Spending won't save us

India, the west and the debt trap

Many in the west believe that spending will save the economy in the wake of Covid-19. Arvind Panagariya argues debt must be kept under control if economies are to survive the crisis, and that India is showing early signs of getting it right. 

A strict lockdown, beginning on March 24, initially kept Covid-19 cases in India at low levels.  But amid a phased lifting of lockdown measures, the cases have surged.  As of July 11, 2020, the total number of cases at 850,000 is the third largest in the world, behind only Brazil (1.8 million cases) and the United States (3.2 million cases).  Taking recovery and deaths into account, the number of active cases is far smaller at 292,000.

20 08 13.EconHeader.ata SUGGESTED READING Groundbreaking economics at HowTheLightGetsIn By When seen against India’s vast population of 1.35 billion - compared with 210 million in Brazil and 328 million in the United States - so far, India has done well in managing the crisis.  Indeed, India’s management looks particularly impressive when measured by the number of deaths despite its large size and low level of per-capita income. As of July 11, 2020, the total number of Covid-19 deaths stands at 22,674 in India, 71,469 in Brazil and 134,817 in the United States.  Indeed, several countries with fewer cases of infection than India, such as the United Kingdom, Mexico, Spain and Italy, have seen significantly larger number of deaths.

India’s management looks particularly impressive when measured by the number of deaths despite its large size and low level of per-capita income.

Like most countries around the globe, but unlike the handful of the countries in East Asia, India was initially slow to respond to the impending crisis.  Whereas countries such as South Korea, Taiwan and Vietnam learned from their previous experiences with epidemics and put response mechanisms in place, India did not. 

During 2009-10, the H1N1 virus hit the country hard, with resulting deaths running to several thousand. But the lessons from that experience did not get translated into preparedness against future epidemics.  India began the Covid-19 crisis grossly short of supplies of masks, personal protective equipment (PPE) and ventilators.  It also lost the crucial months of February and March when supplies of masks, PPE, ventilators and test kits could have been beefed up and dedicated Covid-19 testing facilities and hospitals created.

But once Prime Minister Narendra Modi announced the lockdown on March 24, governments at all levels— central, state and local — moved swiftly.  Testing capability was quickly built up, patients were identified and quarantined, and contact tracing was done.  In many jurisdictions, local officials exhibited remarkable capacity to trace contacts and quarantine individuals and localities. 

India has also quickly ramped up testing facilities and hospitals dedicated to treating Covid-19 patients.  From near nil, per-day production of PPE had risen to 600,000 and ventilators to 1,000 by the end of June.  By the end of May, annual production capacity for N95 masks had reached 31.2 million and for 3-layer surgical masks to 1.5 billion.  India is now in a position to export these items, except perhaps N95 masks.

At the current rates of infection, hospitalization and deaths, India is now equipped to deal with Covid-19 medically.  Therefore, the attention has shifted to the economy.  Here uncertainties associated with Covid-19 are reflected in the expected economic outcomes.  When the first vaccine will be approved and when it will become available in large enough quantities to vaccinate 60 to 65% of the population remains uncertain.  Accordingly, how the virus will spread in the meantime remains uncertain as well.  That uncertainty makes workers apprehensive even in areas where the government regulations permit workers to return to work.  As a result, many of them are choosing to stay home.

In India, major cities such as Mumbai, Delhi, Chennai, Hyderabad and Ahmedabad, which are hubs of economic activity, have also been the most impacted by the virus. Therefore, large swaths of these cities remain under relatively strict quarantine.  How the Covid-19 situation and therefore resumption of economic activity will evolve in these cities remains uncertain.  Similarly, what other new hotspots may emerge until a cure for Covid-19 or a vaccine against the virus becomes available remains uncertain.

The attention has shifted to the economy. Here uncertainties associated with Covid-19 are reflected in the expected economic outcomes

It is no surprise, given these uncertainties, that economic forecasts for the fiscal year 2020-21, which began on April 1, 2020 and will end on March 31, 2021, range all the way from a decline of 8% in Gross Domestic Product (GDP) to a modest increase of 1 to 2%.  At this stage, this is not surprising.  With strict lockdown during April and only mild relaxation in May, the decline in April-June quarter is expected to be sharp.

At the same time, if the expectations of the availability of vaccine in September or October are realized, we might see significant growth in the last two quarters.  On the other hand, if the vaccine takes much longer and we continue to observe repeated waves of infections, economic activity will remain tepid throughout the year.  Depending which regime the forecaster chooses, she may predict a small expansion in economic activity, or a large decline in it, or anything in-between.

Western countries, especially the United States, responded to the Covid-19 shock with very large fiscal stimulus packages.  That in turn led the vast majority of commentators in India, including many well-informed ones, to call for similarly large fiscal packages.  My own view, expressed in op-eds and interviews at the time, was that such a large package would not be right for India.  In the early stages of the crisis, there was both demand and supply shocks.  On the supply side, the withdrawal of workforce put a sudden stop on production activity.  On the demand side, incomes stopped accruing and therefore purchasing power of individuals plummeted. My argument was that until workers could return to work, putting lots of purchasing power in the hands of people would generate no supply response.  A demand stimulus could only help after workers were allowed to return to work and demand remained weak. 

Economically speaking, this is an argument that applies not just to India but other countries as well.  Response of the GDP in the months immediately following the announcement of the large stimulus packages in countries such as the United States testify to this fact.  Large demand stimuli in the early stages of the crisis in these countries have failed to deliver rapid recovery.  Instead, the growth rates have seen sharp declines.

Depending which regime the forecaster chooses, she may predict a small expansion in economic activity, or a large decline in it, or anything in-between.

There is one further argument against going hammer and tong on the fiscal front, especially in the early stages but also in medium run, that applies to India and many countries in a situation similar to that of India.  With the sudden stop to economic activity, tax revenues plummet but not the government expenditures.  Therefore, fiscal deficit rises above what had been originally planned in any case. There is thus a built-in stimulus in the economy in times of a slowdown in economic activity.  From a medium to long-term perspective, the enlarged fiscal deficit adds to government debt.  If this debt is already large and gets larger still, it can lead to future problems of debt sustainability.  For instance, pre-Covid-19, debt-to-GDP ratio in India was already 72%.  Combined deficit of the center and states in the current fiscal year is now predicted to rise from the originally planned 6.5% to 13% on account of revenue shortfall. This would raise the debt-to-GDP ratio at the end of the fiscal year to 85%.  To service this enlarged debt, the government will have to borrow more. That in turn will put pressure on interest rates and undermine private investment and recovery.

Need for early caution on the fiscal front is reinforced further when we recognize that once the economy begins to open and supply-side constraints on recovery are relaxed, demand may still remain deficient.  In that case, the government may have no option but to provide at least a modest stimulus. Therefore, it does not make sense to use up all available fiscal space in the early stage of the game.

Therefore, as the crisis unfolded, I argued that the government should limit itself to (i) ensuring that the basic needs of food and shelter for all were met; (ii) health infrastructure was ramped up to tackle the rising Covid-19 cases; and (iii) enough liquidity was made available to firms that were otherwise solvent but faced liquidity crunch due to the sudden stop on revenues.  To its credit, broadly speaking, this is what the government has done. Indian media severely criticized it for opting against a large fiscal stimulus upfront but it stayed course.

The government’s response came in two broad phases. Phase 1 followed the announcement of the lockdown on March 24 by the Prime Minister. And Phase 2 followed his address to the nation on May 12 in which he announced the beginning of a phased opening up of the economy.  The phase 1 package included Rs. 1.7 trillion (a little less than 1% of the GDP) worth of fiscal support for the provision of basic necessities for the worst affected and poor sections of the population by the Finance Minister and several liquidity-enhancing measures by the Reserve Bank of India (RBI, India’s central bank).  The phase 2 package was significantly larger with many components.  The Finance Minister announced it in five back-to-back press conferences during the week beginning May 13.  RBI followed it up with its own package of measures on May 22. Total monetary value of the packages announced in two phases, much of it in the form of credit at generous terms, was placed at Rs. 20 trillion or approximately 10% of the GDP.  Though large, it is to be remembered that its fiscal component was not more than 2% of the GDP.

From early indications, India’s strategy has worked.

From early indications, India’s strategy has worked.  The Purchasing Managers’ Index (PMI) for manufacturing in June was 47.2 compared with 27.4 in April. Indirect tax collection via the Goods and Services Tax in June has reached 91% of its level in the same month in 2019.  Exports during the month have reached 88% of their level in the corresponding month last year.  We do not yet have reliable estimates of employment but by all accounts, the labor market has been tight with employers having difficulty in finding workers.  If fewer workers are employed than a year ago, it is because fewer of them are offering themselves for work.

As India comes out of the lockdown, early news is encouraging.  But given the highly unpredictable nature of the virus, it will need to remain continuously vigilant.  Medical infrastructure must stay ahead of the virus so that any unexpected surge in infections does not force another lockdown.  On the economic front, three areas will require attention.  First, the government must keep an eye on the possibility that weak demand may slowdown recovery.  One indicator of this may be rapid accumulation of inventory.  Should this happen, the government must be prepared to provide some demand stimulus through cash transfers.  Cash transfers up to 1% of the GDP for this purpose will not be out of order.  Second, India went into the Covid-19 crisis with an already stressed financial sector.

As it comes out of the crisis, bankruptcies are likely to happen adding to the non-performing assets of banks.  Therefore, the government must be prepared to spare some resources for further recapitalization of banks. Finally, in view of these and other unanticipated need for fiscal resources, the government must seriously consider a major rejig of its expenditures in 2020-21.  Expenditures on many of the Centrally Sponsored Schemes can be suspended for a year without much impact on productivity and welfare of the population.  The resources so saved may then be used to finance cash transfers and recapitalization of banks that are essential to keep recovery on course.

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