Global markets haven’t witnessed such panic and dislocation since the global financial crisis of 2008. Global equity markets have collapsed, the US’s 10-year bond is at its lowest level ever, and crude prices underwent their largest single-day fall in 30 years. What’s going on? The market mayhem is the upshot of three global shocks interacting with each other.
First, a negative demand shock around the world. As the coronavirus proliferates globally, households and businesses are understandably becoming risk averse, and the consequent “social distancing” is expected to exert significant demand destruction around the world.
Second, a negative supply shock emanating from China. The widespread industrial closures in China on the back of the COVID-19 outbreak will impact imports and supply chains in other countries, and thereby constitute an adverse supply shock for the rest of the world. The 20-point drop in manufacturing output in the February PMI and the 17 per cent contraction in Chinese exports across January and February, suggests that the shock was large and immediate. That said, with the virus gradually being contained in China, this supply shock is likely to fade even as the demand shock in the rest of the world widens and deepens.
Third, a positive oil supply shock. The failure of oil producers to agree on production cuts has led to a price war with production increases on the anvil. Cumulatively, crude pieces are down almost 50 per cent — about $30/barrel — since January. While the first leg of the decline reflects virus-related demand destruction fears, the second leg reflects a positive supply shock, which even adjusting for the concentrated stress in the oil sector, is growth-additive for the world and particularly for India.
As if these cross currents aren’t enough, there is a fourth India-specific force at play. The resolution and reconstruction of YES Bank was inevitable, but, at least temporarily, it is likely to result in a “flight to quality” in India’s financial sector, with resources moving from the financial periphery to the core. To the extent that the periphery — smaller private banks and non-bank financial companies — will find it harder to mobilise resources, financial sector risk aversion could rise again. With private banks responsible for a bulk of the incremental credit offtake in recent months, a redistribution of resources is likely to dampen credit offtake, at least temporarily.
So, how will all this impact India’s macros? India is a much more open economy than is widely believed with exports constituting almost 20 per cent of GDP. Therefore, the impact of the demand destruction around the world will not be trivial. If global growth is marked down by 100 basis points in 2020, which increasingly appears to be the case, we estimate that this would shave off about 40 bps from India’s growth through the export channel alone. Furthermore, foreign tourism was down 20 per cent at the peak of SARS. If foreign tourism were to fall by, say, 30 per cent this year — since COVID-19 is proving to be a bigger deterrent than SARS — the cumulative drag to growth from exports and tourism would be a meaningful 60-70 bps.
But this is where the importance of the large crude price decline on India’s macros becomes evident. The near $30/barrel decline since January constitutes a large positive terms of trade shock for India — equivalent to about 1.3 per cent of GDP even accounting for reduced remittances from the Middle East. It, of course, remains to be seen whether the current oil price equilibrium can hold given the game of chicken being played by oil producers. But if it does, it would constitute a meaningful mitigant to India’s macro headwinds, boosting activity, dampening prices, creating fiscal space and reducing external imbalances. We estimate that every $10 reduction in crude prices, boosts growths by about 20-25 bps. Therefore, the $30 decline in crude, if it holds, should boost growth by about 60-70 bps, thereby largely offsetting the negative hit to growth from external trade and tourism. Furthermore, crude at $35-40, along with the global demand destruction is expected to generate large disinflationary forces, opening up space for monetary easing. Finally, India’s current account deficit would virtually disappear, for the first time since 2003-04.
The growth offset, however, assumes that the coronavirus does not spread within India. If India witnessed a rapid domestic proliferation, heightened risk aversion by economic agents could meaningfully hurt domestic demand. Here’s a thought experiment. Discretionary services constitute about 35 per cent of GDP and have been growing at 8 per cent a year. If that growth rate were to halve, that alone would deduct 140 bps from growth, and swamp any growth tailwinds from lower oil prices, especially since heightened consumer risk aversion would also reduce the marginal propensity to spend out of any fuel savings. Furthermore, a “sudden stop” of demand to certain sectors may necessitate fiscal/liquidity support to ensure these don’t magnify into more disruptive credit events for the financial sector. All told, the best antidote to a prolonged growth hit would be to aggressively contain the virus domestically, as authorities appear to be doing. The experience from other countries suggests aggressive containment early in the process (isolation, quarantines, contract tracings, cancelled gatherings) reduces the growth rate of the virus from exponential to linear. All told, therefore, the key to India’s macro outlook is whether the crude price decline can sustain and whether India can avoid a sharp domestic proliferation of COVID-19.
What are some other policy implications? Should any oil windfall be largely absorbed by the government (through higher excise duties) or be given to the private sector? Given current fiscal pressures, it’s tempting to advocate that the public sector appropriate much of the windfall. But with consumption under such pressure, there’s a strong case to pass this on to households. A sharp cut in domestic fuel prices will boost household purchasing power and aggregate demand thereby creating contemporaneous counter-cyclical pressures. Instead, if the government were to absorb it, it’s hard to see how authorities could immediately ramp up spending. Instead, higher excise revenues are likely to translate into fewer expenditure cuts in the last quarter of 2020-21, if other revenues don’t materialise. That would help activity in the last quarter, whereas passing it on to households would help activity now, when it’s most needed.
Further, while the turbulence in equity markets could understandably delay the government’s asset sale programme, it should not be allowed to derail it, given the criticality of asset sales to this year’s fiscal math. Absorbing all the oil windfall through higher taxes as a substitute for asset sales would be a suboptimal mix. More fundamentally, the salutary effects of falling crude prices — which would boost India’s macros relative to other emerging markets — should not mask the imperative to continue with reforms, particularly recognising and resolving any further financial sector stress proactively. Global markets are witnessing their most acute volatility since 2008. All we can do is mind our own house amidst the gathering global storm.
This article first appeared in the March 12 print edition under the title ‘Corona, crude and credit’. The writer is chief India economist at JP Morgan. Views are personal
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