Indian Economy: 2nd wave & after

 

 It is useful to compare India's second wave with the first wave, in analyzing its effect on the Indian economy. However, this analysis is incomplete, unless there is a better understanding of the speed and severity of the 2nd wave relative to the first (see previous blogs). It also requires an understanding of Pandemic and lock-down economics (see research & policy papers at foundation for economic growth and welfare (EGROW) website).

 This note contains a preliminary analysis based on available data. Among the elements of this analysis is the comparison of Lockdowns/restrictions, the differential impact  of  pandemic on the three aggregates, essential goods, manufacturing, mining & construction & contact services, the unemployment comparisons, Income and wealth effects and their effect on private consumption, effect of skilled labor shortage and supply chain disruptions on inflation. The note concludes with implications for monetary and fiscal policy.

1.       2020 Lockdown started on 20th March and shut down 60% of Indian economy, in 2021, lockdowns were narrower, State/District specific, starting in April. The lockdown arithmetic therefor suggests smaller effect of lock down on economy.

2.       Essential goods were exempted from both lockdowns, so there is little reason to expect agriculture to be affected very differently, except for two exogenous. One global and Indian agricultural prices are much higher than a year ago, so this will have a positive effect on agriculture sector despite some increase in input prices as terms of trade are clearly better. The second is the rise real wages following, years of falling or stationary real wages. Both are a positive for rural economy in FY22. I think too much weight is being given to Covid wave effect on rural economy relative to urban economy. The fact that second wave has 4 times the cases of first wave, means that direct effects on health will be 4x what they were last time. Overall, the latter effect is short term while the former two are medium term, so agriculture will do better that in 1st wave, after an initial hiccup.

3.       Conventional wisdom is that the Covid 2nd wave will follow the same pattern as the first wave. Our analysis shows that the second wave was faster and much more virulent in terms of numbers of cases and deaths and will therefore subside much more sharply and quickly than the first wave. There will therefore be an upside surprise to the economy.

4.        In first wave, unemployment rose to 8.8% in March, 23.5% in April & May and improving to 11.6% June as lockdown was eased. In 2nd wave, Unemployment rate rose from 6.5% in March to 8% in April and further to 11.8%. This is half of first wave peak, so direct effect of lockdown on production is about half of first wave! The ratio of the urban to rural unemployment rate in the second wave is 1.4 compared to 1.1 in the first wave. Urban areas have been hit harder than rural areas contrary to the assumption of most analysts. This is to be expected from our research on the State wise spread of the mutated virus causing the second wave, which showed that states with higher urbanization have been worse affected than less urbanized states.

5.       Income effect: Post lockdown the Manufacturing-Mining-Construction sectors recovered rapidly after supply chains disruptions were addressed, as our research had predicted. Given the geographically and sector-ally more limited nature of the current restrictions/lockdown, supply chain disruptions are more limited in India, and there is recent experience of dealing with them, the recovery will be as, if not more, rapid. Supply chain disruptions are more widespread across the world and the consequent rise in oil prices will have a negative effect on national income & growth, but as usual this  will be partly offset by higher exports and remittances.

6.       Contact services (hospitality, entertainment, tourism) would take much longer to recover, because of the reality and the fears of infection, particularly in indoor venues and badly ventilated locations. Govts need to incentivize improved ventilation in outdoor venues as well as indoor public spaces & factories & offices, installation of high-quality air filters in air-conditioned halls & buildings and Ultra-Violet (UV) ceiling lights in crowded, small rooms (pubs, bathrooms, kitchens, restraints).

7.       Wealth effect(negative): Saving, Consumption: The first wave eliminated the meagre accumulated savings of the poor. The second wave has done the same for many lower middle-income households as well as the middle-income families affected by disease and death. The precautionary savings are therefore expected by many analysts to increase, post second wave, and thus delay the recovery of private consumption. There are however three other factors one negative and two positive that need to be considered to derive the net effect on consumption.

8.       Consumer Expectations: The consumer confidence incidence (RBI survey) fell from 86 in March 2020 to a low of 50 in September 2020 and had recovered to 55.5 by Jan 2021 & declined to 53.1 in March 2021. This will be a negative factor in the speed of recovery of private consumption after lockdown. Interestingly, the gap between the current and future expectations index has more than doubled since pre-covid days and may result in a fast reversion in current expectations, once it starts. Institutions providing consumer credit (e.g. NBFCs) are in a much healthier position than they were 18 months ago, while credit demand from corporations for bank credit is low, given higher internal savings. So, consumer credit will aid recovery. There was no vaccination in sight through much of the first wave. There are now several approved vaccines, including two produced in India, with several more on the way.  The planning & management problems which have slowed vaccination are manageable and will be solved. So, the medium-term income growth trend is much more positive than during the first wave. Both these factors will offset the desire for more precautionary savings.

9.       Skilled labor effect: In the second wave, Severe Covid cases and deaths are four times that in the first, and the urban middle class has been more heavily impacted. It is therefore possible that preexisting shortages of skilled labor will be accentuated, negatively affecting the speed of recovery of industry & services for which demand recovery is quick. Govt should quickly implement the changes in the Apprentice ship act announced in budget, and to improve training of semi-skilled workers in cooperation with industry.

10.   Across the World (including India) supply chain disruptions and short-term adjustments in demand (e.g. diversion of demand from contact services to goods, because of contagion fears) have led to inflationary pressures in particular goods or sets of goods. These pressures are temporary and will subside as Covid contagion fears decline and demand patterns normalize in 2021. The long-term increase in Govt infrastructure investment in USA is a different aspect, whose effect on inflation needs to be assessed separately.

11.   Overall, GDP growth in Q1 of FY22 will be lower than projected in March 2021, and investment revival delayed by one quarter. As consumption depends on expected income, which is clearly on an upward trajectory in H1 of FY22 as against the downward trajectory in H1 of FY21, this factor will offset the impulse to increased precautionary savings, from Q2 of FY22. Recovery will be much faster in Q2 than anticipated by forecasters. FY 2022 GDP growth will remain within the range of 10% +/- 1.5%, even though the downside risk appears much higher at this point, than it was in February 2021.

12.   Fiscal deficits are being driven by GDP linked revenue fluctuations, which act as automatic stabilizers. The best fiscal stimulus that Govt can provide is revenue neutral or revenue negative tax reform, by accelerating simplification of GST towards a single rate (15%) for 75% of G&S, introducing a new direct code. Speedy revival of construction intensive infrastructure projects will help normalization of total employment. Incentives for air filters & UV lights and investment/production/distribution of Covid vaccines, will help reduce the chances of a third wave, reduce fears of contagion and restore consumer confidence.  Govt can speed the recovery, by implementing the apprenticeship act reform announced in budget and completing Ease of compliance of Labor, tax & financial laws & rules, which it has previously promised. Central govt should also review the laws, rules and regulations affecting start-ups and tech companies to make them competitive with other locations like Singapore. State governments must do their part in simplifying the jungle of controls and regulations imposed by them, and speeding up the vaccination process.

13.    Monetary policy is and has been on the right trajectory since the start of the pandemic and should continue the same path.  Only fine tuning of credit policy or govt security markets may be needed.

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.