“If you've never stared off into the distance, then your life is a shame”
Counting Crows
Drawing inspiration from these words, while acknowledging the somewhat self-involved generalization embedded in them, we have been trying to assess a tentative macro framework that may apply on a more steady state basis once this growth dip and the subsequent recouping (whatever alphabet shape it takes) is behind us. This line of thought draws from what is by now an obvious observation that Covid is unlikely to be a one-time, limited period shock. Apart from the human aspect that will never be compensated, there are economic reasons as well to believe that the post Covid shape of the world may have changed for some time to come. For one, till a vaccine or a sustainable cure is found, the ‘new normal’ whenever we are able to attain it will still entail quite a few industries and services (travel, tourism, leisure, hospitality, etc) operating at much less than full capacity. More long term, the trend of de-globalization in play since the Global Financial Crisis (GFC) but accentuated dramatically with events like the US – China trade war, will get further legs with consequent impact on world trade and individual country growth rates. With greater “zombification” of the world as leverage goes up and incremental efficiency of capital further depletes, potential growth rates will fall further across the world. Finally, Covid will likely bring a second wave of global inequality which was in play since GFC. As central banks dramatically ease financial conditions, asset owners prosper while interest-earning savers suffer. Also, asset market recovery much precedes gains in the real economy, especially for the more susceptible parts of the population.
A Post-Covid Framework
With the benefit of hindsight, an economic response design to the Covid shock would have had to take the following two parameters into account:
1. How much growth could you “afford” to lose: This in turn would have been a function of two factors: One, how far was your actual growth from potential growth just pre-Covid (were you growing below, at, or above trend). Generally speaking, the closer to trend that you were the more robust your starting point was. Two, what was the fiscal and monetary policy space available to respond. This would decide how strong a backstop policy could provide. Ceteris paribus, stronger the backstop available more the growth you could afford to lose.
2. What would be the permanency of the loss: This essentially pertains to assessing whether as a result of the shock, are there aspects of growth that may be lost for a greater period of time; or even permanently. This in turn would be influenced by the starting strength of the country’s various economic agents : households, firms, lending institutions.
When the above framework is applied to India, one can readily see that we had obvious constraints when crafting a response function to Covid. Thus India’s growth had been steadily slowing in the years before this crisis. Even as, worryingly, potential growth would also have fallen it can still be argued that at 5% (initial FY20 growth) we were growing much below our potential. Further, our public deficit was already bloated thus limiting space available to respond even as monetary policy had much more flexibility and is being used thus today. Finally, the banking system was running high levels of stress on aggregate even as some non-bank finance companies were struggling since 2018.
Constraint Optimization
It is clear from the above, that India entered the crisis with a lesser affordability on losing growth and with a higher risk that some of this loss may turn more permanent in nature. Drawing from this, a steady base case for the time ahead seems to involve lower level of potential growth rates and a longer period of substantially higher public debt to GDP. For an emerging market, that doesn’t have the luxury of printing one of the reserve currencies of the world, there are certain binding conditions in our view to be able to run this for an extended period of time without courting financing risks. These are as follows:
1. Most of the debt should be domestically financed: An adverse debt to GDP ratio may be looked at unfavorably by external investors who may in turn be prone to turning skittish in such a situation. Having the debt largely domestically financed is a great comfort in such a situation, and indeed one that India enjoys currently. As an example the total holding of foreign portfolio investor debt in India at the current juncture is lesser than the accretion that has happened to our forex reserves since the start of the year. However, an important related point for the future is that so long as our higher debt to GDP burden sustains we should probably not be as active in courting offshore capital for our bonds.
2. A stable external account: This is another enabling condition for being able to sustain a higher deficit. One aspect of the argument is that instability in the external account, even as it is an indication of past excesses for the most part, nevertheless puts pressure on monetary policy and on general cost of funds. This may not be amenable to an environment of already high debt sustainability pressures. Again for India external account is quite strong currently with a collapse in the current account deficit (CAD) getting accompanied with robust foreign direct investment flows. However, importantly, this situation is temporary and cannot be taken for granted as growth and hence CAD revives in the time ahead. It is also in this context that we see RBI’s more aggressive stance in accumulating forex reserves lately. It is prudent to shore up external defenses given the long haul ahead.
The above constraints help quantify the imperatives for public policy in a higher debt to GDP regime:
1. Focus on nominal growth revival: For our public debt dynamic to turn sustainable again, nominal growth rates have to sustainably pick up. Most of the difference in opinion with respect to the future sustainability of our debt rests in the different expectations on where our nominal growth rate will stabilize. Such is the power of compounding that a 1 – 2% difference in these assumptions makes a material difference to future debt / GDP ratios. Importantly as policy focus shifts to nominal growth it is logical to expect a de-facto dilution in the CPI targeting framework as well. This may well be India’s version of “financial repression”, a term one is going to hear more and more in a post Covid world especially in the developed market context where the only way to keep debt sustainable will be to keep funding costs extremely low.
2. Be acutely cognizant of potential growth: Even more so now than usual, and as discussed above, it is very important to have a stable external account. This is heavily pegged in running a sustainable level of CAD. This in turn is influenced by how close to potential growth is actual growth. Thus as an example, if we were to focus only on reviving nominal growth in order to bring down public debt to GDP via short term stimulus without first focusing on expanding our potential or trend rate of growth, we will then quickly see our CAD spike and bring instability to the external account. This will then cause policy to turn restrictive thereby raising cost of money and bringing down growth, thereby undoing the gains in debt sustainability. In fact this is the biggest argument in favor of emerging market central banks being able to execute limited financial repression since even if CPI targeting may be diluted, they will still need to be very watchful of the CAD and the external account.
On first glance the two objectives of public policy mentioned above seem mutually conflicting. However, in our view, they also best describe the constraint on public policy and the direction it must take. It is clear that given our starting fragilities and the size of this shock, the next few years are likely to be critical and almost “make or break” for India. Public policy will accordingly need to show somewhat of a reset rather an incremental tweaks. Some of the asks from policy are as follows:
1. Maximize growth multiplier effect of future spending: It is well recognized that most fiscal spending across the world so far has been survival spending. While it was absolutely essential to do this, it is also true that such spending is likely to have weaker forward growth multipliers. Thus future spending as economic activity comes back has to focus more on generating growth multipliers. Typically capital / investment spending satisfies this criteria (please refer here for a detailed view https://idfcmf.com/article/1912). Hence it is essential, especially for India where resource constraints are obvious and investment rate has fallen meaningful over the past few years, that incremental public spending focusses on productivity and maximizing future economic impact. This will obviously need to get done within the constraints that salaries and interest payments will still take away a large part of the total expenditure of the government.
2. Higher fiscal impulse without higher deficit: While fiscal deficits will have to be brought down from the unsustainable levels they will reach this financial year, the government will need to ensure that fiscal impulse doesn’t weaken as much. Put simply this means a much higher reliance on capital receipts and asset sales to finance spending, as opposed to changing taxes.
3. Aggressive trade-offs on where to provide policy support: As resources shrink and clamor for public money being asked to spend for business backstops increases, it is very important to objectively assess where such backstops will be the most useful. Thus wherever systemic risks exist or a permanency of output loss is perceived, the government will have to obviously step in. However, wherever else previous capital mis-allocations are now reflecting in stress and where the systemic importance is probably being exaggerated the government will have to be careful about ‘bailing out’. This is because while it Is probably good to have helped everyone, the argument as made above is that genuine resource constraints may just not allow that luxury.
4. Maximum policy stability: This sounds very much like a truism and hence may not need too much elaboration. However, the key imperative here is that in an era of de-globalization the “pie” is shrinking and hence you need to increase your share. Also, with obvious resource constraint at least for the next few years, public policy will need to think about non-fiscal and monetary supports almost with equal vigor. Crucially here, stability also means announcing one set of long term policies which are then not tinkered with even to keep sweetening them. Even this sometimes works perversely in postponing investment decisions as economic agents expect that the next round of incentives are around the corner.
Conclusion
Covid is not a one time shock but will rather amplify many previous global trends and embedded weaknesses. For India particularly because of previous growth constraints, related vulnerabilities in the lending system, and a somewhat bloated public deficit, the post Covid world will require a careful navigation. While challenges look daunting currently there are obvious starting advantages including a largely domestically financed debt profile and a stable external account. These advantages have to be leveraged and sustained in the time ahead even as public policy needs to be decisive and precise in order to optimize growth given constraints. While we aspire, a necessary fuel for our endeavors also has to be a constant reminder that we can no longer take a high growth trajectory for granted.
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