Covid 19 - The economic imperative for India now

On March 25, 2020, V Ananthanageswaran and me had written arguing in favour of burning the playbooks and called for unprecedented fiscal and monetary actions, despite all its implications. Evidently, as with all such complex policy choices, it requires time for the political economy to play out and explore various options before biting the bullet. But the time may have come to make those choices for both the government and the RBI.

As the pandemic disruption endures, it is increasingly clear that the Indian economy will contract this year and will suffer large drop in revenue collections, thereby worsening an already bad fiscal position. As Mr Subhash Chandra Garg has very eloquently demonstrated in a series of blog posts, Covid 19 has questioned all the fiscal projections of the government. While the medical mitigation and basic relief measures are well underway, the challenge now is to ensure that recovery is managed in the quickest possible time. 

The developed countries have thrown the kitchen sink at the pandemic with extraordinary stimulus spending. Apart from direct income transfers, they have included wage subsidies to prevent lay-offs, debt forbearance and very generous lending programs to businesses, and even equity infusions into private businesses. The major share of stimulus measures have been in the form of tax deferrals and loan guarantees. This is apart from the unlimited liquidity taps opened by their central banks.

While developed country governments have been profligate with their stimulus responses, with several attendant problems likely in the days ahead, anything even remotely close to the same fiscal space is not available to developing countries. Besides, it is an institutional flaw of the global financial markets that developing countries, even the best managed ones, do not enjoy the same market confidence as enjoyed by even the likes of Greece or Italy with history of massive and unsustainable debts. 

Be that as it may, all major economies, developing and developed, have announced significant stimulus measures. 

Interestingly, among the major economies, the Indian government's stimulus has been among the smallest.

The Rs 1.2 trillion stimulus package of the government, when stripped off all revenue deferrals and front-loading of expenditures, has been estimated by the Citibank economist Samiran Chakraborty (HT: Ananth) to be just 0.55 percent of GDP. They estimate the fiscal slippage due to Covid 19 to be about 2.3%, thereby pushing the fiscal deficit for 2020-21 to 6% of GDP. Combined with a 4% FD of state governments, they see space for a 1.5-2%of GDP fiscal stimulus space. 

In recent days, several other notable people too have called for higher stimulus spending. Arvind Subramanian and Devesh Kapur have proposed five options to mobilise 5% of GDP in additional fiscal stimulus spending required - eliminating wasteful or “un­spendable” expenditures; borrowing from multilaterals and non-resident Indians (NRIs); borrowing from public (via markets and financial repression); printing money; and raising “solidarity resources” via increasing taxes or cutting subsidies. They estimate 2.5% of GDP to come from public market borrowings, and 0.5-0.75% of GDP to come from each of the remaining four.

Unfortunately, again as Mr Garg has shown, while they provide a framework for thinking in theory, they are perhaps not well-thought through in details and unlikely to yield much given the scale of additional spending required. Further, expenditure compression as a means to find space for fiscal stimulus, while necessary to some extent with certain kinds of low-multiplier expenditures, may also be counter-productive with capital expenditures. This is especially important given that recovery is the top priority now and government is the only game in the town in these times to lead the economic recovery. 

Andy Mukherjee has argued against "excessive virtue signalling" and in favour of the Indian government burning the fiscal rectitude playbook and deficit financing by the RBI. He suggests that the government complement deficit monetisations with a big-bang privatisation of public sector units. The approach,

For a start, Prime Minister Narendra Modi’s government should sell stakes in every company that’s on the block for privatization — as well as some that aren’t — to a special purpose vehicle run by, say, the National Investment and Infrastructure Fund Ltd., which has demonstrated fund-raising clout with global investors. The SPV will finance the purchase by issuing sovereign-backed debt. When market conditions improve, it will sell its stakes and redeem the bonds. Whatever is raised should be deployed in an infrastructure plan that has health at its centerpiece. This will boost construction and create jobs. Subsidized loans should be made available, but only to businesses that keep at least as many people on their payrolls as they had in February and make suppliers’ invoices available on a bill-discounting platform so vendors can get paid. It’s the workers and small and mid-size enterprises that are getting hammered by large companies passing on the painof dislocation. In some private firms, such as airlines, the government will have to infuse equity.

Given the extraordinary situation, C Rangarajan, the RBI Governor who put an end to deficit monetisation from April 1997, has now called for RBI to directly finance the fiscal deficit. He suggests a doubling of the fiscal deficit target from its current 3% limit under the FRBM Act. With that doubling and another 4% from states, he estimates the general government deficit to therefore be 10%. He's not alone in this, there have been calls from several prominent people in this regard. The Kerala Finance Minister has called for the RBI financing even the state government debt issuances. And Dr Rangarajan has suggested that even states too be allowed additional borrowing beyond the FRBM 3% limit.

The problem with this analysis is that the starting point, the real current fiscal deficit, is more likely 5-6%. Then there is the revenue decline which would add at least 2-3 percentage points. Coupled with the 4% state government deficits, which too is perhaps being conservative, we are starting with a 11-13% fiscal deficit. Any stimulus space will have to be on top of this. A 3 percentage points stimulus package would entail a general government deficit of 14-17% of GDP. Now, that's some number!

On the credit policy side too, he also felt the need to go beyond mere rate cuts, liquidity provision and temporary forbearance to get banks to lend to distressed businesses. He points to the need for some guarantees to certain types of businesses. More on this latter.

The government faces one of its toughest choices since the financial liberalisation. On the one hand, its fiscal spending demands are massive, while its space is limited. Foremost, such spending is required to mitigate the suffering of people who have lost their incomes and livelihoods. Further, as the country exits lockdown and starts the recovery journey, it is inevitable that there will be demands for fiscal spending to support businesses. Recovery has to be expeditiously managed to ensure that businesses don't become insolvent and recovery does not become long-drawn. While debt forbearance and additional lending can help, it cannot completely make up for the losses incurred by businesses due to the force majeure event. Some of the losses will have to manifest on the balance sheet of the government. It could be by way of greater defaults by borrowers (which hits public sector banks, and thereby forces recapitalisation) and lower revenues (due to slower recovery).

On the other hand, there is the challenge of how to plug the fiscal gap. The standard practice of issuing Treasuries has hard limits given the low level of national savings. Further, as Mr Subhash Garg has written in another separate series of posts, there are reasons to feel that the various proposals for revenue mobilisation pathways suggested are based on optimism and theory than practical assessment. 

It is here that, breaking ranks from orthodoxy, several prominent people have in recent times called for deficit monetisation. As per this, the government would request the RBI to skip the financial market and directly purchase Bonds issued by it and provide credit (or "print" money). Indian Express has a primer on deficit monetisation here. This has the advantage of not crowding out private investors or raising the general cost of capital in the debt markets. This path may well have to become the primary, even predominant, source to bridge the fiscal deficit.

(Note that while local experts have made several constructive suggestions, none of the reputed academics ensconced in top US universities have had anything but inane platitudes - this and this - to offer as suggestions in this regard.)

If the RBI finances the government directly, then it would purchase Treasuries from the government directly and issues credit to the government's account held at the RBI. Government's expenditures will be made through the commercial banks, in turn driving up their (banks') reserves with the RBI, probably not proportionately. This earlier post outlines all the issues on deficit monetisation.

In this context, there is a need for some costs-benefits assessment required. How do the long-term benefits of fiscal rectitude balance with the political cost of immediate suffering and the economic cost of a long-drawn recovery?

So, what are the consequences of higher fiscal deficit. One, it would immediately cascade into the foreign exchange market, and rupee will fall. This is only to be expected since all the major EM peers of India have undergone 10-25% exchange rate depreciation over the last month after their respective announcements. While India's fiscal deficit position is weaker than that of peers, its external exposure situation is superior to peers. However, unlike peers, India is not vulnerable to sovereign bond exposures and its short-term public and private combined external exposures are smaller. Besides, it is sitting on nearly half a trillion dollars of foreign exchange reserves. So, while a stimulus amounting to 5% of GDP will most likely lead to a 10-15% fall in Rupee. 

This is perhaps even desirable given the trends with other peer currencies and the resultant issue of export competitiveness. The problem will be with the unhedged ECB exposure of corporates which is over $200 bn. These are mostly the larger corporate groups, who are perhaps among those best placed to manage the risks. However, in recent months NBFCs and HFCs too have picked up exposures, and this would have to be carefully considered and mitigated. This is an important challenge requiring attention. But, given the stakes involved and the lack of alternative courses of action (to finance the stimulus), this risk will have to be assumed.

Further, while the rupee depreciated 28.2% between May 1 and August 28, 2013 (taper tantrum) (HT: Ananth, FRED) and it did doubtless trigger its set of immediate problems, its consequences were soon left behind. Given the nature of the shock, even a 20-25% post-stimulus announcement hit, as has already happened to the currencies of countries like Mexico and Brazil, is unlikely to be of the same effect as would have been the case in other more normal times. Also, the universal impact of the pandemic and the universal over-shooting of fiscal deficit targets, and that too by large percentages in the developed economies, means that the consequences of FD excess of 5% of GDP are likely to be less damaging. As I blogged earlier, when everyone is in the same boat, even the credit rating agencies will have to recalibrate their models.

Another concern is that government's borrowing cost will go up, as was the case with the other EM peers in the aftermath of their stimulus announcements and currency drops. Again, here too unlike the other EM peers, the local treasury market is not too reliant on the foreign institutional investors. In fact, foreign portfolio investors hold a mere Rs 4 trillion out of the total Rs 140 trillion of government debt. Further, a significant share of their investments have already fled, with $15.9 bn fleeing the equity and debt markets in March 2020, of which around $5 bn were from debt markets. This concern, as mentioned earlier, can be mitigated by having the RBI directly finance the government through deficit monetisation.

The final concern is that it can be inflationary. This, however, is unlikely to be an issue for atleast the immediate future given the deeply deflationary nature of the Covid 19 shock. The economy was anyways in a disinflationary path even before the Covid 19 struck. It is likely to take atleast a couple of years for economic normalcy to be restored and purchasing powers regained in a broad-based enough manner to trigger demand-pull inflationary pressures. In this context, given the accumulation of debt stock, it may actually make some sense to have a mild dose of inflation after the two years. In fact, before the Covid 19 struck, the economy was already feeling the pinch from low inflation and attendant low nominal GDP growth.

As to the specific stimulus measures, given the fiscal constraints, loan guarantees are a good strategy to generate value for money from public spending. This assumes greater relevance given the nature of the shock, the demands for working capital especially for SMEs, and the general reluctance of already embattled banks to pass on interest rate cuts and open their lending taps. This could be used to finance SMEs and MUDRA loan-holders with working capital loans, with a lending limit of twice their last working capital loan availed in the previous six months. Larger businesses in certain other sectors, especially those worst affected by the pandemic (HORECA), too could be considered for inclusion.

This could be operated in a couple of ways. One, the government could set apart Rs 25000 Cr to guarantee loans by banks with a first-loss buffer of say 10%, which could help unlock bank lending of about Rs 2.5 trillion. Second, would be for the government to set up an entity with 10% equity and have the RBI providing the remaining fund, and the same being administered through banks. The option to be selected would depend on the constraints faced by banks in unlocking its own capital. 

The government should mandate that any business or bank benefiting from stimulus should necessarily register on the factoring receivables platform, TReDS. Further, it should not be confined to mere registration, but active participation. This can be monitored in terms of their activity, transactions or volumes. Beneficiary banks would need to finance small businesses, and larger businesses would need to provide the support required for their payables being financed for their suppliers. Some incentive structure can be framed to expedite the growth of TReDS. Some measures are suggested here.

In fact, TReDS should become the default platform for small business to access working capital loans availed through the guarantee fund. Similarly, for MUDRA loan beneficiaries availing such loans, some of the reforms suggested here could be considered. 

In any case, to sum up on the fiscal policy side, the government has actually initiated a stimulus of only 0.55% of GDP. It could immediately announce on-budget measures for upto 2 percentage points (and additional 1.45 percentage points), which could include measures aimed at small businesses, corporates in general, and also on the guarantee funds. All measures aimed at providing the backstops required to support a swift recovery. It should then keep the powder dry for quickly unpacking more stimulus spending as required to support the emergent requirements in the post-lockdown exit period. 

As a strategic choice, it is important to announce any fiscal breach with a time-bound medium-term plan for fiscal consolidation. The rating agencies will be interested in this, though the history of reneging on such commitments means that they may not take these at face value. For whatever it is worth, this is required. 

It may therefore be useful to supplement it with a detailed reform plan with milestones and timelines (along the lines of the National Infrastructure Pipeline) both to commit the governments, both at central and state levels, to these reforms as well as thereby signal to investors and other stakeholders about the commitment of the government to undertake these reforms. This may be helpful not only in partially addressing the concerns from the higher fiscal deficit, but also in creating a positive sentiment among investors about India. The latter could be especially valuable in an environment of global economic despair. And India’s unquestioned economic potential makes it uniquely positioned to make this offer.

Finally, while the government does the fiscal heavy lifting, the RBI may have to borrow from the playbook of the western central banks and step in with measures that go beyond its traditional toolkit.  The credit squeeze is already binding and will devastate the financial markets and spill over into the real economy.

A proactive role by the RBI assumes even greater importance given the perilous state of the banking sector and the uncertainties surrounding the NBFCs. The unprecedented decision by Franklin Templeton to shut down six funds with Rs 31000 Cr of assets under management is certain to exacerbate the credit squeeze. The resultant liquidity crunch can lead to insolvencies. For example, the Franklin decision can spook MFs with exposure to NBFCs, besides also spooking investors in MFs themselves. 

In a very good article, Mr UK Sinha warns about the dangers,

The liquidity released by the RBI is just not reaching the desired beneficiaries. Banks have instead parked huge amount with the RBI under reverse repo. Insurance companies are, reportedly, out of the bond market right now. Today, no HFC is getting any repayment from home loan buyers, no SME is able to service its Non-Banking Financial Company (NBFC) loans and no MFI can hope to get any repayment from its low-income borrowers. Banks are reluctant to lend and refusing to apply the moratorium facility to them. Part of the reason could be the bankers’ worry about punitive action even if honest mistakes are made. But the problem of the mutual fund industry can swiftly migrate to the entire financial services industry and might then soon spread to the real economy. The All India Manufacturers’ Organisation predicts the closure of 25 per cent of MSMEs if the lockdown is extended. Microfinance clients may not have a place to go for fresh support whenever the lockdown is lifted and similar will be the fate of home loan buyers. According to a McKinsey report, in case of a 25 per cent default by the MSMEs, there will be solvency issues for the entire financial system.

He also points to the prevailing credit squeeze,

In the week ending April 9, state development loans of Rs 37,500 crore which were put for auction had to be either cancelled or reduced in size — and that too at a yield almost 70-75 basis points higher than the previous week. This was in spite of the rate cut by 75 bps by the Reserve Bank of India (RBI) and injection of liquidity in the previous week. Even highest rated Public Sector Undertaking (PSU) bond issues faced a gripping problem. Rural Electrification Corporation (REC) had to withdraw one of its issues and National Bank For Agriculture & Rural Development (NABARD) could not get the full amount it had sought. ‘AAA’ rated private sector issuers met similar fate and lower rated (investment grade) wouldn’t even consider entering the market. RBI came out with a second package on April 17, where 50 per cent of the Rs 50,000 crore was earmarked for smaller Non-Banking Financial Company (NBFCs) and Microfinance Institutions (MFIs). But, no bank is willing to entertain this. In the first such auction made by RBI on April 23 for Rs 25,000 crore, only half the amount was subscribed. Another booster shot from RBI by way of refinance through NABARD, National Housing Bank (NHB) and Small Industries Development Bank of India (SIDBI) is yet to take off.

The RBI has been providing liquidity and credit to banks by lowering the CRR and through its Targeted Long-term Refinancing Option (TLTRO) window for lending to SMEs, NBFCs etc. But spooked by market uncertainty, recent auctions have not received enough takers and banks have been unwilling to on-lend and have been keeping the money with RBI as excess reserves (more than twice the volume of liquidity off-take has returned to RBI as excess reserves in recent days). This makes a case for direct lending by RBI to NBFCs through the TLRTO window, a mandate that RBI already has. This assumes importance also because the NBFCs are now experiencing Rs 50000-60000 crore funding gap, which is only certain to increase in the coming weeks.

Besides NBFCs, the TLTRO operations may have to target other worst impacted sectors and those where impacts are likely to remain significant even after exiting the lockdown. Here too, if the banks hesitate to lend, taking a leaf out of the Federal Reserve, the RBI may have to consider directly providing them credit. 

Direct purchases by the RBI of solvent and top rated corporate bonds, which too run the risk of being caught up in the liquidity crunch, is most likely to become inevitable. This would ensure that these markets (which are solvent and good businesses) do not get disrupted by a pandemic shock and sink into insolvency. 

Strong co-ordination between the market regulators and government, with perhaps daily calls between the heads of the main regulatory agencies among themselves as well as with the political leadership for some days may be necessary to also create market confidence. These are truly extraordinary times, a perfect storm of real economy and financial markets in synchronised turmoil, and that too globally.

Update 1 (03.05.2020)

Widening CDS spreads of overseas bonds issued by Indian companies. See also Manish Sabharwal here.

Update 2 (08.05.2020)

As they discuss the next stimulus package, ratings downgrade is the elephant in the room for India's policy makers.

C Rangarajan and DK Srivastava does the fiscal arithmetic for India,

Financing of the fiscal deficit poses a major challenge this year. On the demand side, the Central (6.0%) and State governments (4.0%) and Central and State public sector undertakings (3.5%) together present a total public sector borrowing requirement (PSBR) of 13.5% of GDP. Against this, the total available resources may at best be 9.5% of GDP consisting of excess saving of the private sector at 7.0%, public sector saving of 1.5%, and net capital inflow of 1.0% of GDP3. The gap of 4.0% points of GDP may result in increased cost of borrowing for the Central and State governments. This gap may be bridged by enhancing net capital inflows including borrowing from abroad and by monetising some part of the Centre’s deficit. Monetisation of debt can at best be a one-time effort. This cannot become a general practice.

M Govinda Rao argues for empowering states with more resources to fight the pandemic,

it is important for the Central government to provide additional borrowing space by 2% of GSDP from the prevailing 3% of GSDP. This is the time to fiscally empower States to wage the COVID-19 war and trust them to spend on protecting lives, livelihoods and initiate an economic recovery.

Update 3 (21.05.2020)

Vivek Kaul argues that the liquidity support measures enacted by the Government may be pushing at a string.