Many high frequency indicators in February, as well as a rise in IIP and export growth, point to a turnaround due to the moderate monetary-fiscal stimulus adopted in the last year. Of course, now Covid-19 has interrupted the recovery, but evidence suggests counter-cyclical monetary-fiscal policy works in a slowdown even without concurrent reforms. But the opposite is not true. Reforms without complementary macroeconomic stimuli have been hurting growth ever since 2011.

The Indian financial sector is said to be in a weak state, making it unable to withstand this new shock. But the system had absorbed a number of shocks showing resilience, even as reforms strengthened its fundamentals. NPAs (non-performing assets) had peaked, public sector banks had made recoveries through the bankruptcy process, been recapitalised and were in a position to lend if demand recovered. Private banks were largely healthy, while the festering problems at YES Bank had been addressed through resolution, fresh capital and new management.

Deposits were guaranteed but equity and bonds wiped out. This approach reduces both systemic risk and moral hazard. For example, a Swedish banking crisis in the early 1990s was resolved within a couple of years and at lowest cost to the taxpayer by following a policy of saving banks but not their owners. The cost of the rescue to taxpayers amounting to about 2 per cent of GDP was recovered as asset values rose. The current volatility in markets underlines again that financial sector diversity is the safest. Overdependence on capital flows and markets is dangerous.

Responding to Covid-19

Steps to minimise impacts on the economy must follow a sequence. First, enable daily workers and casual labour to survive this period. Income transfers, food kitchens and quarantine arrangements will be required, in which States, civil society and NGOs are also active.

Second, temporary provision of credit and tax breaks so that no inherently viable firm has to close down permanently or create irreversible job losses. It must be clearly communicated that quick preventive actions are likely to reduce the period of disruption and activity. The revival of units will help reduce exit decisions. Loans must not be classified as non-performing for a period of six months in order to give firms time to resume activity and re-payment.

Credit distribution channels must be strengthened. This requires supporting the bond market through repos and refinance for entities that can help liquidity percolate through every nook and corner of the economy. These measures must be announced to be temporary in order to prevent moral hazard. Unviable entities will want permanent support, which should be avoided, even as a temporary shock is prevented from resulting in a permanent destruction of assets.

Third, as supply revives, demand boosts must be given through fiscal and monetary policy. The stimulus must be adequate but temporary. Additional fiscal stimulus of even 3 per cent of GDP will make about ₹6 trillion available for up-front spending. Since tax revenue will plunge it has to be financed by credit. Normally in India credit follows growth. It must be the other way around now.

Fiscal consolidation can be resumed after growth revives. The crisis can be invoked to pause both FRBM and inflation targeting. The RBI can then cut policy rates further, even if there is a temporary inflation-spike under supply shortages. But more importantly it has to bring down spreads, reduce risk aversion and improve transmission through liquidity injections.

When demand for India’s export from oil exporting countries fell with fuel prices and headline inflation in 2014 and in 2018, interest rates were not cut commensurately. This hurt an incipient industrial recovery. The same mistake must not be made now.

Adequate durable liquidity should be provided to compensate for foreign outflows. The RBI itself may consider extending OMOs to other types of AAA-rated bonds, to alleviate severe risk-aversion. Outflows allow the RBI to replace foreign securities in their balance sheet with domestic securities thus supporting borrowing without necessarily over-expanding the money supply. In crisis times the FRBM allows it to lend directly to the government bypassing skittish markets.

The large outflows seen in fixed income flows suggest caution in lifting caps on these further. They are the most volatile and the first to leave on global risk-off. Since even large interest differentials do not suffice to retain them, the policy rate must be based on the needs of the domestic cycle. Recovery in growth brings back fixed income flows also. The rupee should not be allowed to depreciate too fast. Excess volatility can be reduced through intervention. The current equilibrium nominal exchange rate is around ₹73/dollar. Export competitiveness in Indian conditions of dependence on oil imports has to be built through supply-side measures. Excess depreciation only contributes to inflation and eventually creates real appreciation.

Fourth, financial institutions and markets need a combination of liquidity support, capital injections, lower rates as well as discipline from strong corporate governance. Temporary payment difficulties must not be allowed to lead to a chain of bankruptcies that magnify each other.

Finally, longer term measures must bring back some key production, such as of active pharmaceutical ingredients, to India from China. Continuing supply-side reforms that reduce the cost of doing business will attract foreign firms looking to reduce dependence on China.

Assessing steps taken

Measures belonging to the first steps in the sequence have been announced. The preponed monetary policy statement focussed on financial stability, although it remains consistent with flexible inflation targeting.

The large rate cuts and liquidity injections should help ease stress in both equity and debt markets, but will not immediately stimulate demand since supply is crippled in a lockdown.

There are welcome signs of listening and responding to valid needs as well as attention paid to incentives. For example, that cheap LTRO (long-term repo operation) can only be utilised for on-lending, parking excess liquidity with the RBI will earn very little, and corporate bonds that will not have to be marked to market will all induce banks to lend.

The cut in CRR and more time given to meet Basel norms will improve bank profitability, allowing them to reduce loan rates even if deposit rates have to remain competitive. That tax and regulatory compliance remissions are temporary reduces possible moral hazard.

But so far the RBI continues to rely on banks for rate and liquidity transmission.

Fire-power is kept in reserve, to use if the above steps prove inadequate, or support is required for a larger fiscal push.

While the stimulus is large and well-thought through, there is room to calibrate it further as the situation and needs evolve. Effective policy is correctly sequenced. The next steps are awaited.

Whatever is necessary for revival should and will be done, but excess avoided. The government already pays almost a quarter of its revenue in interest payments. In a country of India’s complexity, extreme policies create problems. Both over-stimulus such as happened after the global financial crisis and over-strictness that followed must be avoided.

Balance will give a strong recovery with the least expansion in debt.

The writer is Professor, IGIDR, and Member, EAC-PM. Views are personal

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