There is a well-established pattern to economic crises in emerging markets (EMs). In the years preceding the crisis, because of loose fiscal and monetary policies, the economy goes into a demand overdrive that spikes inflation and widens the current account deficit, which is financed by foreign capital chasing the promise of even higher growth and asset prices. At some point, the overdrive is perceived as unsustainable, which triggers a reassessment of growth, inflation, and financial stability. Domestic and foreign investors stop new investments, large capital outflows ensue, and banks stop giving new loans and rolling over old ones on fears of worsening credit quality. Growth collapses and a full-blown economic crisis follows.
The 1995 Mexican, the 1997 Asian, the 1999 Russian, the 2008 sub-prime, and the 2013 Taper Tantrum are all examples of such crises. In the case of India, the 1981-82, the 1991-92, and the 2013 crises all had the same characteristics.
There is also a well-established pattern to responding to such crises. The first response is to restore confidence in policymaking, which typically means large increases in interest rates, massive withdrawal of liquidity, and deep cuts in fiscal deficit. The second step is to restart the economy by restructuring the tattered balance sheets of banks, firms, and households where the asset side had been severely overvalued on inflated views of growth, profits, and income prior to the crisis. This means debt restructuring and bank recapitalisation aided by privatisation, closures, and mergers. These measures often need to be bolstered by structural reforms with the economic crisis making it easier to forge the political consensus for them.
The pandemic is not such a crisis. Before the COVID-19 outbreak, far from overheating, India was already struggling with slowing growth, falling incomes and profits, and a financial system that had virtually shut off the flow of credit as it wrestled with its bad debt burden. This is not an instance of a financial crisis turning into an economic shock weighed down by damaged balance sheets. Instead, this is an instance of an economic shock that could turn into a financial crisis if the damaged balance sheets are not repaired. So what is the first response in this case? Do the opposite of what is done in a typical EM crisis: Cut interest rates, increase liquidity support, and allow the fiscal deficit to widen. The RBI has done the first two generously, although with the coming disinflation, it needs to cut interest rates much more. The government’s approach to fiscal policy, however, seems ambivalent.
As it should be clear by now, the overall fiscal support from the government will be limited to 2 per cent of the GDP because that is the line on the sand it has drawn for itself. So all the revenue shortfall and the pandemic-related budgetary support must add up to 2 per cent of the GDP. If the revenue shortfall is more than 2 per cent of GDP, then total spending will need to be cut.
As in a typical crisis, what happens to the economy’s balance sheets also becomes critical. Except the causality runs opposite. Balance sheets will be damaged not because of prior excesses but because of the collapse in incomes during the lockdown. Consequently, debt doesn’t need to be restructured to resume the flow of credit and get the recovery going. Instead, what is needed is adequate income support to households and firms to provide the needed time and space for the recovery to take hold, which, in turn, would repair much of the damage to the balance sheets.
But the fiscal response so far has been inexplicably restrained. In the last few weeks, one rating agency has downgraded the country’s rating while another has reaffirmed it. If one looks under the hood of the two agencies’ reports, then the only difference between them is a 1 ½ per cent-point gap in their medium-term growth forecasts. The one with the more sombre forecast downgraded the rating while the one with the marginally higher projection reaffirmed it. It wasn’t because one rating agency projected a higher deficit for 2020-21 than the other.
Just like in any other EM economy, what matters today is the assurance of medium-term growth and not a few higher or lower points of GDP in this year’s fiscal deficit. To do that, the government needs to allow the deficit to rise to accommodate not just the decline in revenue but also provide adequate income support such that the recovery is not hamstrung by impaired balance sheets. Some have argued that the government, instead, needs to offset the decline on private demand by increasing public spending. This is an odd argument. One would have thought that using the same resources to ensure that private demand did not decline was the more natural and efficient response rather than letting it collapse and then compensating it with higher government spending.
The RBI, too, has a very large role to play. As elsewhere, it is now the only entity that has a strong enough balance sheet to provide any meaningful support. Apart from keeping markets flush with liquidity and low interest rates, which it is already doing, the RBI needs to undertake extensive quantitative easing to keep bond yields from spiking given the likely large increase in deficit.
Because of the depth of the growth shock, bad debt will rise. The natural instinct of banks is to cut back credit because of worsening credit quality. To prevent this from happening, the RBI will need to extend substantial regulatory forbearance on accounting norms, provisioning rules, and, if needed, even capital requirements. In addition, like the US Fed and the ECB, the RBI might also need to provide liquidity directly to corporates, instead of through banks supported by government guarantees as proposed now.
These proposals are likely to raise more than just eyebrows. However, this is not a crisis like the ones before. This time around, we need to weigh not the cost of taking these measures but the cost of not taking them.
This article first appeared in the print edition on June 24, 2020 under the title “This crisis is different”. The writer is chief emerging markets economist, JP Morgan. Views are personal