Growth in the Time of Corona

As the globe faces its most severe health and economic crisis in a century, the unique pressures confronting emerging markets often go unappreciated. Given the sheer population densities in some of these countries (making social distancing harder), limited economic safety nets (precluding extended lockdowns) and challenged healthcare systems (pushing up mortality rates), it’s no surprise that cases and deaths have continued their relentless rise in emerging markets.

New cases in these economies have almost doubled over the last two months and, adjusted for population, daily cases and deaths are now much higher than virtually all advanced economies, barring the US. This health crisis will simply accentuate economic pressures. Advanced economy policymakers have thrown the kitchen sink at their economies. But, without the benefits of exorbitant privilege and decades-long institutional credibility that characterise advanced economies, emerging markets cannot be as unfettered in their approach. How then can they respond aggressively, without losing credibility? What should the economic priorities in the crisis year be? Where could growth come from, post crisis? We explore these questions as they relate to India.

WHY DID GROWTH SLOW IN THE RUN-UP TO COVID?

To understand India’s future prospects, it’s important to start by looking into the rear-view mirror. GDP growth has averaged almost 7 per cent the last six years. Yet, that average masks significant temporal and sectoral heterogeneity. Growth averaged almost 8 per cent between 2014 and 2017—likely helped by a meaningful positive terms of trade shock from lower oil prices –before slowing discernibly over the last three years to 4.2 per cent in the pre-COVID year.

Second, the drivers of growth in this cycle were very different from previous cycles. Exports (16 per cent a year on average) and investment (10 per cent a year on average) powered India’s growth between 2002 and 2010, as emerging markets rode the hyper-globalisation wave. Investment became endogenous to exports, as domestic capacities had to ramp up quickly to fulfil strong and sustained external demand.

In contrast, between 2014 and 2020, export growth slowed to just 2.4 per cent a year as developed market capex stalled and India’s exports began to lag some of its peers. Instead, India’s growth since 2013 has been driven largely by consumption—both private (well acknowledged and celebrated) but also public consumption (largely unrecognised). Private consumption has impressively averaged 7 per cent over the last six years, but less appreciated is that much of this was financed by households taking on debt and running down savings. Consequently, individual debt jumped from 19 per cent of GDP in 2015 to 28 per cent of GDP in 2019 as households were increasingly able to tap formal credit channels to try and smooth lifetime consumption levels.

With growth slowing for the last three years, however, risks were mounting that households would begin to perceive the slowdown as being more permanent and accordingly adjust consumption downwards. Indeed, in the pre-COVID year, these fears combined with an increasingly impaired financial sector to pull private consumption down to 5.3 per cent—the lowest since the global financial crisis.

THE (UNRECOGNISED) ROLE OF PUBLIC CONSUMPTION

While the contribution of private consumption is well recognised, that of the public sector is much less so. Unbeknownst to many, public consumption has grown at a sizzling 9 per cent annual pace since 2014, accelerating further to an 11 per cent pace since 2017—growth rates not seen since the global financial crisis.

Strong consumption but weak exports has meant investment growth has middled, averaging just over 5 per cent since 2014. But averages can be deceptive. By mid-2019, slowing demand and reduced capacity utilisation meant that investment was fast decelerating, and contracted for three consecutive quarters, a first since 2000-01.

India therefore entered COVID with both private consumption and investment slowing. Instead, GDP growth was largely held up by government spending, which grew twice as strongly as the private sector since 2017 and almost four times as strongly in the pre-COVID year.

These dynamics help explain why the public sector’s borrowing requirements (PSBR) have increased discernibly in recent years, which could have a bearing on the fiscal response in the crisis year. What they also suggest is the private sector appeared beleaguered pre-COVID, and therefore may recover only slowly from the added COVID shock.

LOOKING AHEAD: BREAKING THE VIRUS-MOBILITY LINK

Against this backdrop, how should one contemplate the recovery and policy response in the COVID year? As the economy has begun to unlock, activity has expectedly begun to recover, but off a depressed base. Output is estimated to have jumped from about 40 per cent of its pre-pandemic levels in April to 60 per cent in May and then to 80 per cent in June. Since then, however, activity appears to have plateaued at those levels. This shouldn’t be surprising. First, some of the initial rebound was likely reflecting pent-up demand from the lockdown. Second, the continuing spread of the virus in India (new daily cases have increased six-fold since early June though, per million, still remain much lower than several emerging markets) has both induced another round of local lockdowns but also likely kept households risk averse. Indeed, we find empirical support for a simultaneous relationship between virus proliferation and mobility. Higher mobility increases proliferation, but higher proliferation, in turn, impinges on mobility. This is evident in states (for example, Karnataka, Andhra Pradesh, Tamil Nadu, Maharashtra) where mobility has begun to sputter as virus growth rates have risen.

All this has two implications. First, we should not conflate a V-shaped recovery in growth rates with that in levels of output. Levels of output still appear to be, on average, about 20 per cent below pre-pandemic levels. Second, containing the virus will be the most important pre-requisite to enabling a self-sustaining economic recovery.

PREVENTING NON-LINEARITIES

Virus containment apart, the depth and duration of India’s slowdown is likely to hinge crucially on whether the COVID shock amplifies through India’s financial and labour markets.

The first order of business must therefore be to prevent bankruptcies of economically viable firms. Such bankruptcies will result in higher non-performing assets (NPAs) for (an already risk-averse) financial sector—further depressing their ability and willingness to lend—higher unemployment in the labour market, and reduced productive capacity for the economy post-COVID. Higher unemployment, in turn, could result in higher retail delinquencies, accentuating the pressure on the financial system.

A key tenet of crisis-year policy should therefore be to keep economically viable firms alive. Towards this end, policymakers have undertaken some important steps. First, a 100 per cent credit guarantee scheme for bank lending to small and medium enterprises (SMEs) to ensure credit flows to SMEs. Second, the RBI has injected a deluge of inter-bank liquidity, which has begun to ease financial conditions for non-banking financial companies (NBFCs). Third, the central bank announced a one-time restructuring of loans to avoid preventable bankruptcies. To be sure, this will help viable firms stay afloat, but runs the risk of keeping zombie firms alive, and so it’s important to avoid some of the pitfalls of the past.

But liquidity and credit, by itself, will not necessarily increase the economic viability of firms. Only stronger demand and revenues will. As Fed Chairman Jerome Powell famously noted, central banks have “lending but not spending” powers. If aggregate demand remains tepid, fiscal policy will need to step in. The more the fiscal can boost demand, the more firm-viability will increase, and the less risk-averse banks may get in extending credit. Therefore, judicious use of fiscal policy could help reduce financial sector risk aversion and catalyse credit, thereby engendering a virtuous cycle of sorts.

A DEFT BALANCING ACT

In sum, the fiscal and financial will need to work in concert to minimise the hysteresis from COVID.

To be sure, India entered COVID with a combined fiscal deficit of about 8 per cent of GDP, a public-sector borrowing requirement (PSBR) of over 10 per cent of GDP, and Debt-GDP that is headed towards 85 per cent at the end of the COVID year. Therefore, fiscal space is not unlimited. But it’s equally important that fiscal policy does not, unwittingly, become pro-cyclical in the crisis year. Tax revenues are expected to fall materially, but any stimulative impact from a lower Tax/GDP ratio (the automatic stabiliser) is expected to be limited as the private sector’s precautionary savings rises amidst the slowdown. Therefore, expenditures should not be cut to compensate for lower tax revenues. Instead, the revenue shortfall should be fully accommodated and, if anything, expenditure actually increased if needed—and helped financed by rising private sector savings in the crisis year. To the extent that well-directed government spending holds the economy together, and preserves medium-term growth, it will help stabilise medium-term debt dynamics, and therefore eventually pay for itself.

Financial sector interventions will be equally critical. Given the risk aversion across the sector, a holistic approach involving recapitalising public sector banks for both growth and resolution capital, and fast-tracking resolution mechanisms to enable some inevitable creative destruction post-COVID will be critical. Ultimately, the economic recovery will only be as strong as the financial sector is willing and able to fund.

Finally, the labour market, will need to be monitored. The reverse-migration of labour from the urban to rural economy, and the wariness of migrant labour to fully return to the cities for now, is likely to create a segmented labour market in the near term. One can therefore expect excess labour, reduced productivity and downward wage pressures in the rural economy, juxtaposed with labour shortages and higher wages in the urban economy. Policymakers have rightly doubled down on MGNREGA to support livelihoods in the rural economy. Over time, however, policy must enable and incentivise labour migration back to the cities, to ameliorate any urban supply shock.

All told, the trade-offs confronting emerging market policymakers will be manifold and delicate:

– How to provide adequate crisis-year fiscal support while simultaneously signalling credible medium-term consolidation?

– How to keep economically viable firms alive, while simultaneously protecting financial sector balance sheets?

– How to enable creative destruction while simultaneously minimising economic hysteresis?

– How to take advantage of the glut of global liquidity without falling prey to the Dutch Disease?

POST-COVID GROWTH: THE PARADOX OF THRIFT

If the crisis-year imperative is to contain the virus, provide humanitarian assistance, and keep viable firms alive, the post-crisis focus must be to generate new sources of growth. To be sure, the growth rebound in 2020-21 will likely be strong, but this should be construed as a mechanical rebound from the contraction of 2019-20. Levels of output in 2021-22 are expected to be close to 2019-20 levels. The question is what will drive growth after that?

As discussed above, consumption was already slowing in the run-up to COVID as household debt rose and income growth slowed. With household balance sheets likely to be adversely impacted from COVID—as incomes and jobs come under pressure—consumption is unlikely to regain its pre-COVID buoyancy, reinforced by the RBI’s most recent Consumer Confidence Survey. Furthermore, the greater the perceived permanence of the shock, the more inclined will households be to reduce steady-state consumption—the classical ‘paradox of thrift’. Any precautionary savings motive, on account of continuing uncertainty, will simply accentuate this phenomenon. To be sure, there will be some mitigating forces at play: consumption is likely to benefit from strong farm growth this year combined with the terms of trade moving back towards agriculture, though some of this could be offset by lower urban-to-rural remittances. But these offsets are likely to be partial.

Similarly, the outlook for exports looks tepid. With the global recovery expected to be incomplete—activity levels in 2021 are forecast to be about 6 per cent below pre-pandemic forecasts—the global economy is unlikely to be a rising tide that lifts all boats.

But if the prospects for both consumption and exports look uncertain, why would domestic private investment pick-up, especially if capacity utilisation levels were below 70 per cent going into COVID? Therein lies the growth conundrum.

A PRE-PAID, POST-PANDEMIC, PUSH

The implication? If other drivers of growth remain shackled, scripting a growth revival may have to fall on the shoulders of a meaningful public investment push post the pandemic. India continues to face a significant physical and social infrastructure deficit. A large infrastructure push would therefore serve multiple purposes. First, it would boost aggregate demand, crowd in private investment and have a large multiplicative effect on the economy. Second, because infrastructure construction is labour-intensive, it would create jobs, attract rural migrant labour back and help fill the vacuum left by the real estate sector. Third, a big infrastructure push will boost the economy’s competiveness and medium-term growth potential.

But how will this be paid for? With fiscal starting points already stretched, and likely to widen further in the crisis year, a credible fiscal consolidation plan will be important from next year. How then can the next Budget accommodate a large infrastructure push while simultaneously reducing the fiscal deficit?

By pledging to aggressively sell public-sector assets. The public sector has a large quantum of monetisable assets, and the government has recently expressed a desire to privatise public sector enterprises across both strategic and non-strategic sectors. This can be complemented by off-loading infrastructure assets to the private sector. Therefore, aggressive asset sales (disinvestment, strategic sales, infrastructure monetisation) can be used to fund an expanded infrastructure push in the next few years, thereby delivering a productivity-enhancing ‘asset swap’ on the public sector’s balance sheet.

INSTITUTIONALISING THE RETURN TO ORTHODOXY

Paradoxically, therefore, despite limited space heading into COVID, fiscal policy could have a vital role to play both during and in the immediate aftermath of COVID. The implication, however, is that it will be crucial to juxtapose crisis-year support with a credible medium-term fiscal consolidation plan. Failure to do so after the global financial crisis cost India dearly as the resulting macroeconomic imbalances came undone during the 2013 Taper Tantrum.

The ratings agency Fitch recently observed that ‘India’s record of fiscal consolidation has been mixed since the 2008 global financial crisis.’ Therefore, institutionalising the return to fiscal orthodoxy could go a long way in countering any such perceptions across markets, foreign investors and ratings agencies. This could be done in several ways (for example, potentially setting a new debt target and corresponding fiscal glide path in a post-COVID fiscal law, instituting a Fiscal Council, publicly committing to a multi-year asset sales plan). Some combination of these would send an unmistakable signal of fiscal intent.

THE ASIAN SUPPLY-CHAIN OPPORTUNITY

Finally, India must stay vigilant to external opportunities. While COVID could precipitate more global protectionism, it will also accelerate the reorganisation of supply chains within Asia. Several multi-national firms leaving China are relocating to Vietnam and Taiwan. India must quickly position itself to become a viable contender, so as to try and break into the Asian supply chain. Having achieved a few notable successes in attracting multinationals, India must try to institutionalise these gains. A reformed Special Economic Zones (SEZ) model (to avoid past pitfalls) appears most pragmatic given the narrow window at hand. SEZs need to serve as discrete eco-systems where land acquisition is less onerous, labour laws are more flexible, infrastructure/port-connectivity is of global standards, and the economies of agglomeration allowed to flourish. Path dependence will be key. If the first few SEZs succeed, it will create a powerful demonstration effect both externally (to help attract more firms into India) and internally (different states would compete to create their own zones). But integrating into the Asian supply chain will also entail (i) remaining open and keeping import tariffs regionally competitive (as the Lerner Symmetry Theorem demonstrates: an import tariff is equivalent to an export tax), and (ii) ensuring the exchange rate is kept competitive.

JUST LIKE ABC, IT’S FINALLY ALL ABOUT TFP

Ultimately, however, sustained growth in emerging markets is all about periodic reforms that continue to move the production-possibilities frontier out. If India is able to reform the financial sector, develop a viable-SEZ model, execute a public infrastructure push—financed by asset sales—and deliver on the recently announced agrarian marketing reforms, not only will near-term growth get a boost, but the economy’s total factor productivity (TFP) will get a much-needed fillip. This, in turn, is crucial to boosting medium-term growth which, as we have found out, is the only sustainable recourse to creating jobs, boosting incomes and eradicating poverty. Unprecedented crises create unprecedented opportunities. India can and must seize the moment.

About The Author

Sajjid Z. Chinoy

Sajjid Z. Chinoy is Chief India Economist at JP Morgan. Views are personal