India macro-economic review: Pre-monetary policy

 

Covid economy: Lockdown, Transition to Normalization & setback

More than a year ago, EGROW research paper discussed the economics of lockdown[1] and the transition to normalcy. The transition played out as we had envisaged and normalisation had occurred by March 2021 as anticipated.

Second Covid wave started in April and we were back into another transition period, characterised by regional, better targeted restrictions in terms of services and selected district lockdowns. In the last meeting we had pointed that public forecasts were following the covid waves, but our analysis of the second wave allowed us to see through it.

The available forecasts were much too affected by short term developments resulting in a high correlation between covid cycle and GDP forecasting cycle. Our analysis of the delta variant, in EGROW foundation research paper, clearly showed that the new variant is not part of the old wave which is more or less over. Based on our dual S curve model, we predicted that the covid variant would spread very rapidly and then decline just as rapidly as it grew. This is what happened by end of July.

The key point to note is that people were focussing on the wrong issue. It was not the incompetence of the government or the carelessness of the public which was critical in the second wave, but the high transmissibility and severity of the new variant(s). This has been proved by the spread of the Delta variant in the UK, Indonesia, other SE Asian countries, US and China.

Based on the second wave model, published in May 2021[2], we had concluded that FY22, Q1 GDP would be much worse than predicted by anyone and Q2 GDP would bounce back much faster that anyone was expecting. Consequently, Q2 GDP would make-up most, but not all of the losses during Q1. With H2 growth recovery still on track, the full year growth would remain within our six month earlier forecast of 10% +/- 1 percent, with a downside risk. That is how the economic recovery has played out so far.

In our 2020 paper on fiscal policy during the transition[3] emphasis was on logistics disruptions, and supply chain disruptions during the transition period. Logistics problems were much severe in other parts of the world than India. There were problems of sudden stops and sudden starts. The logistic costs of Indian exports went up by only 20 percent, compared to the logistic cost of exports from China to the US, which went up by 100 percent or more.

In the USA this was aggravated by a shift in demand, from services to goods. Demand for manufactured products and imports of the same shot up. This resulted in unexpected pressure on logistic chain.  The logistics of delivering commodities are completely different from services and there was a shortage of ships and containers, and those costs went up. As covid wave dies down, we will see a reverse shift, the demand will shift back to services. Disruptions in the supply chain are an important factor to keep in mind. E.g. semiconductor disruptions, the natural resource commodity disruptions, etc.

As our analysis indicated, inflationary pressures from logistics and supply chain disruptions would have a large temporary component in India, USA and worldwide, because of its origin in the supply chain disruptions. However in the case of India inflation is also strongly affected by global petroleum oil and edible oil prices, both of which have increased substantially during the last six months.

Macroeconomics of Indian economy: Exports, Investment and private consumption

There has been a surge in exports from India especially in the Q1 and till July. The macroeconomic issue is to determine how much of this is temporary and permanent. There have been many indications in the data and personal observations that supply chain shifts are occurring. Most of the surge seems to be due to the shift in supply chains. This has two elements- incremental demand and diversification and risk reduction. There is increasing willingness to pay 10-20 percent higher cost of imports from India, to reduce China risk. This willingness is increasing with the unpredictable behaviour of Chinese authorities, ranging from random actions with respect to capital markets and tech companies and severe lockdowns in many cities purportedly based on a few Covid Delta cases numbering in the tens.

The government must make sure, with the help of industry associations, that any new bottlenecks are identified and solved expeditiously, to ensure that this great opportunity is translated into permanent increase in World export shares.

The government’s provision for Capital expenditure was increased by 30-34 percent in the budget. This will finance construction intensive infrastructure in FY22. The momentum was somewhat disrupted by the second wave but will pick up in Q2 FY22 and stimulate complementary private investment. We expect the Digital economy to lead private investment during FY22. However, much of this investment comes under intangibles and will not be visible in the usual indicators of fixed investment. 

Doubts remain about the speed of recovery of private investments because of the depletion of private saving/increase in indebtedness of those affected by Covid infections and those with employment/income losses during lockdowns. EGROW’s research paper in 2020 had pointed to the importance of distinguishing between Contact Services, goods and their related services, and non-contact services. The key new element is the dynamics of the shift in relative demand for goods and services. The shift from savings to goods consumption took place during the lockdown and transition period was when fears of contagion were high. As vaccination drives proceed and fears of Covid contagion subside, there will be a gradual shift back to services and a reduction in the pressure on the demand for goods. This will translate into reduced pressure on logistics chain, logistics costs and inflationary pressure on commodities.

In India, a nationwide third wave is highly unlikely unless there is a new mutation similar to the delta variant. But, regional variations in the number of cases will be observed.

The overall GDP is expected to be 10% -/+ 1 percent, with downside risk higher because of the second wave. Though the second wave is over on a nation-wide level, we may continue to see regional flare ups as have happened in Kerala, Maharashtra and the Northeast. However, given the learnings from the first two waves (Govt, business, public), the increase in Sero-positivity (2/3^rd of population) and the higher vaccination levels (1/3 of adults), a nationwide third wave can only happen if there is new Covid variant comparable in transmissibility and severity as the delta variant. Nobody can predict this, but the medical community can ensure that any such variant is detected quickly and contained before it becomes another wave!

The interest rate should, and is likely to, remain unchanged. So too the future guidance on monetary policy.

Capital depletion, capacity destruction!

The government and RBI must be alert to any, “Capacity destruction” and “capital depletion in informal enterprises” that has taken place under the radar of regular data collection. The formal sector, particularly the corporate sector is flush with cash and have reduced their demand for credit. The medium-large firms in the MSME sector will also have sufficient access to credit once their demand revives. My concern is for the self-employed and the micro & small enterprises which have exhausted their personal and family sources of working capital and may have difficulty obtaining the capital needed to restart their enterprises. The government and RBI must be on the look-out out for sectors/industries/services where capital depletion has happened and ensure that help is provided for restarting their business.

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[1] https://egrowfoundation.org/research/policy-for-post-lockdown-indian-economy/

[2] https://egrowfoundation.org/research/indias-second-covid-wave/

[3] https://egrowfoundation.org/research/lockdown-economics-fiscal-policy-during-pandemic-crises/

 

Lockdown Economics: Pandemic Fiscal Policy

   There is widespread misunderstanding of the economic nature of the lock-down and the effects of monetary and fiscal policy during a lock-down . This note attempts to clarify the different elements, so that correct policies can be devised, with particular reference to Indian lock-down. However the analytical approach and several conclusions are equally applicable to other countries which have imposed a lock down or Social confinement of citizens in their homes.

Equilibrium: Essential Goods & Services

   The Indian lock-down, closed all economic activity, except Essential goods and services, through an order of the Union Govt under the Disaster Management Act. The bulk of Essential commodities consist of food and beverages and its entire supply chain up to the consumer including related transport and sale. Essential services also included Government administration, electronic communication & media services. We estimate, that these constituted 40% of Gross Value Added and about 55% of employment. Except for administrative glitches and minor disruptions, this part was almost fully functional(>90%), with Demand matching Supply at approximately levels prevailing before the pandemic. Consequently it can be assumed that both incomes and tax revenues originating in this sector of the economy are also at levels prevailing before the pandemic.

Equilibrium: Non-essential Goods & Services

   With the rest of the economy closed there is no production and supply of "non-essential" goods and services. With supply zero due to Govt imposed lock-down, there is excess demand for the goods and services in this part of the economy but it's not expressed, in the market, because the markets are shut by Govt order. So effectively there is a demand-supply equilibrium at zero. Note that even the govt is unable to actualize the demand for non-essential goods and services because supply is shut.

Assume, for the moment that there are no legal obligations on the economic agents in this part of the economy. Then both incomes (of workers and owners of capital) would be reduced to zero, as would all the tax revenues of the Govt's from this sector of the economy. Private individuals would still have to buy essential Goods and services to survive. Those who do not have liquid funds would therefore be desperately in need of transfers to survive. It would be the primary duty of govt to provide such transfers to ensure survival of those with no or little savings to fall back on. Those with accumulated savings would use these savings to purchase essential commodities and thus become net disasters. The savings of their counterparts in the essential goods and services sector would however increase, because they would be unable to spend that part of their income which they normally spent on non-essential goods and services. The net effect is likely to be a decline in private saving rate given the relative size of the two parts of the economy.

Govt Fiscal Balance

Govts revenues from and expenditures on non-essential goods and services would also be zero. As taxes on essential goods and services are generally less than on non-essentials. On the expenditure Govt would continue to pay its govt employees as they are considered essential. It would not, however be able to purchase any goods and services to carry out projects and programs so these would halt. Given the relative size of wages and commodity purchases by the Govt, the net effect of the lock down is likely to be an increase in the deficit from pre-Pandemic levels, but not by big amounts. To the extent, Welfare transfers increase to ensure survival of workers and self employed in the non-essential commodity sector, the deficit would increase further, but there is an upper limit, given by the normal consumption of essential commodities by the poor. Any further increase in transfers to the poor or transfers to the non-poor will have No effect on the economy. ie fiscal stimulus is irrelevant to an economy in lock down.

Legal Asymmetry & Force Majeure

The key problem for the economy in lock-down is asymmetric legal contracts and Government policy and rules which impose asymmetric obligations on employers. Examples of the former are rental agreements, loans taken with obligation to pay interest and repay debts. Examples of the latter are labor laws which keep employers from reducing work hours and wages or fire them, or arbitrary decisions of State Governments to keep paying full wages to employees who are sitting at home due to lock-down. The lock-down therefore creates a threat of mass bankruptcy of firms (SMEs & Household enterprises) in the non-essential sectors. The govt must suspend such asymmetric contracts, so that mass bankruptcy is prevented.

Fiscal Policy during Lock-down

  The central bank's obligation is to provide enough short, medium term liquidity, but the Govt has to backstop this through risk sharing and credit enhancements of lending to firms under threat of bankruptcy. Any transfers to firms and individuals who have sufficient savings to meet their normal demand for essential goods and services, do not have any effect on aggregate effective demand, only on the ability to restart their business after the lock-down is lifted.

   To summarize, targeted Govt transfers to those who do not have enough family savings to maintain their normal expenditure on essential goods and services. Beyond this no govt stimulus is possible. The only effect of any other govt transfers is to reduce net debt creation and/or stave of bankruptcy of firms. The only feasible objective of Govt during a lock-down, is to ensure no individual goes hungry and to Stave off Mass bankruptcy in non-essential goods & services. Monetary policy has to work closely, in tandem with Fiscal policy to achieve the latter policy by providing enough liquidity to the banking system and securities markets that underpin and anchor the payments and credit system and to every systemically important segment of the financial market (NBFCs, Mutual Funds) to ensure that liquidity problems in any institution, don't translate into insolvency and contagion.

Phased Unlocking: Transition From Lockdown To Normalcy

While phasing out the Lock-down the most important distinction to keep in mind, is between individuals as consumers and individuals as workers, professional service providers, mangers and owners of businesses & companies. It is possible to minimize transmission of Corona Virus while speeding economic recovery, by a combination of quicker freeing of production and supply and slower normalization of interpersonal and social freedom.

 The second important dimension, which is critical to efficient and cost effective transition, is that between Contact Services, which contribute about 10% of Gross Value Added (GVA) and employment, and Manufacturing, mining, construction & allied services(MMC&AS) , which contributes 50% of GVA and about 35% of employment. By their very nature, former involve mass contact with many other individuals in confined spaces, while in the latter, supply chains are fragmented and spread out geographically. A similar two speed approach to these two sub-sectors of non-essential G&S, is necessary to optimize the trade-off between health and income. The overall goal is to minimize spread of virus through social contact while resuming economic & income generating activity while taking all necessary and feasible precautions at the workplace, in transport of workers and in sale of goods.

  The third dimension of the transition is the definition of confinement/quarantine zones which must be isolated, red zones in which all Contact services must remain locked down even as MMC&AS is freed to ensure that supply chains function smoothly and orange zones where social activity remains severely constrained eg by night curfew and green zones where even personal services can be liberalized.

Given some version of these policies, what is the economic nature of the transition? While the problems of personnel stress among the poor and the threat of mass bankruptcy among in business and trade begins to ease it does not disappear; the latter becomes less widespread but more acute in selected industries, requiring a narrower focus. The new problems relate to the fragmentation of supply chains, and divorcing of workers from workplace, resulting in local and/or regional pockets of demand-supply imbalances in markets for goods, labor and working capital. While RBI has to focus attention on working capital & credit, the Union Govt has to focus on smoothening inter-state flow of goods and allied services and the State's on ensuring the intra-State flow of goods & services(within State), with close cooperation of the Union Govt on both matters.

With lockdown remaining in contact sectors, the question of stimulating demand in this sector does not arise. Demand & supply are both closed by Govt intention and feat. The critical issue in MMC&AS, is one of fragmentation of demand and supply and not of a shortage of aggregate demand. The aggregate imbalance will become clear, only after national supply chains in all industries are functioning smoothly will the aggregate demand picture become clear.

During this period Governments normal project, program & developmental activities will and must resume. However, it's unclear to what extent these need to be stepped up beyond levels budgeted in February. By the nature of the transition outlined above, there will be much greater need for flexibility on the part of both State and Union Govt. There would be a need for speeding up projects in certain geographies where there's excess supply and to slow down activities in geographies where there is excess demand, to smooth imbalances instead of aggravating them.

Fiscal Stimulus Post-normalization

We can however, anticipate the nature of the aggregate imbalance, which will need to be acted on as supply chains start functioning normally. This is the sharp reduction of income in the contact sectors, and its effect on demand in the MMC&AS. Thus the issue of fiscal stimulus will become relevant as the issues arising directly from the economic lockdown are resolved.

Govt should prepare a three pronged strategy. One is revenue-negative tax reform which gives a boost to demand in short term, raises entrepreneurial optimism and the buoyancy of the tax revenues. This can be done jointly with States through the GST council by simplifying and reforming the GST and by the union govt alone by simplifying and rationalizing the Direct Tax Code. Both these will immensely benefit the SME sector which faces the greatest thereat of bankruptcy during the transition. Replacement of the entire subsidy system by an Aadhar linked, mobile payment based Direct Cash Transfer system, will greatly enhance the ability of the Union and .state governments to ensure that those most effected by the Pandemic receive the most assistance form the government in the most timely manner. The third leg of the stimulus will be targeted expenditures and short term subsidies for those contact services, in which fears of contagion continue to depress demand, even after lockdown has been completely lifted. These subsidies should provide capital assistance for creating a new environment of safety to calm fears of consumers. 
 

Conclusion

   Economists should be very careful in prescribing or demanding a Fiscal stimulus which will have no positive outcome, but can do great harm by diverting Government's attention from problems it must address during a lockdown and while phasing out the lock down and transitioning to normalization. Once the economy returns to a semblance of normalcy normal fiscal issues return to the fore, and will have to be addressed along with critical need for reforming the fiscal system to promote growth recovery and return to its potential.