Round 2 of the demand problem. A large number of white-collar workers will lose jobs or face reduced salaries because many financially stressed businesses will no longer be able to keep them on the payroll. The Round 2 effect, which will play out in the medium term, might be more severe because it will have a broader impact on purchasing power. As this happens, and the demand contraction becomes more acute, many more firms will struggle to stay solvent or even to survive. In other words, the economy may get trapped in some sort of a vicious cycle of low demand–high unemployment–low demand.
In addition to the reduction in consumption demand, private sector investment which has already been declining over the last few years, is unlikely to get restored in the next few quarters. Due to demand contraction, capacity utilisation of manufacturing firms has fallen drastically, eliminating any possibility of investments in new capacity addition. Most firms will struggle to obtain financing for working capital in order to simply stay afloat.

The above discussion demonstrates the kind of fiscal support that might be necessary right now.

On the supply side: To extend financing to firms to enable them to stay solvent and help resolve other supply disruptions.
On the demand side: To give relief to those who are in need, to help prop up demand.

What was announced?

The economic relief package announced by the government has three components: (i) monetary actions, (ii) fiscal actions, and (iii) economic reforms.

Monetary actions: These include announcements by the RBI, such as a reduction in the policy rates, release of more liquidity for the banking system, a moratorium on term-loan repayments for six months, etc.

Fiscal actions: Policies focusing on low-income households include repackaging old schemes, increasing the allocation of existing schemes, and some new initiatives:

Front-loading payments under the existing Pradhan Mantri Kisan Samman Nidhi Yojana (PM-KISAN)³ to the tune of Rs. 160 billion
Direct benefit transfers (DBT) to old-age people, widows, under Ujjwala Yojana⁴, and under Jan Dhan Yojana⁵amounting to Rs. 470 billion
Extending MNREGA⁶ (Mahatma Gandhi Employment Guarantee Act) to migrant workers, and to some workers in organised employment, adding up to about Rs. 922 billion
A fund for construction workers of about Rs. 310 billion
Direct food distribution using stocks available with the Food Corporation of India (FCI) to the tune of Rs. 35 billion

Salient fiscal initiatives focusing on MSMEs (micro, small, and medium enterprises) include:

Collateral-free bank loans of up to Rs. 3 trillion to MSMEs with 100% credit guarantee
Government investment of Rs. 100 billion in funds that in turn will invest Rs. 500 billion in the equity capital of MSMEs
Rs. 200 billion subordinate debt issued by banks and other financial institutions (such as SIDBI (Small Industries Development Bank of India)) for stressed MSMEs, out of which the government will refinance Rs. 20 billion
Rs. 450 billion partial credit guarantee scheme for NBFCs (non-banking financial companies), where first 20% of the loss will be borne by the government

New spending on all these initiatives amounts to around Rs. 2.04 trillion.

Economic reforms: A few policy reforms (such as, amendments to the Essential Commodities Act, liberalisation of investment norms for some sectors, etc.) and schemes (setting up of a social infrastructure fund, agriculture infrastructure fund, micro food processing enterprises scheme, etc.) were also announced. Total government expenditure on these new schemes will be about Rs. 0.55 trillion.

An evaluation of the economic package

Notwithstanding the fact that typically monetary policy changes announced by the central bank are considered separate from any ‘fiscal package’ announced by the government, the actions taken by the RBI are unlikely to have any impact either on the supply or the demand side. On the supply side, risk-averse banks are reluctant to lend despite the rate cuts and liquidity injection. In the absence of proper transmission, the monetary policy changes will fail to revive demand. When the financial intermediaries do not function normally, the usefulness of monetary policy gets limited. The rate cuts will however relieve the debt-servicing burden of the stressed firms to some extent and hence, ease the pressure on the banks.
A major component of the ‘fiscal package’ is the MSME loans backed by 100% government guarantee. Given the risk aversion in the banking system, the government needs to step in to bear some of the credit risk, so that banks can do what they are good at, which is, allocating capital. To this end, a credit guarantee scheme is a step in the right direction. Another advantage is that credit guarantees do not have immediate impact on the government budget. However, there are two issues with the announced scheme. First, credibility of a credit guarantee scheme and the lenders’ trust in it depends a lot on the details of the scheme. There may not be any take-up until the government clarifies the mechanics of the scheme (such as the conditions imposed on availability of the guarantee, the timeline to make claims and encash the guarantee, etc). Second, even if these issues are resolved to banks’ satisfaction, credit allocation may be distorted with a 100% credit guarantee because banks have no skin in the game. This takes away the incentive of the bank to scrutinise loan applications and can lead to moral hazard. Instead, the credit guarantee could have been a partial one.

Implementation of many of the initiatives will require proper targeting of beneficiaries and an efficient delivery mechanism. This in turn would require close coordination between the central, state, and local governments. In absence of this, effective implementation of these announcements would be doubtful.
On the supply side, the package addresses the financing problems, but in an inadequate way, and there is nothing to address other issues related to supply-chain disruptions. Announcements regarding existing schemes (such as, MNREGA, DBT, PM-KISAN, etc.) are meant to address the demand-side problems, but given the severity of collapse in aggregate demand, the monetary amounts appear insufficient. Overall, the package is unlikely to provide any significant relief to a crisis-ridden economy.
The economic reforms that were announced are necessary and long awaited, but their benefits will accrue in the long term. They will not do anything to resolve the problems that the economy is facing right now.
While the aggregate ‘benefit’ of the package was announced to be Rs. 20 trillion or 10% of GDP, the package entails an incremental government spending of only Rs. 2.6 trillion, which is less than 2% of GDP.

Given the acute nature of the problem, instead of announcing many small-ticket items that further complicate matters of targeting and delivery, the package could have been split into two main parts: (i) partial credit guarantees and direct lending programmes for targeted MSMEs, possibly channeling the latter through government-owned institutions (such as National Bank for Agriculture and Rural Development (NABARD) and SIDBI); and (ii) DBTs to low-income households.

There are around 260 million households in India. Paying the poorest 10% of them Rs. 5,000 per month, would cost Rs. 130 billion per month. If this was done for six months, it would amount to Rs. 780 billion or 0.4% of GDP. This would arguably be more effective in temporarily alleviating the demand pressures that the economy is facing right now. DBT gives flexibility to households to decide how to spend the money. This is important considering that the challenges faced by the low-income households vary across geography, and between urban and rural households.

Conclusion

Careful assessment of the package announced by the Indian government shows that given the widespread demand destruction, the package will fall short and may need to be enhanced. A large component of the package constitutes monetary actions which are unlikely to be effective (Sengupta and Vardhan 2020). The fiscal initiatives only address the financing constraints on the supply side, that too inadequately.

The eventual damage to the economy is likely to be significantly worse than the current estimates. On the demand side, the government needs to balance the income support required, with the need to ensure that the fiscal situation does not spin out of control. The balance struck seems to be a reasonable one, but the government needs to find a greater scope for supporting the incomes of the poor. Involvement of the state and local governments may also be crucial in the effective implementation of further fiscal initiatives.

The authors thank Joshua Felman for useful comments.

Notes:

RBI conducts monetary policy through open market operations (OMO) – purchase (or sale) of securities to infuse (or absorb) liquidity. OMO though essentially a monetary tool, has to factor in the large market borrowing at times to maintain orderly financial conditions.
The rate at which RBI lends money to commercial banks.
PM-KISAN is a central sector scheme that provides an income support of Rs.6,000 per year to all farmer families across the country in three equal installments of Rs.2,000 each after every four months.
Pradhan Mantri Ujjwala Yojana (PMUY) is a centrally sponsored scheme launched by the Ministry of Petroleum & Natural Gas in May 2016 to provide LPG connections to Below Poverty Line (BPL) households.
Pradhan Mantri Jan dhan Yojana(PMJDY) 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.
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.