Modi government and RBI can learn from mistakes made during 2008 crisis, but time’s running out,

The Print, August 19, 2020

Five months into the lockdown, the Covid-19 pandemic is nowhere near its end, while the economy continues to steadily deteriorate. The pandemic is unprecedented in modern India, but its economic impact is familiar: a toxic mix of poor growth, high inflation, and numerous bad loans, similar to the period after the 2008 Global Financial Crisis. This means we can look to the 2008 crisis for lessons that can help us avoid policy mistakes, especially with respect to inflation and bad loans.

Inflation pressure

Let’s first consider inflation. In the aftermath of the Global Financial Crisis (GFC), the Reserve Bank of India (RBI) responded aggressively, lowering the policy rate by more than 4 percentage points in just four months, to 4.75 per cent in December 2009. At the time, the RBI felt it was safe to relax its monetary policy stance, since the wholesale price index (WPI) inflation had collapsed. But the respite in inflation proved temporary, and soon the WPI was rising at a double-digit pace, causing inflation expectations to soar. Bringing this situation under control proved to be difficult. It was not until 2013, when policy rates had been increased to painful levels, that inflation finally began to subside.

In retrospect, the RBI made two mistakes. First, it focused on the WPI, even as more comprehensive indices were signalling towards growing inflationary pressures. The erstwhile CPI (Consumer Price Index)-industrial workers series exceeded 12 per cent, as early as 2009-10. Second, and more critical, even after the WPI itself began to rise the RBI was slow to respond, since it always had reasons to hope that the increases would be temporary.

When the current Narendra Modi-led government came to power in 2014, it seemed determined to not let such a harrowing episode be repeated. Accordingly, it introduced into law a new monetary policy regime, committing the RBI to keeping inflation within a 4-6 percent range, as measured by the CPI — not the WPI. If inflation did exceed 6 per cent for three consecutive quarters, the RBI was required to explain in a report to the government, in a report, what it was doing to bring inflation back to target levels.

The RBI now finds itself in precisely the situation that the law meant to safeguard against? CPI inflation has exceeded 6 per cent for the past 10 months. But the reaction of the RBI has been the same as it was after the GFC. The central bank has been reluctant to increase interest rates, on the grounds that high inflation triggered by supply side constraints is temporary. Without doubt, prices have been pushed up by supply disruptions during the lockdown period, and these will eventually disappear. But the process of restoring supply chains might easily take a year, by which time high inflation expectations could become firmly entrenched. Hence, there is a risk that despite all the efforts to ensure post-GFC mistakes never happen again, they are about to be repeated.

Covid's bad loan crisis

So much for inflation. What about bad loans? After the GFC, slower growth and higher interest rates rendered unviable many of the investment projects initiated during the 2004-08 boom. , making This made it impossible for many firms to repay their bank loans. The RBI responded with a series of restructuring schemes, which failed to resolve the problem. Instead, the schemes facilitated an ‘extend and pretend’ policy which enabled the banking sector to hide the bad loans for years.

The delay in resolution of the stressed assets triggered a prolonged phase of low investment-low growth in the economy, and high risk aversion in the banking sector, from which the economy still hadn’t recovered when it was hit by the Covid-19 pandemic. As these consequences became apparent, the Modi government brought in the Insolvency and Bankruptcy Code (IBC), mandating that bankrupt firms be resolved expeditiously, and in a transparent manner, essentially by auctioning them off to new, financially stronger, owners.

For a time, the IBC was indeed able to whittle down the stock of bad loans. But the Covid-19 shock generated a new wave of stressed assets, which according to the RBI’s latest Financial Stability Reports is likely to propel nonperforming assets (NPAs) to a new peak of 12.5 per cent by March 2021, even under a favourable scenario.

Going forward

It is unclear how the authorities plan to deal with this problem. So far, the government has suspended the initiation of fresh insolvency proceedings for a year, while the RBI has appointed a committee to recommend new restructuring guidelines.

If the new restructuring guidelines follow the same ‘extend and pretend’ strategy chosen after the GFC, the outcome will be the same as before. Or possibly worse, given that in 2008 the corporate and banking sectors were comparatively stronger, whereas even before the virus hit in 2020, they both had been substantially weakened by years of balance-sheet stress. Hence, the effects of delaying resolution this time might be more serious. If the banking sector gets paralysed, unlike the post-2008 period, borrowers will no longer be able to turn to the non-banking finance companies (NBFCs), since the NBFCs are also in a weak condition now.

India, thus, stands at a crossroads now. Soon, the Modi government and the RBI will need to decide whether to deal quickly and decisively with the economic problems that Covid-19 has created, or wait and watch in the hope that they will disappear over time. The stakes in this decision are high, since it will determine the course of India’s economy for the next decade.

Looking back, the GFC episode makes it clear that the decisive strategy is superior. What is unclear is whether this lesson has truly been learned. And we all recall American philosopher George Santayana’s admonition: if we do not learn from history, we are doomed to repeat it.

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Covid-19: Policy Challenges And Traps In Restarting The Economy

Bloomberg Quint, April 6, 2020 (with Harsh Vardhan)

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.