Choices in the time of an epidemic - Series II

The Covid-19 outbreak has continued to lead to a significant deterioration in economic activity with private forecasters now estimating India’s real GDP growth to fall into a negative territory for the 1st time in 40 years.

A stimulus was definitely the need of the hour not only to kickstart the economy but preserve macro-stability as the supply disruption threatened to turn into a heterogeneous demand shock. Rising business bankruptcies, job losses & subsequent value destruction in real assets can lead to significant spike in credit costs amongst banks/non-banking financial companies (NBFCs) which would ultimately require even higher Govt/RBI bailouts but not before perpetually damaging “animal spirits” & resulting in “secular stagnation”. As we elucidated in our last note, (https://www.idfcmf.com/article/1717) given the private sector deleveraging in India in the last 5 years, the Government had adequate headroom to expand its balance sheet without threatening to be seen as an outlier in an environment of global fiscal expansion.

Govt did unveil a fiscal stimulus woven amounting to Rs. 21 lakh crs (10% of GDP). This includes approximately Rs 8 lakh crores worth measures announced by the RBI. For the rest, a substantial portion takes the form of liquidity and lending support programs run by entities in the public sector as well as support in form of guarantees by the sovereign that is aimed to incentivize commercial lending to parts of the economy. In our assessment, the direct near impact on the fiscal from the total announced package is around 1% of GDP or slightly lower.

A large section of policy experts has been calling for a meaningful fiscal stimulus with adequate monetary support from the Reserve Bank of India (RBI). Taking monetary support as a given (low rates, bond buybacks/direct placement of debt with RBI), we examine various stimulus options with the Government. Given that aggregate demand is sum of consumption, investment & net exports, a fiscal stimulus from govt can be usually directed towards the consumption/investment. 1) Consumption stimulus usually works through increasing disposable income through cash transfers, rebates & cut in consumption-based taxes which can boost demand immediately. Consumption stimulus could be also in the form of direct support to weak firms irrespective of their inherent fundamentals which can ensure survival of their eco-system (lenders, employees, suppliers etc) & gives time for recovery while 2) Investment based stimulus works through tax incentives to private sector for infrastructure investment or direct investment by Govt in assets such as roads, railways, irrigation etc which does not boost growth immediately but increases the long term productivity and potential output of the economy. Given that this is a healthcare induced slowdown, Govt also needed to take the increased healthcare spending into account while deciding on the space for stimulus.

One strong criticism of the policymakers even before the onset of Covid-19 that India needed an aggressive demand push with the economy slowing down due to decline in household consumption & risk aversion amongst lenders due to their legacy balance sheet impairments. An added dimension of the criticism was that the Government needed to step up to provide for funding of the NBFC sector preferably backed by sovereign & tax cuts for Indian middle class to revive demand hit after the spate of NBFC/Bank defaults. In the aftermath of Covid-19, as the SMEs/NBFCs become more vulnerable, the chorus has become vocal along with the demand for direct sovereign support to bond markets for lower rated credits & wage support to businesses. There is also a demand from various industry bodies to cut Good & Service tax (GST) rates to help reduce prices for their products. The overarching theme among the proponents of this stimulus option is saving weak firms from bankruptcies & putting higher disposable income amongst the hands of consumers will boost consumption & henceforth growth.

We hereby examine the various policy options for the Govt & policy space for providing a consumption stimulus

1)  Cut in GST rates

There seems to be a near uniformity amongst various sectors that high GST rates & onerous GST compliances are behind India’s economic slowdown & GST rates need to be cut in order for industries to reduce their prices & revive consumer demand. While some of the issues like multiple registrations/ form filing, frequent invoice upload/matching face transition challenges, an analysis of GST collection since its introduction reflects that tax incidence for taxpayers has actually gone down drastically.

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Chart 1 above indicates the rolling 12 months gross indirect tax collection (Customs+ Excise  Service tax + Others before July 2017 (introduction of GST) & GST post July 17) plotted with nominal GDP Year-On-Year growth for every quarter. The gray line represents the average rate of growth for the rolling 12 months tax collection before the introduction of GST i.e. Mar’10 to Jun’17 (17.6%).  As can be seen from the chart above, the growth in indirect tax collection has actually substantially fallen since the introduction of GST. The average tax buoyancy (Growth in tax/Growth in GDP) of 1.5 between March 2010 to June 17 has fallen sharply to 0.3 between July-17 to Dec-19. Keeping nominal GDP growth as same, if the GST collection had continued to follow its historical buoyancy i.e. 1.5, the rolling tax 12 months collection as on February 2020 would be Rs. 13.3 lakh crs vs Rs. 9.7 lakh crs actually realized. Whether we attribute the lower tax collection to transition issues i.e. multiple rate structure, lower compliance etc, at the end of the day, the taxpayers (individuals/firms) are gaining a substantial Rs 3.6 lakh crores annually due to GST. Far from being a deterrent, the GST has unwittingly acted as a countercyclical fiscal stimulus to the tune of 1.7% of GDP.

2)  Support to SMEs

The SME (Small & medium enterprise) sector has been the backbone of the Indian economy & has been the hardest hit by the lockdown. With the sector employing 11 crs workers (40% of Indian labour force), contributing towards 29% of GDP & 40% of exports (Source: RBI), financial health of Indian households & subsequent viability of the banks & nbfcs depend a lot on the recovery of these SMEs. A survey of 5,000 MSMEs (micro, small and medium-sized enterprises), conducted by the All India Manufacturers’ Organisation, found that 71% of them could not pay their worker salaries in the month of March.  The government announced a Rs. 3.8 lakh crs stimulus package for the sector with the most critical being 100% guaranteed loans (Rs. 3 lakh crs), subordinated debt and equity infusion to provide liquidity during this phase of cashflow shock. Raising the minimum threshold for insolvency proceedings should insulate the sector to an extent. Some relief has also been given to small businesses via a 2% interest subvention (MUDRA-Shishu loans) and to street vendors to enable them to restart their operations. While it is expected that SME’s will be cash constrained when the restrictions are lifted & would need some working capital support/debt restructure/NPA dispensation for immediate survival, the long-term viability of the sector would be a function of demand of their products & their ability to deliver them. As the UK Sinha report on MSME sector submitted to RBI in June’19 recommended, SME’s are also constrained by infrastructural bottlenecks & inadequate availability of basic amenities such as work sheds, electricity, rural broadband etc. While Govt gives them priority in procurement, their payments remain stuck for a long time prolonging their working capital cycle, something which will need to be addressed going forward. While need for credit support towards the SMEs can’t be denied, the policymakers will need to decide that the support needs to be geared not only towards their credit requirements but creation of a long term enabling eco-system. Once the lockdown ends, MSMEs will need to be assured of timely supplies of raw materials from other states/countries without significant price hikes. Given the reverse migration, labour supply could be constrained where state govts might need to co-ordinate among them to make sure availability of labour for these industries along with provision of infection control mechanisms. Industrial areas might need to be ring-fenced, with accommodation to be set up for the labor force which SMEs might not be able to afford. MSMEs could also need higher allocation in public procurement than current policy on an exigent basis.

There are demands from various quarters that Govt has done very little for the SME sector & the sector requires for a substantive support from Govt like wage transfers, cheap credit, working capital etc. While the need for a financial support cannot be denied, before deciding on the quantum of fiscal support to the sector, it is important to assess the current support Govt is already providing.

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Source: Government Mudra website, Note: PMMY is Pradhan Mantri Mudra Yojana

As can be seen from the table above, Govt has already been supporting the SME sector (apart from the priority sector lending through banks) through the Mundra scheme which to the tune of Rs. 3.16 lakh crores or 1.5% of GDP every year since FY18. This is on the top of the “one-time restructuring” of bank loans to MSMEs that were in default but ‘standard’ as on January 1, 2019 (the cut off was later extended to 1/January/2020), without an asset classification downgrade, Despite supporting the sector through off-balance sheet lending & regulatory dispensation, policymakers need to ascertain whether the risk aversion amongst financial participants towards SME in past years is due to their concerns regarding the viability of SME’s business model. If the SME sector has remained weak despite a regulatory dispensation & additional funding support of 1.5% of GDP, maybe SME sector needs an eco-system apart from credit availability.

3)  Direct lending to private Sector / NBFCs

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Total of 41 Pvt sector NBFC/HFCs excluding PFI; Wholesale loan is defined as corporate/developer loan

Others: Consumer loan/Gold loan/Microfinance, SME as classified by the firm. LAP (loan against property) includes loan against shares

As can be seen from the chart above, the NBFC sector grew very rapidly in the recent past, tripling in size in the between FY13 & FY19 with significant exposure to high yielding but vulnerable segments such as SME/Real estate/personal loans as banks underwent asset quality reviews. As the loan book started to season after a period of unhindered growth, the sector started to face higher credit costs/refinancing pressures which have got accentuated due to the lockdown.

While RBI has been trying to bring down bond yields & has already done more than 1.25 lakh crs of TLRO 1 & 2.0 since March, the spread between prime quality NBFCs & lower rated NBFCs has continued to widen given the risk aversion in the system. The Govt announced a Rs 300bn scheme for NBFCs where investment will be made in both primary and secondary market transactions in investment grade debt securities of shadow banks (NBFCs/HFCs/MFIs), with the securities fully guaranteed by the government. However, given the illiquidity & lack of price discovery in the bond market, the pricing will need to be fair to the taxpayer & the bondholder.  The government also expanded the scope of its partial credit guarantee scheme introduced in December 2019 for public sector banks to purchase pooled assets from lower-rated shadow banks, including AA rated and even unrated papers where the government will now step in to bear the first 20% loss, up from the erstwhile level of up to 10% with the Govt expecting release of Rs. 450Bn liquidity towards the sector. However, the package has been criticised for being too low compared to the size of sector & there are demands from policy experts that the sovereign either directly or through RBI should start taking credit risk on the lines of US & Europe should starting buying bonds of lower rated weak NBFCS due to absence of investors for them & let them live “to fight another day”. There is also a genuine debate on the cost of saving some of these NBFCs today v/s cost of not saving them & threaten a disorderly breakdown of the system in the future.   

While conceptually it makes sense for the sovereign to step up, there is a difference between the Fed/ECB/BOJ who print world’s reserve currencies & RBI which is the last bastion of macro-stability for India. We believe the Rs. 300Bn special liquidity scheme for NBFCs, partial guarantee scheme of Rs. 450Bn, MF window for Rs. 500Bn along with Rs. 500Bn under TLTRO 2.0 (aggregating to 0.8% of GDP) is a reasonable support terminus a quo to the NBFC sector given our limitations. An expeditious implementation will be the key to the program’s success.  

Combining the unintended benefits of GST & SME funding through Mudra, India had already given a combined fiscal stimulus of 3.2% even before the onset of Covid-19. It is doubtful that the overleveraged households & SME’s take the bait of a temporary stimulus (suggested by many policy experts) & use this stimulus to spend or de-lever which will offset the intended demand push. As we saw during the Global Financial crisis from the US & European experience, typically overleveraged firms prefer to at least partly save & pay down their debts rather than fully consume the stimulus. Moreover, once firms & households get used to the stimulus without any accompanying reforms, it is very difficult to exit from the same as the Japanese experience post 1990’s or the US economy post 2009.

Choice II: An investment stimulus

India does have its problems ……… every commentator today highlights India’s poor infrastructure, excessive regulation, small manufacturing sector, and a workforce with inadequate education and skills”.

These words which ring somewhat true in the current context true weren’t spoken last year but in Oct’2013 in a speech by then RBI Governor Dr. Rajan (https://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/01SP_BUL111113.pdf), underscoring India’s need for a stronger infrastructure even today. Otherwise, we risk falling once again into the traps of macro imbalances such as high inflation/trade deficits post the positive demand shock.     

Various extensions of the Keynesian model have demonstrated that the magnitude of the fiscal spending multiplier is, not necessarily greater than one but depends on (i) the extent of monetary policy accommodation, (ii) the prevailing exchange rate regime, (iii) the degree of trade openness in the economy, and (iv) the extent of financial development (Tang et al., 2013). For example, the leakage from aggregated demand (spurred by higher government spending) could be higher through import channels if a country does not have a competitive manufacturing base, causing the multiplier to be small. On the other extreme, if households know that a stimulus is temporary & likely to be pulled back, forward-looking households may save more during tax cuts to bear the burden of lower income in future under a Ricardian equivalence. Hence any tax rebates or temporary stimulus would not be as successful as direct Govt spending.

Moreover, it is also important to understand the dynamics of private sector investment before embarking on the mix of future stimulus

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As can be seen from the chart 5 above, a high share of participation for bank credit growth between FY2010-13 was for infrastructure or industries connected to global growth cycle such as mining/chemicals which has been tapering out in past few years. The demand for credit was mainly in power (growth of 36% v/s 2.3% in last 3 years), metals & mining (25.3% v/s 1.3%), roads (30% v/s 2.3%) & chemicals (20.6% v/s 6%). FY10-13 was also a period where both domestic & global growth outlook was robust, credit availability was easy, domestic real rates were negative & India was benefitting from a substantial monetary/fiscal stimulus post Global financial crisis. FY14-17 was a period of transition as the global growth outlook worsened marginally, commodity prices fell, domestic resource allocation was reviewed (telecom/mining licenses were cancelled & re-auctioned), banking sector went under Asset Quality Review (AQR), real rates turned positive as RBI moved towards inflation targeting & corporates prepared for the onset of IBC/GST. However, as can be seen from the chart above that demand for credit has not picked up in these sectors & is unlikely to pick up even in the future as the commodity sector suffers from a global glut with its biggest consumer- China slowing down, power sector suffers from discom related issues, capacity utilisation remains below trend while IBC has made it easier to acquire brownfield assets in lesser time frames.

As can be also seen in the table from sector wise contribution to gross capital formation, it is the Govt. which is doing the heavy lifting on the capital expenditure with non-financial private sector corporate sector share declining & is likely to remain low till global growth cycle picks up or capacity utilization goes above trend. While private sector has turned out to be historically more efficient than Govt. in utilizing its capital, the Govt. will need to continue to spend till private risk capital returns. However, there is a possibility that Govt given the revenue constraint might push more expenditure through PSUs. However, the increased PSU borrowing especially towards capital spending has to be seen in context of muted capital demand from private sector.

As can be seen in the table below, the RBI working paper on expenditure multiplier published in 2013 (Source: https://www.rbi.org.in/scripts/PublicationsView.aspx?id=15369)  also confirms that public expenditure allocated for investment has a larger growth inducing impact than that used for consumption & is consistent with a priori assumption that a consumption stimulus works only in the short run.

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During the period of global financial crisis, the Central government undertook an additional fiscal stimulus package during October-December 2008 and February 2009. Of the expenditure measures, revenue expenditure constituted around 84% and the capital component accounted for the rest. On the whole, the fiscal stimulus measures appeared to have supported consumption demand rather than investment demand. Given the size of multiplier estimated for revenue expenditure and non-defence capital outlay and their respective share in fiscal stimulus during 2008-09, the overall size of multiplier is estimated around 0.5 according to the paper. In other words, for every rupee of the growth, the taxpayers paid 2 rupees as taxes.

The bond market even before the onset of Covid-19 was going through serious challenges due to uncertainty on Govt. revenues & lack of demand even for the existing borrowing program. While India might not be seen as on outlier this year, rating agencies & foreign portfolio investors will not be infinitely charitable. We have to be cognizant that a considerable portion of foreign flows come to India because of its “perceived” macro-stability. Probably, this will be the last window of opportunity before foreign investors/rating agencies stop taking us seriously about our fiscal consolidation. The current stimulus has tried to minimise the fiscal disruption while balancing the humanitarian needs with improving business conditions in the medium term by undertaking key sensitive reforms in the agriculture, mining, power, defence & space sectors. However, with potentially 10-12% of loss of economic output in FY21 due to the lockdown, there could be clamour for more direct support in the coming months to support growth.

Historically, there could have been a preference for revenue stimulus as identification & implementation of long term projects could have been a challenge. However, the Rs. 102 lakh crores National Infrastructure Investment pipeline (NIIP) unveiled by the Hon’ble Finance Minister (FM) in 2019 (Source: https://pib.gov.in/PressReleseDetail.aspx?PRID=1598055) has already identified critical projects under implementation & development out of which the Govt. had identified Rs. 15.4 lakh crores worth of projects on the rural infrastructure & irrigation sector which could be brought forward. This will also help provide sustainable employment to the work-force especially the migrant labour. There are also reports of various countries giving special incentives to firms diversifying their supply chains where India should also compete aggressively although that would again be a medium-term program. While the need for a humanitarian face of the stimulus cannot be overemphasized, given the limited resources & a small window available, any stimulus needed to strike a balance between an immediate relief to the lower income households & target to build long term infrastructure capacity. A balanced stimulus will further improve the fiscal and monetary coordination (market will not have to discount for future demand shock), bring greater macro-stability & further improve the attractiveness of India as a long-term investment destination.

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