With the imposition of a national lockdown in March, it was clear that the first quarter (April-June) of the current financial year would be a lost quarter for growth. The revelation that GDP has shrunk by nearly (-) 24 per cent confirmed that the damage to the Indian economy was amongst the most severe globally. There were some saving graces: Agricultural performance was robust, the government did indeed increase its spending, and low oil prices as well as lower imports due to weak domestic demand offered some arithmetic relief. However, these silver linings were largely overshadowed by the massive contraction in private consumption and investment, with largely hamstrung industrial and services sectors.
Why did India perform so badly relative to other countries? First, India had one of the world’s most draconian lockdowns. Even though the economy theoretically started unlocking from May onwards, states continued to enforce local lockdowns. Second, unlike other countries, India was far more parsimonious in its fiscal response. The “survival kit” fiscal response of free food, subsidised credit and a handful of transfers to the most vulnerable not only limited the contribution of government spending to the economy, but was also insufficient to offset the drag caused by households and firms scaling back consumption and investment. Third, the economy was in a classic balance sheet crisis before the pandemic began. The major engines of growth — consumption, investment, and exports — had been decelerating since the end of 2018. The pandemic aggravated the already frayed finances of corporates, banks and shadow banks. That said, there is a question over the reliability of data. The lockdown required the statistics agency to rely on approximations from unconventional sources of data. This makes it susceptible to future revisions.
We see broadly four phases involved in the return to normalcy. The first involves the gradual process of unlocking, with supply-chain normalisation and pent-up demand resulting in faster sequential momentum. The second involves exiting from the lockdowns, but not from the pandemic. During this phase, the post-lockdown pent-up demand typically fades, while operations plateau below the pre-pandemic levels. The third phase involves an exit path from the pandemic, either through the flattening of the curve, the emergence of vaccines or the development of herd immunity, resulting in activity cobbling back to pre-pandemic levels. This brings us to the fourth phase (that is the post-pandemic new normal), in which potential growth settles lower.
We believe that the Indian economy is currently straddling between the first and second phases. High-frequency data for the second quarter paints a picture of an uneven recovery, primarily led by the supply side, in rural consumption and in the industrial sector. Early indicators suggest that the recovery in August may have been better than the stagnation observed in July, reacting to the easing of lockdowns and the re-emergence of demand. The key concern is the sustainability of this momentum as a second wave of COVID-19 cases envelopes a “rolling wave” in traditionally safer states (in the south and east) and in the rural hinterlands. While we may estimate a sequential improvement in GDP growth in the second quarter, there is likely to be another massive contraction of (-) 10.4 per cent. Growth is likely to remain in negative territory for the next two quarters, clocking in at (-) 5.4 per cent in Q3 and (-) 4.3 per cent in Q4, averaging (-) 10.8 per cent in 2020-21. This is significantly lower than our previous growth outlook of (-) 6.1 per cent.
What does this mean for policy? The precipitous fall in growth should serve as a grim reminder of the cost of having an excessively cautious fiscal response. Left unchecked, a longer period of below-normal activity risks the knock-on effects on the labour market, MSMEs and ultimately on the banking system. Monetary policy has over-delivered, and with a bout of high inflation effectively hamstringing the RBI from cutting policy rates further in the near term, the ball is in the fiscal court. This could involve cash transfers and public employment programmes in urban areas, among other support measures. When inflationary pressures eventually ebb, which we expect by end-2020, this should create the legroom to cut rates. Cumulatively, we see another 50 basis points bp of rate cuts in the pipeline.
The elephant in the room is the limited amount of fiscal support offered so far — presumably due to concerns over the fiscal space. Yet, even with the limited fiscal package announced, falling growth and plummeting revenues may cause the central government’s fiscal deficit to widen to above 7.5 per cent. State governments also remain in a fiscally precarious position. As the conventional monetary policy space is narrowing, we expect the implementation of coordinated fiscal and monetary policies as the RBI endeavours to keep long-term government bond yields low to ensure smooth financing of higher deficits.
The huge GDP growth contraction in the first quarter technically triggers one of the “escape clause” conditions (real output growth falling by at least 3 percentage points below the average of the previous four quarters), which could result in the RBI directly monetising government debt of up to 0.5 per cent of GDP. So far, the RBI has focused on support via liquidity in secondary markets and other regulatory measures to bring yields down, flatten the yield curve, and incentivise banks to buy more government paper. If these fail, debt monetisation, as Indonesia has already done, might be the second round of defence.
This article first appeared in the print edition on September 8, 2020 under the title ‘How to take on negative growth’. Varma is the Chief economist for India and Asia ex-Japan at Nomura, Nandi is the India economist at Nomura