To return to steady growth: India’s monetary and fiscal authorities both need to lend stronger shoulders to the economy

According to estimates recently released by the ministry of statistics and programme implementation, the GDP of India fell by 23.9% in April-June quarter of 2020 relative to that in the same quarter in 2019. The decline is comparable to countries in which economic activity had been similarly severely impacted during the quarter due to Covid-19. For instance, the United Kingdom saw its GDP shrink by 21.7%, Spain by 22.1% and Italy by 17.7%. Less severely impacted Germany saw its GDP decline by 11.7%.

GDP decline in India was concentrated in sectors that bore the brunt of the lockdown. Thus, construction fell by 50.3%; trade, hotels, transport and communication by 47%; and manufacturing by 39.3%. At the other extreme, agriculture, which had been largely unaffected by the lockdown, could grow at its approximate trend rate of 3.4%. Likewise, financial, real estate and professional services, which can be substantially provided online, declined a modest 5.3%.

The lockdown had administered an unprecedented shock to both demand and supply. The dominant view at the time was that the demand shock would overwhelm the supply shock, leading the vast majority of analysts to recommend a large fiscal stimulus. In the event, the government chose a modest fiscal stimulus.

The sectoral pattern of GDP growth during April-June clearly points to the dominance of supply shock. High inflation rates of 7.2% in April, 6.3% in May and 6.1% in June reinforce this conclusion. The decision by the government to go easy on fiscal stimulus is thus vindicated.

As the economy gradually returns to its pre-Covid-19 level on its way to 7% plus growth trajectory, both monetary and fiscal authorities need to lend their shoulders to it. For the RBI, this means erring on the side of supporting aggregate demand rather than using its levers to push inflation down. Rising supply of output would help ameliorate inflation in any case. But even if not, it is critical for the central bank not to thwart recovery by making credit more expensive and thus clamping down on investment demand.

In the same vein, it is critical that RBI prevents rupee from appreciating in response to robust inflows of foreign capital. The institution had made admirable progress in this direction until April this year but the gains it made have been partially reversed recently. Accelerated monetary easing by developed countries in the wake of Covid-19 has led capital to flow in considerably larger volumes to emerging markets, especially India. The result has been an appreciation of the rupee.

In the coming months, foreign capital inflows are likely to continue at a fast pace and it is critical for RBI not to let them force further appreciation of the rupee. As workers continue to return to work and economic activity picks up, India will need to recapture its share in the world markets for which a competitive exchange rate is critical.

Turning to fiscal policy, it may be noted that due to Covid-19 related uncertainty, private consumption demand will remain tepid in the foreseeable future. At this point, any income transfers run the risk of translating into savings rather than extra private consumption. Therefore, the safer bet for fiscal policy is to work its way through a boost to public spending.

Accordingly, this is a good time for the government to significantly expand its spending on infrastructure. To do this speedily, it will be best to work on cutting red tape and removing bottlenecks facing projects already underway. One major advantage of infrastructure spending is that this is a labour-intensive activity. Therefore, it would create jobs and in turn partially restore the confidence of households as consumers. It may also help catalyse private investment demand in construction related activities.

During 2014-17, India hesitated and delayed recapitalisation of banks on an adequate scale. It paid a heavy price for this mistake with GDP growth in 2019-20 witnessing its sharpest decline since the global financial crisis. As the economy travels towards normalcy, the country must not repeat this mistake. Rather than hesitate and wait yet again, the government must move decisively to recapitalise the banks pre-emptively. While restructuring of loans will delay bankruptcies, possibly even avert some of them, it is a foregone conclusion that when payments on restructured loans become due, defaults will accelerate and the banks’ non-performing assets would grow. If India is to avoid the recurrence of credit collapse it experienced in 2016-17, it must act now.

Even without these additional expenditures, fiscal deficit in 2020-21 is predicted to rise to 13% of GDP, which would raise debt-to-GDP ratio to 85%. Increased debt in turn would bring significantly larger interest payments in future years, limiting the government’s ability to spend on education, health and defence. A partial way out of this fiscal conundrum is greatly accelerated sale of public sector enterprises and monetisation of public assets such as roads, bridges, ports, airports and transmission lines. Such a policy offers us a rare opportunity to kill two birds with one stone: The government will get much needed revenue while public enterprises and public assets perform considerably more efficiently in private hands.