It is now widely acknowledged that the scale of the economic damage caused by the Covid-19 pandemic will be far greater than that caused by the 2008 global financial crisis, globally as well as for India.
There exists considerable uncertainty about the duration and depth of the crisis but one thing is becoming increasingly clear: dealing with the after-effects of Covid-19 will be a major economic policy challenge over the next few years. While some policy actions have been announced by the government and the Reserve Bank of India, they are interim measures and are not going to be adequate to support the economy. Given the uncertainty, policy responses are likely to be reactive. Here, we discuss a few challenges in fiscal, monetary and financial policies and also lay out some policy traps that must be avoided in order to prevent a long-term economic disaster.
Fiscal Conundrum
Let’s start with fiscal policy. Even assuming a conservative scenario where the government does not incur any additional expenses due to Covid-19, the deficit will be greater than the projected value in the 2020-21 budget. During the ongoing three-week-long lockdown, almost all economic activities have been suspended and most of these are unlikely to resume in the near future given the nature of the health shock. As a result, government revenues will fall drastically. Given the depressed equity market condition and global economic uncertainty, the disinvestment targets are unlikely to be met. Over and above this, much of the policy actions required to minimise the economic fallout of the shock will involve government spending.
It is almost certain that the government will not be able to adhere to its fiscal target for 2020-21 and will most likely breach it by a big margin.
In India, the fiscal deficit is supported by financial repression wherein the government borrows from a captive market of banks and other institutional lenders. In the pre-Covid19 period, total central and state government borrowing had already exceeded total household savings. Further borrowing will sharpen the yields in the bond market and crowd out private capital at a time when a large number of firms and households will need to borrow to stay afloat. The large-scale income losses of many businesses and households that are inevitable during this crisis imply that the savings rate is likely to fall. These factors leave little room for the government to increase its domestic borrowing.
Recently, a scheme has been announced to encourage foreign investment in government securities. With the global spread of the pandemic, foreign portfolio investors have already been taking money out of the Indian capital markets. Given the widespread risk aversion, it is unlikely that this route will bring in a lot of financing for the government. If anything, the widening fiscal deficit may lead to a sovereign rating downgrade or a lowering of the macro outlook which in turn will increase the risk premium demanded by FIIs. Therefore, the biggest policy challenge now will be financing the rise in the government deficit. The only favourable factor in this regard is the sharp decline in global oil prices which are expected to remain subdued given the worldwide decline in demand for oil.
The Risks To Print-And-Spend
Next comes monetary policy. There are now calls from certain quarters for the RBI to print money to finance the rise in the fiscal deficit, a practice that was prevalent in India but discontinued since 1997. Monetisation of fiscal deficit will create inflationary pressures, lead to greater uncertainty about future inflation, increase long-term interest rates and adversely impact growth, thereby defeating the very objective of supporting the economy.
All efforts to flatten the Corona curve would steepen the yield curve.
This move will violate India's inflation-targeting framework and attenuate the effectiveness of future monetary policy actions. It will also hurt the credibility of the government.
Financial Freeze?
Finally, in the financial sector, banks and non-banking finance companies will witness a precipitous rise in non-performing assets, both from the private corporate and the retail sectors as firms and households struggle to deal with this unprecedented shock. A large number of firms especially the micro, small and medium businesses and also self-employed individuals are likely to default on their bank and NBFC loans.
Rising NPAs will erode the capital of lenders at a time when they are expected to lend aggressively to revive economic growth.
With the stock market touching new lows every day, it will be difficult for private banks to raise capital and the strained fiscal situation will make it difficult for the government to recapitalise the public sector banks. Capital deficiency in the face of rising NPAs will lead to demands for ‘forbearance’ from the RBI. There may also be further easing of capital requirements by tweaking the risk weights or outright reduction of capital adequacy requirements, on the basis that Indian requirement has been tighter than international standards. The net result of such regulatory concessions would be that the banking sector will remain undercapitalised for some time and will hide its losses.
Rules Matter
When the Covid-19 shock hit India, the economy was still recovering from the twin balance sheet crisis, the seeds of which were sown in the years of regulatory forbearance of the post-2008 period. Postponement of NPA recognition helps to 'extend and pretend'. Soon the problem becomes too big to tackle and the damage to the economy becomes long-lasting. If allowed now, this will lead to a system-wide crisis as it did in 2016-17 post the asset quality review by RBI.
Defaults by firms would trigger a wave of bankruptcies.
The Insolvency and Bankruptcy Code has introduced, for the first time, a rigorous and disciplined process for dealing with bankruptcies. There will be a demand now to dilute the provisions of IBC. This could undermine the most important reform of the last decade and render the code ineffective.
In such extraordinary times, the temptation to ignore rules and frameworks, and apply discretion runs high. This approach is neither effective nor sustainable. Over the last two decades several important policy frameworks have been put in place – FRBM, inflation-targeting, Basel norms, IBC, etc. These frameworks provide institutional support to policy decisions and must be adhered to in the interest of the long-term health of the economy. Policy responses to the ongoing crisis potentially risk undermining these frameworks and must be decided with utmost care and caution.
