BQ - All that needs to done to fix a Covid-19 economy

(The following article appeared in Bloomberg Quint on March 30, 2020, link below:

https://www.bloombergquint.com/coronavirus-outbreak/all-that-needs-to-be-done-to-fix-a-covid-19-wrecked-economy )

Policy at the time of Covid-19

When a financially constrained household is hit by a severe medical emergency, it faces a dreadful, unspeakable dilemma – balancing monetary cost with the human outcome. With Covid-19, whole nations, India included, face this predicament. 

Whatever choices we make, we will likely incur significant humanitarian and economic costs. In addition, the duration and extent of this crisis remains very unclear as yet.

Against this backdrop, we need a two-fold economic policy response. First, we need an emergency response to avert a humanitarian disaster. At the same time, we have to consider life after Covid-19. Our already vulnerable economy will suffer a body blow, and in the end, we could find ourselves at policy crossroads.  

Emergency Financial Response 

Last week, India’s war-time emergency financial response finally commenced. 

First, the center and states provided some limited fiscal relief directed towards our first responders and vulnerable sections of society. 

Second, RBI Governor Shaktikanta Das unveiled a strong set of monetary, liquidity and macroprudential measures. Make no mistake - these were solely designed to provide much-needed relief to our fragile financial services ecosystem, borrowers, and credit markets. This was all about staving off financial instability - inflation or growth targeting be damned. 

Keep the Kitchen Sink Ready

Even as tax collections plummet, much more emergency spending will be needed to help vulnerable households, sustain essential supplies, and avert a humanitarian crisis. Our fiscal deficit is already far higher than acknowledged. It will worsen.

In turn, the RBI will have to fund the fiscal slippage, and ensure interest rates do not rise and burden fragile financial institutions and borrowers. This doesn’t necessarily mean that RBI needs to buy government bonds in primary auctions. Secondary market bond purchases and surplus transfers by the RBI will achieve the same effect – with fewer questions raised.

Print and spend of this kind usually entails inflation and currency weakness. Through the immediate crisis though, we should get away with it. Demand-led inflation is not a concern for now. The external front looks manageable as well. After all, we have currency reserves, our currency is overvalued, every other country is printing and spending, and our current account balance is comfortable for now. 

No Free Lunch

Here is the brutal truth. This much-needed emergency print and spend package will not come for free. It will have to be paid for, eventually, by an economy considerably weaker than now.

Our economy is already brittle, even before the impact of Covid-19. 

Our financial institutions – the engines to fund our growth - carry more bad assets than acknowledged and suffer from a trust deficit. Large swathes of sectors such as power, real estate, construction, airline and shipping, ands telecom are chronically stressed. Absence of true ease of doing business has come in the way of manufacturing, exports, investment and employment generation.

Battling this context, the extent and quality of our fiscal deficit is already far worse than acknowledged. RBI has been implicitly funding this slippage with bond purchases and large surplus transfers. We have already been printing and spending for a while now. 

This economy will suffer a body blow through the crisis. While we have little choice now, we have to be painfully aware that every additional rupee that we print and spend today could add to our considerable burden when we emerge from Covid-19. 

Policy Crossroads After Covid-19

Through Covid-19, developed markets would have printed and spent enormous amounts of money. When they emerge from the crisis, they will likely be in no hurry to withdraw this accommodation. 

When we emerge from the crisis, given the likely deep distress, there will be similar temptation to continue print and spend, with perhaps a dose of 1970’s style populism thrown in. That would be a grievous mistake. We do not have the luxury of printing a hard currency.

Unlike developed economies, we are young, underemployed, relatively poor and aspirational. We need investments to create jobs and spur consumption. Our true growth potential remains enormous. However, the financial sector engines that should fund our growth and investment are stalled. Our chronically stressed sectors and inadequate ease of doing business come in the way of fresh investments and job creation. 

Prolonged printing, spending and populism beyond the emergency – as we have indeed tried these past few years – will do little to address these core issues. We would continue to see our golden opportunity slip by us. Instead, as during 2012-13, eventually our external balance could suffer, inflation could rise, and financial instability could ensue.

Instead, we will need to undertake a 1991 style hard reform that we have put off for many years now. First, our financial institutions need cleansing. This will entail addressing the stock of non-performing assets with a one-time radical solution, and following it up with core reforms of banking, markets and governance. Second, we have to address the viability of chronically stressed sectors such as power, real estate and telecom. Third, we will have to foster employment generation. This would require true ease of doing business, factor reforms, and attracting global supply chains. Finally, we have to draw in global savings and invest into areas such as education, healthcare, water, nutrition and urban infrastructure. 

Summary

We have no alternative but to pursue a print and spend emergency response through Covid-19, to stave off a humanitarian crisis and financial instability. 

Cruelly, this is not a free lunch.

Our already weak economy will suffer a body blow through this crisis, and we will likely emerge at policy crossroads. 

Continued print and spend and 70’s style populism beyond the emergency will not deliver sustainable growth. Rather, it could lead us to severe financial instability.

We instead need a pivot towards hard reforms that we have put off for many years. While the immediate priority is the emergency relief, to the extent possible, work on the reform agenda should begin now.