The Anatomy Of An Economic Response

With the latest set of announcements made on Sunday, the government’s unveiling of the stimulus package is complete. It totals to almost INR 21 lakh crores as per details presented by the finance minister. This includes approximately INR 8 lakh crores worth measures announced by the RBI. For the rest, a substantial portion takes the form of liquidity and lending support programs run by entities in the public sector as well as support in form of guarantees by the sovereign that is aimed to incentivize commercial lending to parts of the economy. In our assessment, the direct near impact on the fiscal from the total announced package is around 1% of GDP or slightly lower. However, this will likely rise with the passage of time as some of the credit support provided may turn out to be actual liabilities for the government down the line.

A Common Template

The trade-offs embedded in the design of an economic policy response have some global commonalities, even as the specific nuances are of course critical for each country. The dominant first imperative for policy has been preservation; for individuals and families as well as for businesses. Thus for the citizenry suddenly cut off from employment, governments have had to step in with emergency support. The income support being given to households in the US or the cash and food transfer in India are both examples of this first order response. For businesses this has meant interventions to prevent, as far as possible, the destruction of precious risk capital in the system as well as the associated dimensions of spill-over risks in the general market for financing evidenced as rising credit spreads and illiquidity. The US and some other developed nations, with their embedded privileges of printing the reserve currencies of the world, have a wider canvas available here as well. Thus the Federal Reserve can intervene more freely in markets for financing as it is doing, including through the special purpose vehicles capitalized by the US government. In India, with its narrower range of options available, this is being done more selectively for small and medium enterprises and to some extent for non-bank and housing finance companies. The model, however, is similar with the sovereign participating with equity and with other agents (commercial banks, public sector financing entities) providing the financing.

This response is necessary both from a welfare aspect as well as to be able to preserve the productive capacity of the system that will kick into gear once the economy is allowed to open. However, there are bound to be allocational inefficiencies here. Thus it becomes difficult to distinguish between businesses that need support “only” to tide over the Covid shock from those that were suffering from previous capital allocation flaws but will nevertheless be recipients of new funding. In such cases, without first addressing the underlying flaws to the model, the new financing is ultimately likely to be wasted. As a more general observation, it is quite likely that the aggregate spending under this preservation package will throw up relatively weak forward growth multipliers ahead. This is meant here not as a criticism, since the inescapable need for preservation is well recognized, but more as an observation and what it means for future policy responses. 

The Indian Context

As described above, adjusted for country-specific nuances, the broad design of the Indian package is consistent with the global template, in our view. The relatively lighter direct fiscal touch seems anchored in a legitimate appreciation of the fact that our fiscal resources were somewhat more constrained to begin with. This in turn is probably due to the fact that our economy has been slowing for the last few years and that the desired buoyancy of the goods and services tax reform was yet to show through before the virus struck. An added challenge for India is that the financial system has already been struggling under the strain of substantial stress. Therefore, risk capital with lenders in aggregate has been already quite thin. Thus the level of incentive required to assure financing to more vulnerable balance sheets in the system has had to be substantial, a fact quite visible in the design of our response package. That said, the general distinction between liquidity and risk capital will likely continue to manifest in the time ahead. Put simply, outside of the explicit state back-stops, lenders will likely continue to be quite cautious. Thus the wedge between quantum and pricing of financing between the “haves” and the “have-nots” will probably  sustain and may even grow as the system lives through the likely damage from the unprecedented nominal growth shock that we are currently witnessing.

Bond Market Implications

The central government has made a reasonable effort at optimizing its fiscal constraints so far. Thus the package is light on direct spending even as revenue enhancement has been opportunistically pursued. Furthermore, we expect some more expenditure switching ahead as well. All told, we are comfortable with our initial expectation of the combined center plus state deficit going from budgeted figure of 6% of GDP to between 10 – 12% of GDP now. Although explicit additional borrowing enhancements so far indicate the lower end of this range, we don’t rule out additional borrowings or short term financing enhancements in the time ahead. This may take the eventual expansion towards the upper end of the range.

What is somewhat different from expectation is that states have been allowed a full 2% of Gross State Domestic Product (GSDP) additional borrowing leeway, but with conditions attached. Assuming that these conditions are ultimately met, 50% of all additional borrowings announced so far will come from states. Even if all states don’t meet these conditions the additional supply of state development loans (SDLs) will still be substantial. This will likely put some upward pressure on SDL spreads and, by implication, on long end corporate bond spreads. However, as far as the overall financing is concerned, we maintain our view that it is RBI which will ultimately have to (directly or indirectly) shoulder a lion’s share of this requirement. It can also help commercial demand substantially as well through measures like providing additional limits for banks held to maturity (HTM) investments in government bonds that may be required to be filled over a limited period of time.     

 The Shape of Future Policy

Before concluding, one is tempted somewhat to give in to the fool’s errand of crystal ball gazing. Looking ahead into the next few years, policy challenges and trade-offs are expected to continue in the phase of recovery. The base case here is that even as a nominal growth recovery will inevitably take hold as the world starts re-opening with starts and stops into a new normal, it is likely to take much longer to become sustainably robust. This is outside of the base effects that may flatter in the first year after this crisis. A lot of additional debt will have been taken  and a substantial portion of this may have gone into areas with weak multipliers. Thus efficiency of capital will arguably have taken a hit. With labor pools taking time to come back and in some cases having to undergo reskilling, the same efficiency argument may hold here as well. Global supply chains may be reshuffled throwing advantages for India. But equally, the global narrative seems also moving towards even more suspicion and less co-operation. This will further impact global trade with consequent impact on growth. Finally areas of the economy, especially parts of the services economy, may take much longer to come back.

 The above has strong implications for public policy. After having ensured that the mandate for preservation is met and the welfare net is working smoothly, policy will have to spend more time ensuring that the potential growth rate of the country comes back from the inevitable destruction that it would have suffered this year. It is also from this viewpoint that one should note and welcome the first steps taken in the government’s policy package in announcing what could potentially be far reaching reforms in agriculture, minerals, and public sector enterprise policy. These, and hopefully more ahead, if executed efficiently will add to the potential growth rate of the country even as they support nearer term incomes and economic activity. Similarly, future fiscal spending will have to be much more focused towards ensuring that it is helping add to the productive capacity of the nation and creating more sustainable multipliers for growth. Put another way, the sequencing to growth from here will have to first ensure that we are able to grow sustainably and not be impatient to get to an arbitrarily defined growth rate that would have been desirable in the pre-Covid era.

Finally, India’s public debt dynamics are its clear Achilles heels. As many commentators have observed, it isn’t the fiscal deficit run this year but the aggregate public debt to GDP ratio that would matter. However, from a debt dynamic perspective, we aren’t as supportive of the prescription to abandon everything and just spend, as “growth will take care of everything”. While this is true mathematically, as argued above it will be much harder to achieve in practice. An inordinately large near focused spending program may temporarily flatter the denominator through a short term nominal growth spurt, but will likely quickly collapse into an imbalanced heap of macro-instabilities. To flog an oft tortured metaphor, this will indeed be a marathon and not a sprint. Thus future fiscal strategy will have to focus on preserving the fiscal impulse while reducing deficit from here (so aggressive role for capital receipts) as well as orient spending visibly towards higher multiplier creation.

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