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Rigorous, Readable, Relevant April 2020

Introduction
Arjun Jayadev

Interview with Dr. Y. V. Reddy

Arjun Jayadev + Avinash M. Tripathi

The Structural Equation

Zico Dasgupta

The Bond’s Eyeview

Sriram Mahadevan

Focal Point
Avinash M. Tripathi

Views expressed in this bulletin are personal. They should not to be attributed

to the employers of the authors past or present. While utmost care has been

taken to ensure the accuracy of the facts, the publishers are not responsible

for any damage that may arise due to any inadvertent error or inaccuracy.

The views expressed in this document do not constitute investment advice.

Disclaimer
Rethinking the Economy
Arjun Jayadev

It is nearly impossible to recall that about 60 days ago, academic

and policy makers in India were discussing rescue packages without

mentioning the Coronavirus. This existential event has of course derailed

those discussions and as of now, the overwhelming concern is simply how

to restart an economy in the face of an ever-present health threat and a

simultaneous restructuring of economic processes. We will be addressing

these concerns for a substantial time going forward. We should not also

forget that there will be a time where we will return to some semblance of

normalcy and that the ‘normal’ facing India just before this crisis was not a

pleasant one. Even before Covid, India was facing very serious difficulties.

For about 20 years now, there has been a consensus that India has

entered, as Vijay Kelkar memorably put it, “The growth turnpike”.

The combination of gradual but consistent reforms and inherent

macroeconomic strengths meant that India could be reasonably optimistic

that it could grow at relatively high rates and could do so for a long period.

That faith has been shaken only twice. The first was in 2012-13, when

macroeconomic considerations of inflation and external vulnerability

combined to put India in the ‘fragile five’ category. We are in the second

period, when a combination of factors has resulted in a sharp growth

slowdown, at the same time as there is widespread labor market malaise

and pressure on the rupee.

Unsurprisingly, the macroeconomy in India has once again become an

area of keen interest. We have developed “Magneto Trouble” as Keynes

put it, but without a clear way forward.There has been an enormous

debate on the proximate causes of the slowdown and the possible policy

framework to address the situation, but it may be fair to say that there

is no consensus at all. Economists differ on whether this is a structural

or cyclical slowdown; whether the triggers are from the real side or the

financial side; whether monetary policy is likely to help (and how much

it has hurt), or whether fiscal policy is a better option; whether this is

a balance sheet recession, or whether by contrast, the main driver is

demand constraints from other domains and so on.

In this periodic newsletter, we seek to create a space for exploring

these issues, combining issues of macroeconomic theory and practice,

financial market policy, tax issues, and private market dynamics. We

hope to provide information, develop arguments and understand short

and medium term macroeconomic issues. Our audience is not simply

economists, but more generally, journalists, policy makers, students and

the general public.

We hope to cover three issues in every instalment of this newsletter. The

short to medium term structural features of the macroeconomy which

are most likely to impinge upon and determine the growth process, the

intersection between financial and real sector dynamics and the activities

of the bond market. We also plan to feature interviews with leading

economists, policy makers and market actors on a range of issues.

In this edition, Zico Dasgupta (The Structural Equation) explores the

specificity of this moment, the requisite response to Covid and the

demand slowdown, the challenges afforded by aggregate demand and

the existing financial fragility of the domestic economy. He discusses the

need to think of growth and fiscal stability more carefully in light of the

challenges looming.

Avinash Tripathi (Focal Point) addresses the immediate (post covid) and

underlying (pre covid) challenges facing the economy. With regard to the

former, he looks at prospective policy challenges. With respect to the

latter, he looks at the interaction of deep and proximate determinants

of the slowdown, examining the role of inflation targeting, GST and

demonetization. He also looks at the housing sector and the particular

role that certain income tax provisions may have played.

Sriram Mahadevan (The Bond’s eye view) takes a bond market

practitioner’s lens to the current situation. He describes the response

of bond markets to monetary and fiscal policy considerations and the

responses of markets to the uncertainties created by Covid.

We are also very happy to feature a long interview with former RBI

governor YV Reddy, done before the crisis on a host of issues, including

the current slowdown, the relationship between the state and the central

bank, monetary policy in historical perspective and managing crises.

We hope you enjoy it and very much look forward to your reactions and

suggestions.

Arjun Jayadev teaches economics at Azim Premji University, Bengaluru.

Interview with Dr. Y.V. Reddy
Arjun Jayadev + Avinash M. Tripathi

This interview took place in mid February. It has been lightly edited for

clarity. The questions were asked by Arjun Jayadev and Avinash Tripathi.

Middle income trap and institutional factors

AJ/AMT: I’d like to begin with the issue of our current slowdown. There are

many different views of the current situation, and one that has attained some

currency is the idea of a lack of broad-based growth and the ‘middle income

trap’, made by many, including Rathin Roy. I was just wondering whether you

had anything to say about that.

YVR: I agree with Mr. Rathin Roy. We are at the lower end of the middle

income group. The fact remains that the institutional setting and the

functioning of the institutions are not exactly conducive to our sustained

high growth path as a middle- income country.

The design of contracts, their enforcement and even public sector dealings

with contractual obligations are poor. The sanctity of contracts is not

maintained. The government should set an example in ensuring the

sanctity of contracts.

AJ/AMT: Do you have any particular example that you are thinking of?

YVR: We have a number of situations in which an amount of whatever

denomination has to be paid, but the government simply delays payment.

There is not even a timely refund to the taxpayers for example. The

biggest player in the country’s economy, namely the government is often

not observing contracts. For example, often the government or a public

sector bank takes your house on rent, but it doesn’t vacate at the end of

the contract.

My limited point is that institutions here, in particular public institutions, do

not facilitate sustained high growth. It is not that we need to necessarily

have everything in place. but the question is whether overall things are

improving in terms of respect for law, regulations and procedures, in a

reasonably predictable manner. It is not really what government orders or

says, but the trust of the people in government - that is important.

AJ/AMT: Do you think it has been the same as before, or is it improving?

YVR: There is no way to clearly measure these things, but there is an

increasing suspicion that things may not be getting better. For example,

you can take public private partnerships. These get revised and the

revisions are not in the public domain. The government asks for a tender

and a private party gets it, but later terms and conditions are renegotiated

between the two. The public doesn’t have the information about why

it’s done and how it’s done. It is not clear that the movement is towards

institutional strengthening rather than institutional weakening. I think

that’s the question we have to ask.

Rathin Roy is correct. If you say you want the economy to improve its

capacity to accelerate growth, you require institutional improvement.

Whether you call it a middle-income trap or not, we have to get to have

rules of games which facilitate growth and more importantly, observe

them.

Interest rate and current slowdown

AMT/AJ: What do you think of the other claim that is going around--that it’s

just that real interest rates are too high that is causing the current slowdown.

It’s a demand- side explanation: With lower inflation, pricing power of firms

have gone just at the same time in which there is a higher indebtedness of the

corporate sector. Richard Koo told this story for Japan. In India, that story you

don’t think it’s compelling?

YVR: Again, there are two ways of looking at it. Does the data show that

investment and growth are interest rate sensitive? In the normal course

of things, given our demography, is it likely that there is an across the

board demand constraint or a savings constraint? Investment depends on

demand as well as the availability of savings. Evidence from the last 10-15

years shows that the savings of the government sector is coming down,

and the financial savings of the household sector are coming down.

AMT/AJ: The counter argument is that it is a demand constraint.

YVR: True, there is a demand constraint at the current juncture, more in

some sectors like automobiles. There can be no doubt about it. But I’m not

sure about the relation of demand to the interest rate.

The lost opportunity and the political economy of growth

AJ/AMT: I wanted to ask your opinion on the question of energy and the oil

price issue. What do you think of what happened in these last 3-4 years where,

perhaps due to deflation in oil prices, we may have had some breathing space,

but not used the opportunity.

YVR: We didn’t take advantage of the oil price fall when it happened a few

years ago. At that point of time, oil prices came down and we raised taxes.

We got money but we didn’t use it for investment. Look, what is the most

important structural weakness of the Indian economy? It is energy. Energy

is a source of revenue no doubt, but it is also a reason for huge subsidies

in state finances. Its effect on the balance of payments is huge. It impacts

inflation. It influences the financial sector, especially the banking sector.

So for us in India, financial sector vulnerability, fiscal vulnerability, external

sector vulnerability all have a common source: energy policy.

AJ/AMT: Are you suggesting we need greater self-reliance in energy?

YVR: Actually, just proper policies! Our dependence on imports is just one

part of the issue. Our pricing is all incentive incompatible! We can’t even

meter properly: in the policy of 2020, we are saying we will meter only in

another 4-10 years. The fourteenth Finance Commission recommended

that the supply of water and energy should be metered with first priority.

Whether you want to give it free or not is the next question! If you can’t

measure usage, how can you manage a resource? Maybe you don’t want

to measure because you want to mismanage!

AJ/AMT: Why do you think that with a strong central government, we have

not seen enough of these kind of changes?

YVR: Why do you think a strong central government will change things for

the better?

AJ/AMT: Well I suppose that is an assumption!

YVR: What’s the evidence for this assumption? In fact, sometime ago,

when the Andhra Pradesh government insisted on price recovery for

energy, it was the strong Congress Party governing in the Centre that

instead offered free power to farmers. Every useful subsidy programme

also started with a state government, was initially resisted by the central

government, but later adopted by the whole country.

The central government and the state governments basically represent

the political economy. The tragedy of Indian political economy is that the

central government of India, the entire political leadership starting from

Mrs. Gandhi, promises delivery of subjects which are rightly in the State

List. Things that are all in the jurisdiction of the state government! Take for

example employment guarantee schemes that began in Maharashtra or

the nutrition programme that began in Tamil Nadu. They were all around

for a decade before they were adopted at the Centre.

Further, there is no evidence at all that the Centre is more responsible

fiscally relative to the state. Interestingly we may also need to examine

whether a strong central government delivered good economic growth.

My hunch is that P.V. Narasimha Rao’s government or Atal Bihari Vajpayee’s

government, both were growth-oriented coalition governments.

Manmohan Singh’s first tenure as PM also saw high growth. The fiscal

deterioration we observed occurred during Indira Gandhi, Rajiv Gandhi,

and UPA II in recent years.

Ideally, if you are not sure in advance whether a particular policy is good

or bad, I would prefer different states adopting different policies unless

centralisation has proven advantages.

Don’t make centralized mistakes! Wisdom is not centralized in the Central

Government.

1991 BoP crisis and external constraints

AJ/AMT: Maybe we can talk about 1991, another period of economic

challenges. You were Joint Secretary, Balance of Payments then. What was

that episode like? What were the challenges and lessons that we can learn

now? Is there anything we can learn now?

YVR: It is useful to think about what is common and what are the

differences between then and now. I think at that point of time, except

for the trigger of the Gulf Crisis, the global economy had no great

uncertainty. We were already in trouble by the time the Gulf Crisis

occurred. In fact, our reserves were drying up rapidly. Domestic

vulnerabilities were very clear (at that time though a bit was covered

up, interestingly- the whole truth was not totally told to the people). For

example, those days there were some forex reserves that were not shown

as reserves and they were kept outside for a period. Reserves were kept

in foreign branches of our banks, and we were asked to put them outside
so that the reserves don’t show on the RBI balance sheet. So, when the

pressure hit, we started using them and only then did we start using

IMF facilities. We had also started taking short-term loans; we started

asking public enterprises to borrow in foreign currency only for balance of

payments support. Special, not so transparent, financing was undertaken

at that point. So the deterioration was really not admitted till quite late.

That is one interesting fact, relevant to the present.

By the late 1980s it was very clear that we required some reform and

some assistance from the IMF. Then, the Bofors scandal happened and it

became politically a difficult time to undertake reform. That was a closed

economy (and of course we are a little more open economy now), that is

not really what matters; what matters is that we are truthful, especially

when we are vulnerable.

AJ/AMT: The great worry for you from the past experience has been that

while we can manage within the economy, the one thing that cannot be

managed is international investment.

YVR: I believe that in India, the maximum possible importance should

be given to external sector constraints. Since independence from till

virtually 2000, we had a binding foreign exchange constraint for all public

policy makers. So I would still say from my policy point of view, given the

geo-political situation, given the size of our country, given the political

uncertainties that exist in the nature of our democracy, the highest priority

has to be given to maintaining external stability.

Inflation is a concern in many countries; for us also, it’s a concern. It is also

a very sensitive subject politically. But politicians are quite conscious of

the trade-off between inflation and growth. By contrast, they are not that

sensitive to build up of external vulnerabilities and this therefore becomes

the RBI’s special responsibility. In our country, the RBI is the primary

institution that has to concentrate on external sector issues.

AJ/AMT: People say though that we need not worry so much about the

external sector and in fact we are not taking enough advantage of foreign

investment. We have hundreds of billions of dollars of reserves. They argue

therefore that now is the time (because of domestic savings constraints) to

open up internationally. What is your view on this?

YVR: Of course we can open up internationally, but the issue is whether

to open up for trade or capital flows. What is the extent to which we

can depend on net capital flows to finance investment? We have to

differentiate between flows and the stock of our external assets and

liabilities. Reserves are only one part. Reserves is an instrument that

will be effective for confidence boosting and market intervention. They

are useful in avoiding vulnerability; it cannot be useful beyond a point

especially if there are serious imbalances and vulnerabilities. It is not only

the current account that you have to take into account, but also the capital

account. The movements in capital flows can be very large for a country

like ours; and they impact the exchange rate too.

The question is whether the exchange rate is adequately reflective of

reality, namely, does it really represent a competitive exchange rate? By all

indications, in real terms rupee is currently quite appreciated.

Monetary policy framework

AJ/AMT: You were one of the architects of the multiple indicator monetary

policy regime. So, how do you assess the relevance of the multiple indicator

monetary policy regime, both vis a vis Sukhamoy Chakravarthy’s monetary

targeting regime and the contemporary inflation targeting framework?

YVR: The original author of the multiple indicators framework was Dr.

Bimal Jalan. But, I assisted him, of course. Given the nature of the Indian

economy at the time, the multiple indicators approach was inevitable. for

two or three reasons. For instance, you look at the price of energy, it was

administered by the government. Similarly the price of food grains was

also administered by the government. How do you relate the change in

prices of these two to demand management by the central bank? It is fiscal

policy which determines the prices of these two commodities. So, you

have to really collect several indicators. In fact, multiple indicators were

analysed even before the formal adoption of such an approach; but the

focus was on monetary targeting. Later, there was a formal acceptance of

multiple indicators to replace monetary targeting.

There are problems in both approaches. The multiple indicators can be

confusing. It relies a lot more on judgement, because it depends on the

weights you give to each indicator, so it can result in loss of focus. A loss

of focus for the policy-makers and a loss of guidance for the markets. But,
having pure targeting, or pure monetary/inflation targeting, can be an

oversimplification of reality.

Do you recall how inflation targeting came about?

AJ/AMT: In New Zealand.

YVR: But for what reason?

AJ/AMT: In India?

YVR: In the world. It didn’t exist before, so when did it come about?

After 1970, because of the oil crisis, prices shot up, and then we had the

Euro-dollar market developments, so the biggest concern for advanced

economies was inflation. The major focus also became inflation for

developing countries when inflation even went upto 80%-100%, like in

Israel, Latin America. There was worldwide concern about inflation, and

restoring faith in money and finance. Therefore, an apolitical central bank

with independence became popular. This is a package. This package came

in the 1980s, formalized by New Zealand. This was a contextual response

which was oversimplified, and became an article of faith.

After the wide adoption of inflation targeting, several other factors that

were important arose. Globalization influenced inflation, immigration

policy influenced inflation, and movement in asset prices were not

captured by the policies. These realities were not captured till global

crisis of 2008 because of the oversimplified approach in the pure inflation

targeting strategy.

In India we were aware of the complications, and did not jump into

inflation targeting. We knew at that time that many factors that go into

policy making. Our communication was to explain the factors and relative

weights involved in decisions. Fortunately, across the globe pure inflation

targeting has been replaced with flexible inflation targeting (Constrained

discretion, or something like that). In a way, what the RBI adopted

formally in 2015, was flexible inflation targeting. The other leg is the fiscal

framework.

AJ/AMT: Do you think the policy was successful?

YVR: In a democratic political country like India, elected representatives

will take care of the inflation part. The RBI has to take care of two more

things: the external balance and the financial sector, especially with regard

to savings.
AJ/AMT: So, do you think in some sense, we over-learnt the lessons of

the 1970s and so on? As a global framework is Inflation Targeting the

overlearning of a particular episode?

YVR: No, it is more a question of policy not capturing all the realities. Alan

Greenspan said we were having productivity gains when inflation was

moderate, but it was not about America having productivity gains, it was

about China supplying the market with cheaper goods.

Global uncertainties

AJ/AMT: So, coming back to the current moment in which we were

contrasting with 1991, in some ways we might be more stable, because we

have greater levels of growth, but it seems to be a moment in which we

require some sharp creative thinking.

YVR: Let me put it this way, now there are lots more global uncertainties

in the way forward than at that point of time. The China- U.S. trade wars

and the undermining of multilateral institutions, for instance. When global

uncertainties increase, we in India have to be careful. Secondly, you have

a more integrated global economy than was the case at that point of time.

Therefore, we have to be more careful about our vulnerability from the

point of view of balance sheet adjustments.

After this, you come to the domestic issues. Now, corporate balance sheets

have a lot more exposure to foreign exchange than before. Therefore, the

profitability of the non-financial corporate sector is heavily influenced by

the exchange rate. And that in turn affects the sensex. Large corporates,

with large exposure to foreign exchange are heavyweight for the sensex.

So the exchange rate is even more important for the financial sector than

in the 1990s.

AJ/AMT: Interesting. So vulnerabilities in one way and more strength

in others. I wanted to follow-up on this. Since you mentioned external

vulnerability, it seems most countries which made the transition to the middle

income group were export-oriented in some ways. Exports have been a sort

of important driving engine. Why do you think India has not been able to take

advantage of this beyond a point?

YVR: If the current account is sustainable, we assume that the current

exchange rate is reasonable. But in India’s case, in the current account on

trade account we are weak and on invisibles; we are surplus since the NRI

remittances plays a large part.

NRI remittances are a reflection of the strength of our people who live

abroad. It does not reflect the current competitiveness of the Indian

economy and people resident in India. These are reflected in the trade

deficit.

Bank recapitalization and political economy of banking

AJ/AMT: My question pertains to bank recapitalization. I was working on one

article and did some research and figured out that recapitalization bonds

were issued in the 1990s as well, and then they were changed into marketable

securities, and that we are still repaying them, and will continue repaying

them. Now, even before repaying them, we have issued another round of

recapitalization bonds-this indicates that we have certain structural problems

in our banking system. What is your view on this?

YVR: Let us distinguish between two things. Recapitalization is a

requirement of the regulator and bonds are the means by which money

is raised to provide capital. Recapitalization arises due to the functioning

of the banks. Let’s understand why the need for recapitalization arose.

Before the 1990s, there was no proper accounting or globally accepted

standards of capital adequacy; so the issue of capital adequacy arose

as part of the reform process. The government as the owner, is virtually

swapping liabilities. It is investing in equity with the bank but by

borrowing from the bank for investment. A share certificate is exchanged

with the bond. The government has to pay interest to the bank, and in

return, the bank will give a dividend. The government is taking risk; but the

bank is holding a sovereign paper.

At the time the recap bonds were structured twenty years ago we didn’t

have an active bond market, so each bank designed its own conditions.

One bank designed a 10% bond for 10 years, another bank said 10% for 50

years. Another bank said till perpetuity--that was how it was done!

After sometime, bond markets have developed further, but the banks

which had these securities with varied features with them, were not

marketable.

If the securities are marketable, they can be released into the market, and

then banks can release the money. That is the background.

AJ/AMT: So, the question is, how do we think about the political economy of

banking?

YVR: It can be argued that the public sector bank is not a limited liability

company. It is a sovereign entity under the law of parliament, and since it

is a sovereign entity, its liability is unlimited! Since its liability is unlimited,

there is no question of adequacy of capital. Capital adequacy is meant to

protect the depositors’ interests.

Central bank- treasury relationship

AJ/AMT: “The more you differ, the more you should be humble”, you had

advised young civil servants at a lecture at LBSNAA. Do you think this

approach is sufficient to minimize the friction that is occasionally visible in the

central bank and Treasury relationships, or other institutional reforms may be

required?

YVR: That comment was in the context of a talk to IAS officers. Generally

there is a belief that IAS officers are arrogant when talking in meetings.

That’s not a good way of carrying on work, especially when your bosses

are politicians. In the decision making process, it’s not only the assessment

that counts, but also the way one puts forward ideas and arguments. You

should try to smoothen the decision making process. This was the context.

The idea of smoothening is relevant in the context of the relationship of

the central bank with the government also. The central bank should be

able to convince the government that it has superior technical analysis. If

the central bank is able to convince the ministry of finance “I have superior

technical capabilities”, then the credibility is established.

Second, central bank independence did not come from heaven. It was

granted by the government. And the government has granted it for a

purpose. The purpose is to tell people that it is independent!

Government wants central bank independence to create legitimacy,

but it has been elected by the people, it knows what the people want.

The central bank should be able to convince the government that

independence is good and is good for the government as well. The

delicate point is that the central bank should be able to convince the

people that it is independent, and simultaneously assure the government

that it is not acting against its interests.

Having differences is not the same as defiance. Difference of opinion is

different from defiance.

Central Banking in a new world

AJ: We had earlier talked about the changing role of central banks in the face

of rebalancing across the world. Could you elaborate?

YVR: Currently, there are three, four kinds of rebalancing happening

globally. The central bank is only a small part of this rebalancing. The first

rebalancing is between the global and national. What has happened,

I believe, is that capital has become global, and labor continues to be

national. The ultimate risk bearer for people in any country is sovereign.

With globalization, the capacity of the sovereign has reduced. Fiscal

policy space has reduced: you can’t control the globalised financial sector

easily.. Therefore, the nation-state wants to claw back and regain its power

and policy space to cater to the aspirations of the people affected by

globalization. This is one rebalancing.

The second rebalancing is between the state and the market. The country

epitomizing the free market, the US, is on the back foot, while the country

using the state to control markets, China, is on the ascendancy. Further,

there is a clash between financial markets of the US and the financial

giants of China. The rebalancing now is not in terms of state versus the

market, but the state’s relationship with the market.

Then there is a third rebalancing: real and financial. The real sector in

terms of employment may be down, but the financial sector in terms

of asset prices is up. There is a disconnect between the two, and it is

increasing.

Fourth, which is beyond all this, is that we now have giant corporations like

Google who have better access to information about every citizen than any

sovereign. They are able to commandeer information, and are not rooted

to any nation. So what is the role of nation-state in this?

For the youth

AJ/AMT: Since this is the last question of this interview, we should end on a

positive note. What message would you like to send to the young men and

women of the republic who may be interested in economic policy? What is

your wish for them…for this country?

YVR: At this stage, the youth have to recognize that the focus has to be

on the people of the nation, and not exclusively the nation itself. You can

have a very strong nation, but very poor people. You can have a powerful

nation with huge inequality and tensions. The youth have to remember
this: People are becoming global. So the youth have to think and work

in an atmosphere where you can take advantage of globalization and

opportunities, but also have the well being of the people of the nation in

mind.

AJ/AMT: That is a lovely note to end on. Thanks a lot.

The Structural Equation

The Twin Challenge and India’s

Macroeconomic Response
Zico Dasgupta

The Covid-19 crisis has hit the Indian economy at a juncture when it was

already gripped by a severe slowdown, characterized by four-decade high

unemployment rate and a high degree of financial fragility. What India now

confronts with the emergence of the pandemic is an economic tsunami

of global scale, the intensity of which is now comparable to the Great

Depression.

The crisis has posed on a global scale the twin challenges of

simultaneously responding to the public health emergency as well

as mitigating the consequent loss in income and employment. These

challenges appear to be ‘twin’ not only because they have appeared

together in the global scene, but also because the possible solution to

these challenges appear to be intrinsically related. There are at least three

interrelated strategies which have been deemed necessary by most

countries: social distancing, testing and relief packages. Because social

distancing adversely affects livelihoods itself and cannot be continued

ad-infinitum, all the three strategies remain intrinsic to an effective policy-

response.

Though the broad contours remain the same for all countries, are

Indian challenges specific in any sense? What has been the broad macro

policy response? Is the policy-framework adequate to address the

unprecedented challenges? What are the policy options? This article is an

attempt to explore these questions.

The Specificity of India’s Twin Challenge

Despite commonalities, the severity of this twin challenge would be

greater in the case of India, which has by now registered over 17000 cases

and made its way to the top 30 most-affected countries. This is because of

the following reasons.

On the health front, the Global Health Security (GHS) report in 2019

(released jointly by Johns Hopkins Centre for Health Security, Nuclear

Threat Initiative and the Economist Intelligence Unit) had noted that no

country is fully prepared to handle epidemics or pandemics. But according

to the GHS index, India’s health system would appear to be even less

prepared, compared to most of its peers in the list of 30 most-affected

countries with Covid-19. Measuring countries’ capabilities on a scale

ranging from 0 to 100, chart 1 shows the GHS Index for the 30 most-

affected countries. With the overall score of 46.5, India ranks 27th among

these 30 countries. This is hardly surprising given India’s historically

miniscule spending in the health sector under successive governments.

Chart 1: Global Health Security Index

90
80 Score for 30 most-affected countries
70
Source: Global Health Security Index, 2019
60
46.5
50
40
30
20
10
0
UK

Sweden

India
Portugal

Turkey

China
Canada

Denmark
USA

Switzerland

Norway

Romania
Belgium

Brazil
Netherlands

S. Korea

Ireland

Poland
Germany
Australia

Czech Republic
France

Chile
Italy
Austria

Russia
Japan

Israel

Iran
Spain

On the economic front, while the pandemic would bring about a sharp

fall in employment and income across the world, the brunt of such

economic impoverishment would be particularly greater in economies

where the share of informal employment is higher. This is because an

informal worker, as considered by the ILO, would be the one whose

employment is not subject to labour legislation, whose social security is

not paid for by the employer, who would not be entitled to paid annual

leave and paid sick leave and who works in a household or owns and

runs an informal enterprise. Typically with meagre level of income and

without a job contract, the brunt of the recession would be greater among

informal workers. Chart 2 shows the share of informal employment in

total employment for the same set of countries as chart 1, excluding

four countries (Australia, Canada, Iran and Israel) for which data was

unavailable. At 88.2%, India’s share of informal employment remains the

highest compared to its peers.

 88.2 Chart 2: Share of Informal Employment
90
80 in Total Employment for 30 most-
70
affected countries (%)
60
50 Source: Women and Men in the Informal

40 Economy: Statistical Brief, ILO, 2018

30
20
10
0
Sweden

UK

India
Portugal

Turkey

China
Denmark

USA
Norway

Czechia

Romania
Switzerland

Belgium

Brazil
Netherlands

S. Korea
Ireland

Poland
Germany
France

Italy

Chile
Austria

Russia
Japan

Spain

Not only the informal sector, the impact of the crisis on the organized and

the corporate sector would be particularly severe as the economy was yet

to recover from its pre-covid slowdown. While the growth rate of profits

of most non-financial corporate firms declined sharply during the recent

period, there was a sharp rise in the share of those firms in BSE-NSE listed

companies whose profits were lower than their interest payments (see

chart 3). With about one-quarter of the non-financial corporate already

confronting a stressed balance sheet by December 2019, as indicated

by profits (PBDIT) falling below interest payment commitments (interest

coverage ratios falling below 1), the coming recession would drastically

increase the number of such firms by further reducing their profits.

Such reduction in profit would be on account of both decline in domestic

sales as well as in exports, since the latter would take a severe hit as the

global recession sets in. The severe decline in profits and the associated

adjustment in expected sales has opened up the possibility of labour

retrenchment at an unprecedented level.

Chart 3: Share of ICR<1 Firms in BSE-

23.9
25.0
NSE listed Non-Financial Sector

20.0 Source: CMIE Prowess Database

14.2 Note: Sample comprises of 2790 non-

15.0 12.7 13.3
12.3 12.0
financial firms.
10.1
8.5 9.1
10.0
5.7 5.8
5.0

0.0
Mar-10

Mar-11

Mar-12

Mar-13

Mar-14

Mar-15

Mar-16

Mar-17

Mar-18

Mar-19

Dec-19
The crisis of the informal as well as the corporate sector has reflected itself

in the sharp and dramatic rise in the open unemployment rate in the last

few days. Chart 3 shows the 30-day moving average unemployment rate

for the rural, urban and the aggregate economy. While the aggregate

open unemployment rates showed an increasing trend since 2018

reflecting the severe slowdown and stood at a very high level by 31st

March 2020, it registered a drastic rise in the month of April when it

increased from 9% on April 1 to 18.7% on April 17.

Chart 4: 30 day moving average

20
18 unemployment rate-Total, Urban and
16
Rural (%)
14
12 Source: CMIE Unemployment Rate in India
10
8
6
4
01-04-2018
27-04-2018
23-05-2018
18-06-2018
14-07-2018
09-08-2018
04-09-2018
30-09-2018
26-10-2018
21-11-2018
17-12-2018
12-01-2019
07-02-2019
05-03-2019
31-03-2019
26-04-2019
22-05-2019
17-06-2019
13-07-2019
08-08-2019
03-09-2019
29-09-2019
25-10-2019
20-11-2019
16-12-2019
11-01-2020
06-02-2020
03-03-2020
29-03-2020

Total Urban Rural

The very specificity and severity of India’s twin challenges demand a

government response that is more proactive than ever before and to an

extent even greater than its peers. How has it responded till now?

The Present Policy Response

Varying only in extent, India’s macroeconomic policy-response has

essentially been a continuation of its pre-covid policy-framework, which

was characterized by high level of liquidity infusion and low level of fiscal

package. The recent measures like the reduction in cash reserve ratio,

the introduction of Targeted Long-term Repo Operations (TLTRO), or

the increase in the Marginal Standing Facility (MSF) have all been aimed

at increasing liquidity (Chakraborty and Thomas, 2020) and relaxing the

existing finance constraint of the economy. Similarly, continuing with

the pre-covid policy-framework, the centre’s fiscal measure has been

weak with a total of 0.9% of GDP (with 0.1% on health and 0.8% on relief

respectively). A large portion of this package is frontloading of previously

allocated expenditure and hence, strictly speaking, not additional fiscal

expense. Even if one adds the fiscal package of the states, the overall

covid-related fiscal package of India would turn out to be 1.1%.

Chart 5 shows the share of covid-19 fiscal packages in GDP for 30 most-

affected countries. As evident from the chart, even if one includes state

expenditure, India’s fiscal package would rank among the lowest (28th).

Chart 5: Fiscal Packages for Covid-19 as

20
18 percentage of GDP for 30 most-affected
16
14 countries
12
10 Source: Policy Tracker, IMF,
8
as of 17th April 2020
6
4
1.1
2
0
United States

India
Portugal

China

Turkey
Canada

Denmark
Switzerland

Norway

Romania

South Korea
Brazil

Belgium
Sweden*

Ireland
United Kingdom

Poland

Netherlands*
Germany
Australia

Czech Republic
France

Chile

Italy
Austria

Russia
Japan

Iran

Israel

Spain

The central drawback of such a fiscal-conservative policy framework

became evident during the pre-covid slowdown itself, as it proved to

be inadequate to mitigate the slowdown. While it attempted to address

growth slowdown primarily through liquidity infusion and thereby relaxing

the economy’s finance constraint, the economy did not register a recovery

as lack of effective demand remained as the immediate binding constraint

(Anand and Azad, 2020). The emergence of the covid-19 crisis has reduced

demand further, created ruptures in the supply-side capabilities and

created the need for higher health-related expenditure.

Further, the need for a higher relief-related package would arise from

India’s specific policy response to the health emergency. Despite

widespread variation across states, for example with a state like Kerala

doing remarkably well in testing rate and “flattening the curve”, India’s

overall testing rate has been among the lowest. Rather, the central

instrument of addressing the health challenge has been stringent social

distancing policy. According to the Stringency Index designed by Oxford

COVID-19 Government Response Tracker, India ranked first on stringency

index on April 17. But the intensity of the impact of social distancing on
the economy not only depends on the extent of stringency, as captured

by the index on a given day, but also on the duration of such policy. Since

the Government response tracker provides data for the index every day

for each country, measuring countries’ stringency of response on a scale

from 0 to 100, one possible way to include the duration of stringency is

by taking the average index value of a country for a given period. Chart 6

provides the average stringency index value of top 30-affected countries

from January 1 to April 17 . As evident from the chart, India ranks among

the top 5 even in terms of the average stringency value in the last four

months.

Chart 6: Average Value of COVID-19

60.0

50.0 Government Response Stringency

40.0 Index for 30 most-affected countries,

30.0 1st January 2020 to 17th April 2020

20.0 Source: Oxford COVID-19 Government

10.0
Response Tracker (OxCGRT), 17th April
0.0
Note: Missing values have been excluded
India

United States
China

Turkey

Portugal

Denmark

Canada
South Korea

Norway

Romania

Switzerland
Belgium

Brazil

Sweden*
Poland

Ireland
United Kingdom

Netherlands*
Germany
Australia

Czech Republic
France
Italy

Chile
Austria

Russia
Israel

Japan

Iran
Spain

from calculation

Such exclusive emphasis on stringent social distancing policy, along with

low fiscal package and low testing rate, has been a policy-mix which is

unique to India (see table 1). Table 1 selects the top 15 among the 30

most-affected countries in terms of the average value of their stringency

index from January 1 to April 17, thereby showing countries which have

implemented highly stringent social distancing policies on average.

Depending on their respective ranks in terms of testing rate (number of

test per million population) and implementing stimulus packages among

30 most-affected countries, these 18 countries are further divided into 6

groups: (i) top 5 in stimulus package, (ii) those ranking between 6 and 25

in stimulus package, (iii) bottom 5 in stimulus package, (iv) top 5 among

testing rate, (v) those ranking between 6 and 25 in testing rate, (vi) bottom

5 in testing rate. The countries within groups (i)-(iii) are described in

columns 2-4, whereas countries within groups (iv)-(vi) are described in

rows 2-4. As evident from the table, India is the only country with high
average stringency index among the 30 most-affected countries which

simultaneously belongs to the bottom 5 in stimulus packages and testing

rate (row 4, column 4).

Top 5 in Rank 6-25 in Bottom 5 in

Fiscal Package Fiscal Package Fiscal Package

Top 5 in

Testing Rate Israel (1) Italy (1)

Rank 6-25 in France, Turkey, Norway, Belgium,

Testing Rate Poland, Portugal, Denmark (7) Spain, South Korea (2)

Bottom 5 in

Testing Rate Japan (1) Romania (1) India (1)

The intensity of the twin challenges, along with the specificity of India’s Table 1: Top 15 among 30 most-affected

policy response in the health front, requires a fiscal package way greater countries in terms of Stringency Index

than what it is right now. The fiscal conservatism that characterizes the Source: Constructed from IMF Policy Tracker

present policy-framework remains inadequate. An alternative policy- and Oxford COVID-19 Government Response

framework is needed, what are the options? Tracker (OxCGRT).

Note: The table excludes China as it did not

Rethinking the Macro Policy Framework report testing data. The number of countries

Two forms of instability had characterized India’s pre-covid slowdown. in each cell is shown in parenthesis.

The first instability involved the insolvency condition of the firms, where

squeeze in demand led to fall in profits below interest payments thereby

triggering a cumulative process of debt default, credit crunch, fall in

investments and so on. The second instability was of a Harrodian nature,

where a decline in output and investments brought forth a fall in expected

profitability thereby leading to further decline in investment and output

and so on (Dasgupta, 2020a).

The emergence of the covid-19 crisis has not only intensified the livelihood-

related crisis and the existing forms of instability, its severity has brought

forth a third kind of instability-which resembles the Domar-Pasinetti

dynamics, but inherits a distinct character within the existing policy

framework. The debt-instability refers to a situation where the public

debt-GDP ratio of an economy increases over time. Such a condition would

emerge once the product of the existing debt-GDP ratio and the difference

in growth rate and interest rate falls short of the existing level of primary

deficit ratio. If the IMF growth forecast for India in 2020 is considered

plausible, then the Indian economy is all set to breach the debt-stability

condition during this period at the given interest rate, deficit ratio and

inflation rate (see chart 7).

Due to decline in growth rate since 2017-18, as evident from chart 7, the

difference between the growth rate and real interest rate has continued

its declining trend and would turn negative during 2020-21. Since both the

debt-GDP ratio and the existing level of primary deficit ratio are positive,

the stability condition would be breached. The debt-GDP ratio would

increase and at a given interest rate, so would the interest payments-GDP

ratio.

10.0 Chart 7: GDP Growth Rate and Centre’s

8.0 Effective Interest Rate (%)

6.0 Source: CSO, RBI and World Economic

4.0 Outlook, 2020 April

2.0 Note: Centre’s effective nominal interest

0.0 rate is calculated by dividing its interest

-2.0 payments at period ‘t’ with its outstanding

-4.0
liability at period ‘t’. Inflation Rate is
2016-17 2017-18 2018-19 2019-20 2020-21
(projected) estimated as growth rate of GDP deflator.
GDP Growth Rate (g) Real Interest Rate (i) g-i The real= interest rate is assumed to remain

unchanged for 2020-21 as compared to

2019-20. The projected GDP growth rate for

But what happens when this stability condition is breached? What is the
2020-21 is 1.9.
implication of such instability? How to address it?

Within the mainstream literature, the site of instability is located exclusively

in the debt dynamics and the usual policy recommendation would be

reducing primary deficits at a given output, interest rate and GDP growth

rate till the debt-GDP ratio stabilizes over time. The central assumption of

this policy recommendation is that borrowings or deficits are unrelated to

growth rate. However, once government expenditures and primary deficit

is linked to the growth rate either through the multiplier or through its

effects on investment, the consequent reduction in deficits would reduce

growth rate and thereby open up the possibility of triggering a cumulative

process of higher debt-GDP ratio, lower deficit ratio, reduction in growth

rates and so on.

In other words, the economy confronts the threat of not one, but rather

two distinct spheres of instability once the debt- stability condition is

breached-one involves the debt-dynamics, the other involves the growth

dynamics. The existing policy-framework which remains intolerant to

increasing deficits, exclusively attempts to resolve the first sphere of

instability without addressing the instability of growth-dynamics. At a

given tax rate, the implication of breaching the Domar-Pasinetti stability

condition within such a framework would be reduction in government

expenditure, primary deficit and growth rate and hence, opening up the

possibility of instability in growth dynamics. Lacking a better term, we call

the latter tendency as growth-fiscal instability.

True, that the above described growth-fiscal instability can be escaped

despite breaching the debt-stability condition and despite deficit

reduction, if there exists an exogenous stimulus which can pull up the

growth rate itself. This was precisely the experience of the Indian states

during the early 2000s when the FRBM act was implemented to address

the instability of debt-dynamics by reducing deficits. However, what

resisted growth-fiscal instability during the early 2000s was the fact that

the GDP growth rate itself increased on account of an unprecedented

global boom and higher exports, which, in turn, unleashed a sequence

of expansion in demand through higher investment (see Dasgupta,

2020b for a detailed discussion). Except for a few niche products like the

pharmaceutical industry, the export stimulus is absent during the covid-19

crisis; rather what one presently confronts is a negative external shock

with the global economy going into a recession. The escape strategy of the

2000s simply cannot be repeated.

Thus within the paradigm of existing policy-framework, which is typically

characterized by its fiscal conservatism, the possibility of confronting

this third form of instability looms large. The very interaction between
the three forms of instability can further set the economy towards a

devastating declining growth trajectory; to paraphrase Harrod (1973),

once kicked with adequate force, the “ball lying on a grassy slope” might

go the whole way down a mountainside. Over and above providing relief

packages and increasing health-related expenditure, India’s macro policy-

framework must aim at stopping the ball from rolling down the slope. One

can think about the following options:

Firstly, both the deficit-ratio and the debt-ratio targets need to be relaxed

not only to the extent that they can absorb higher interest payments

at the given level of primary deficit, but also to accommodate higher

government expenditures on economic relief, health and to mitigate the

adverse impact of covid crisis on output growth rate.

Secondly, higher deficits can be financed by the RBI at the repo rate,

as deficit-financing would reduce the effective interest rate of the

government at a given growth rate. In the middle of an unprecedented

fall in output below its potential level, higher money supply hardly poses a

threat of increasing inflation rate.

Thirdly, while deficit financing is effectively initiated by the RBI at the

present through the WMA (Ways and Means Advances), its limit needs to

be increased way higher than it is right now. This is particularly true for

states which have the constitutional responsibility of undertaking the bulk

of the development expenditure, despite resources being concentrated

in the hands of the Centre. The recent increase in the WMA limit by 60%,

which amounts to about Rs 19335 crores or 0.09% of GDP, seems to be

meagre in comparison to existing challenges. Since at the moment it

seems to be a long haul for the economy, legal and other options need

to be explored to ensure long-term arrangement of deficit financing for

states. One immediate arrangement can be the centre taking additional

loans from the RBI and distributing additional funds to states through

higher grants.

Fourthly, the food-constraint needs to be relaxed by using the FCI’s

buffer stock and the public distribution system. If in the medium-run the

food supply falls short of its demand, the option of food rationing can be

explored.
Fifthly, the possibility of further reduction in the repo rate can be explored

in order to reduce the government’s effective interest rate. However, since

capital flows in the debt-market, inter alia, would be linked to interest rate

differential between countries, reduction in repo rate may have to be

combined with some form of capital control.

In the middle of unprecedented crisis and uncertainty, India’s macro

policy must adjust to the needs of the economy as the covid-crisis

gradually unfolds. What appears to be less uncertain, however, is that

India’s existing policy-framework needs to be fundamentally changed to

address the coming economic tsunami.

Zico Dasgupta is associated with Azim Premji University, Bengaluru.

References

Anand, I & Azad, R. (2019): “India’s Slowdown: What it is and What can be

Done”. Economic and Political Weekly, Vol LIV, no 41

Chakraborty,L and Thomas,E. (2020): “Covid-19 and Macroeconomic

Uncertainty: Fiscal and Monetary Policy Response”. Economic and Political

Weekly, Vol. 55, Issue No. 15

Chandrasekhar,C.P. and Ghosh,J (2020): “Informal Workers in the Time of

Coronavirus”. Business Line, March 24,2020

Dasgupta,Z. (2020a): “Economic Slowdown and Financial Fragility: The

Structural Malaise of India’s Growth Process”. Economic and Political

Weekly, Vol. 55, Issue No. 13

Dasgupta, Z. (2020b): “What Explains India’s High Growth Phase?

Investment, Exports and Growth During the Liberalization Period”.

Working Paper, Azim Premji University

Harrod, R. (1973): Economic Dynamics. London and Basingstoke:

Macmillan.
The Bond’s eye view - March 2020
Sriram Mahadevan

Covid-19 dominated financial markets in March. While the world has seen

many virus outbreaks (see table) over the last two decades, most of them

were largely localised and contained. As a result, Corona started to impact

China towards Q4 of CY2019, markets reacted as if to say , ‘this too shall

pass’.

An additional factor for complacency arose from the unfounded optimism

about medical research promise in eradicating disease. This kind of

narrative was also promoted by the Venture Capital industry over the

years . It is not a surprise that the industry therefore acted too late when

the virus was at the door.

Estimated Period

Virus Outbreak of Outbreak

SARS Jan to Mar 2003

Avian influenza Jan to Aug 2004

Ebola Dec 2013 to Feb 2014

Zika Nov 2015 to Feb 2016

Covid-19 Jan to Mar 2020

The Q4FY20 started with speculations on supply chain dislocations in

China adversely impacting economies. Optimists in the country saw this

as an opportunity to woo businesses away from China. Capital markets

absorbed this speculation and there was subsequent volatility due to this.

Covid coincided with a dispute between Saudi and Russia on production

cuts in crude oil. The result was a supply glut in global markets which

brought down crude prices sharply through the quarter [Figure 2].
Indian market sentiments were initially supported by a sharp fall in Figure 1: Crude price in $ per barrel

crude prices, but by the end of February the markets started to see the

weakness become more broad-based as Covid spread faster than any

other virus and was finally deemed a pandemic by the WHO.

6.50 Figure 2: 10 years benchmark Gilt Yield

6.40

6.30

6.20

6.10

6.00

5.90

5.80

Government Bond markets

Bond markets were heavily traded in the month of March as capital moved

from the potentially weak private sector to sovereign bonds. Bond yields

were also supported by RBI’s sledge-hammer approach in ensuring

transmission of policy rates at least in the term structure first by flushing

the system with liquidity, open market operations and then long-term repo

operations. The RBI’s 75 basis rate cut in the repo rate and 90 basis point

move in reverse repo mean that sovereign bonds ended the month with

gains and rates were slightly lower.

Global equity markets saw a melt down. Indian bourses had to halt

trading for 2 sessions and the period saw the most severe fall in the

history of Indian markets. The sharp meltdown in values across almost all

risky assets resulted in a sharp pull out of investors from money market

funds and bond funds. This came on top of a rather ‘cold winter’ in credit

markets, following the ILFS debacle. Covid was just the perfect storm to hit

the markets at the worst time.

Foreign portfolio investment retrenchment coincided with mutual fund

redemption (see figure 3), and the period saw a complete lack of appetite

for Non-Government bonds. The extent of the deep freeze can be

appreciated by the fact that even PSU Bonds saw weak demand. This was

only mitigated by the fact that the RBI announced Targeted LTRO of Rs

1 lac crore extending financing to banks at a fixed repo rate for buying

investment grade bonds. This allowed for the continued issuance and

purchase of AAA and other high quality bonds.

Figure 3

Figure 4: FII Activity in Debt Markets in

Trend in Monthly FII flows ($ million)
March ($ Mn)
4000 2213
1199 1226 1593 713
2000 537 381
0
-367 -274 -442 -756
-2000 -1158 -846
-1494
-4000
-6000
-8000
-10000 -8680
Apr-19

May-19

Nov-19
Mar-19

Mar-20
Jul-19

Aug-19

Oct-19
Jun-19

Dec-19
Feb-19

Sep-19

Feb-20
Jan-19

Jan-20
At the time of writing, the Government of India has announced a lock-

down of activity to prevent spread of the pandemic thereby bringing to a

halt economic activity covering about 35% of the economy. This also had a

sweeping impact on the financial market functioning and has frozen these

markets too, but the longer term effects at this point are impossible to

guess at.

Sriram Mahadevan is the Principal-Endowment Investment Group at Azim

Premji Trust. He has extensive experience in tracking financial markets in

general and bond markets in particular.

Focal Point

Pre and Post Covid-19 Challenges

of the Indian Economy

Avinash M. Tripathi

This year, the global economy is hit by a black swan event in the form of

Covid-19. Despite stringent measures adopted by the Indian government

to control the epidemic, India seems to be following the exponential phase

of the epidemic curve.

The economic implication of the epidemic is likely to be enormous. First,

the lockdown itself has been a rude supply shock. The sudden and

unanticipated lockdown has left a huge population of migrant workers

especially vulnerable. Looking ahead, the sickness and mortality resulting

from the pandemic is likely to affect the economy considerably.

Immediacy of the Covid-19 challenge should not obscure the deeper

economic realities however. Even before the Covid-19 crisis emerged, the

economy was in bad shape. GDP growth in the first quarter of FY2020 had

dipped below five percent. High frequency indicators such as the Index of

Industrial Production (IIP) were showing a bleak picture. Gross domestic

savings and corporate investment had plateaued. Despite easy monetary

policy, benchmark GSec yields were stubborn. Further, the incipient

inflation had made countercyclical macro policy even more challenging. It

would be unwise to look at the Covid-19 in isolation. Accordingly, this short

essay analyses both pre and post Covid-19 challenges being faced by the

Indian economy.

Post Covid-19 Challenges

Following the outbreak of the Covid-19, the first case was reported on

January 30 in India. Since then, Covid-19 has shown continuous growth

both in terms of numbers of infected and the geographical area involved.

Fortunately, a pandemic is rare, once a century event. Unfortunately, it

also means sufficient variation in data is not available for empirical analysis

and for guiding policy. Further, the epidemic curve being highly non-linear,

extrapolating initial trends, as is being done by some observers, could be

extremely misleading. Using domain specific models for counterfactual

reasoning remains the only alternative.

India announced a nationwide lockdown on March 24 for 21 days which 1

The counterfactual has been generated

was further extended upto May 3. An age-corrected SIR model1 utilizing using the SIR model documented by Singh

the India specific contact structure shows that, despite its extensive and Adhikari (2020). The code and data

coverage, the lockdown had a modest success in controlling the spread are available in the public domain. Data

(~50% lower incident relative to the projected counterfactual). Looking on actual active cases has been taken from

at figure 1, one can see that upto 7 April, the actual cases were closely CoVID19-India.

tracking the counterfactual scenario (without lockdown).

After that, lockdown has slowed down the rate of growth, cutting the

possible cases by half. While this might seem a reasonable success, in

order to control the epidemic, mitigation methods must comprehensively

extinguish the contagion. Otherwise gains are likely to reverse once the

strict measures in place are withdrawn. Given the current trajectory,

complete elimination of the COVID-19 seems extremely improbable.

Figure 1: Simulated impact of lockdown

But what happens if the cases can not be completely eliminated? Any

projection beyond the current month is fraught with uncertainty. But

standard epidemiological models predict a ‘blowing up’ phase by the end

of May and a peak towards the end of June.

Actual dynamics is likely to be more complex. As the disease affects

more and more people, they will practice social isolation more rigorously,

slowing down the rate of spread. Conversely, these measures will become

lax once the cost of isolation becomes prohibitive, marking the resurgence

of the disease. Thus, the contagion will emerge in multiple waves.

Whatever be the short term shape of the epidemic curve, the pandemic is

likely to end only when either herd immunity is achieved or some clinically

proven treatment or vaccine becomes available. Both scenarios will take

a long time to materialize. In the best case, Covid-19 is likely to be a long

drawn battle.

Meanwhile, designing a controlling protocol that balances the imperatives

of life with the economy will be a massive challenge. One technologically

possible, but logistically challenging, option is replacing across the board

social distancing with precisely targeted social distancing.

Scaling up mass testing is an effective, sustainable and underutilized

control strategy available to the policy makers.

Simulations by noted economist Paul Romer suggest that even an

imperfect screening test with false negative rate of around 80% - meaning

only 1 in 5 infected individuals are certified as such - can cut down the

ultimate number of infected people by a whopping 50%! This theoretical

understanding is corroborated by the experience in South Korea and

Wuhan.

It follows that development of a cheap, easy to scale screening protocol

will have the most substantial impact on stabilizing the epidemic, pending

the development of the vaccine. Public policy can aid this by incentivizing

efforts in this direction and removing regulatory hurdles.

Second, the lockdown requires persistent changes in the public behaviour

at least in the medium term. Sharp restrictions, limited in time, will only

delay the inevitable. By contrast, persistent social behaviour--complete

segregation between different age groups; maintenance of social

distancing and hygienic practices--must be encouraged and even enforced

till the vaccine becomes available.

In the interim, the economy is likely to witness extreme stress. The stress

will be more pronounced at the bottom of the pyramid. As documented

by Rajendran Narayan, the lockdown has strained the capacity of the

migrant workers. More than 42% of the distress calls received by SWAN2 2
Stranded Workers Action Network.

complained of having no ration for a day and an overwhelming majority

was yet to receive the government support.

Providing succour to this segment is essential for the success of the

long drawn struggle against Corona-19. In this context, Arjun Jayadev

has proposed five ways of funding the government expenditure which

includes: partial monetizing of the expenditure; utilizing the increased

appetite for government debt; a novel corona cess after the crisis is

resolved; utilizing unspent cesses and finally availing of foreign credit as

a last resort. All these options need to be explored and a comprehensive,

forward looking package for alleviating economic distress must be worked

out.

Pre-Covid19 Challenges

Even before the Corona-19 crisis erupted, Indian GDP growth rate was

lower than its potential. Given the criticality of the growth process for

providing gainful and productive employment to the burgeoning working

population, an urgent diagnosis and course correction may be needed.

The reasons for the tailspin could be seen as the interaction of historical

and contemporary factors.

Figure 2: Financial parameters of

non-financial listed corporations

Source: CMIE
Over-leverage, Moral Hazard and Lack of Debt Resolution Framework

Let us begin with legacy problems. Legacy problems consisted of the over-

leveraged firms and resulting balance sheet problems. The over-leverage

itself was the result of the multiple fundamental problems on the demand

and supply side in the financial market, some of which are discussed

below.

Favorable tax treatment of debt

On the demand side, two factors which were responsible for greater than

optimal demand for credit were a favorable treatment of debt relative to

equity3 and the absence of a bankruptcy resolution framework. These 3

“The tax treatment of corporate debt is

factors when combined with weak credit assessment capacity of banks, quite different from equity. Interest accrued

regulatory oversights and complicated political economy of the public on corporate debt is deductible from

sector banks account for the high level of debt in the Indian corporate corporate profits. As a result, the marginal

sector. effective tax rate is lower in the case of

debt-financed capital used in corporate

The over-leverage encouraged moral hazard in commercial decision activity, as against equity financed capital.

making. Many financially unviable projects were undertaken and the This results in a bias in favour of debt.” -

economy ended up with the Twin Balance Sheet (TBS) crisis. The TBS Report of the Task Force on Income Tax Act

was further compounded by multiple demand and supply shocks in Reforms.

the real economy. Adoption of the Inflation Targeting framework and

Demonetization of specified banknotes were the prominent demand

shocks.

On the supply side, a number of amendments in the Income Tax Act

and the introduction of the Goods and Service Tax (GST) worsened the

problems. Eventually, as many commercial projects financed by debt

turned out to be commercially unviable, firms, both in the real and financial

sector, became risk averse.

Risk-aversion in the non-financial firms led to the collapse of investment,

deleveraging and firms hoarding excessive liquidity, anticipating future

liquidity stress. Risk aversion in the financial sector led to the collapse of

credit creation. Cumulatively, these factors are responsible for the great

Indian slowdown, as some observers have called it.

Demand and Supply Shocks

Demonetization

Demonetization reduced the currency/GDP ratio for quite some time, with

deflationary consequences. Part of the monetary shock was absorbed

by the emergence of cash substitutes (endogenous money creation) like

modes of digital payment and credit. None of these substitutes were

perfect however.

• Digital payment systems require infrastructure and literacy.

Consequently, they are mostly limited to urban areas with low

penetration in rural areas and second tier cities.

• Credit requires trust. Transactions embedded in long term

relationships can be settled through credit, not anonymous or one-off

transactions.

• Other payment systems like barter have their own problems like

double coincidence of want.

Since the cash-GDP ratio remained subdued for quite some time and

other means of payments were imperfect substitutes, the nominal shock

impacted the real economy. Some transactions which otherwise would

have gone through were impeded by the shortage of currency. This first-

order effect was further strengthened by secondary effects like hoarding

of currency. When there is a shortage of cash, people tend to hoard it.

This hoarding further creates an artificial scarcity of the cash, creating a

negative cycle of low spendings and income.

Inflation Targeting

The Inflation Targeting (IT) regime was introduced shortly before the

demonetization. Given the strong duality of Indian economy where

the corporate sector remains the only forward looking agent, the IT

regime had a perverse effect. Further, it reduced the pricing power and

projections of nominal revenue growth by corporate firms and hampered

their appetite for risk taking and investment. By reducing the nominal

revenue growth, it also reduced the probability of growing out of the debt.

In short, it has created a debt-deflation cycle.

GST and Disruption to the Credit General Equilibrium

Typically, the effects of GST on the growth slowdown are explained

through the compliance cost of the firms. But there is an additional

channel through which GST has affected the real economy: By disrupting

what Stiglitz and Greenwald4 had called the ‘Credit General Equilibrium’ of 4
Stiglitz, J., & Greenwald, B. (2003). Towards

the economy. a New Paradigm in Monetary Economics

(Raffaele Mattioli Lectures). Cambridge:

Generally, we think of credit creation in the context of specialized financial Cambridge University Press.

institutions (Banks, NBFCs and so on). This is just a partial picture. In

reality, every sale and purchase in which the payment is not immediate-

-perhaps a majority of transactions-- involve credit creation. Like every

credit creation process, these transactions require mutual trust.

Goods and Services Tax was disruptive of this relationship, as the self-

enforcement of GST involved creating a conflict of interest between the

vendors at different levels. Teething implementation problems related

to GST further exacerbated these issues. Problems were particularly

acute when the relationship involved a formal firm and another small and

medium firm. Different compliance capabilities of formal and informal

firms necessitated different sets of rules, which in turn made the system

overly complex.

Income Tax Act

Moving from the general issues affecting the economy to the sector

specific problems, as the slowdown is particularly acute in the housing

sector and may be dragging down housing finance companies (Figure 3),

it makes sense to investigate the provisions related to this sector in the

Income Tax (IT) Act.

• Section 269 SS and ST of the IT act ban the use of cash in any

transactions involving immovable property with draconian penalty.

Introduced as the tax evasion measure, these provisions are little

thought out and have many unintended consequences. The draconian

penalty increases compliance burden and ends up creating friction

and uncertainty in the transactions which are perfectly bona fide.

These potentially penalise unsophisticated buyers who are not aware

of tax planning. Further, it is perverse to impose stringent conditions

 on the use of cash in real estate compared to immovable assets (say

gold), as the former are better documented.

• Under section 56(2)(vii) of the IT Act, the difference between the sale

consideration and stamp duty value of a property is ’deemed gift’

and taxed accordingly. This provision was introduced as an anti tax

evasion measure. It was based on the assumption that transactions

involving immovable property are often undervalued which results in

revenue loss. This assumption made sense when stamp duty values

were very conservative and the real estate market was booming. This

assumption no longer holds true. For one, in recent years the state

governments have increased the valuation of properties aggressively,

mainly due revenue considerations. Secondly, the stress in the housing

sector means that prices are no longer rising as fast as historically they

used to. The unintended consequence of Section 56(2)(VII) is that it

introduces downward price rigidity in the real estate transactions. This

prevents the market from reaching market clearing prices and leads to

inventory accumulation and financial stress.

Figure 3: Source: CMIE Prowess

Interaction of Balance Sheet Weakness and the Transient Shocks

The interaction of overleveraged firms and demand shocks can explain

various features of the Indian economy. In isolation, neither factor can

provide a satisfactory explanation of the persistence and timing of the

slowdown.

If these arguments are correct then it follows that the most important

economic debate about whether the slowdown is structural and cyclical is

somewhat misleading. In the presence of balance sheet effects, even short

term cyclical shocks end up having large and persistent effects.

Bankruptcy costs are real and once a company enters in the process, the

process is hard to reverse. To put it differently, the symmetry that is often

implied when we discuss counter-cyclical policies may not exist. It is easier

to destroy the momentum of the economy than to revive it.

Prognosis and Organic Recovery

The prospect of organic recovery is bleak, both in terms of its probability

and time frame. As a result, the slowdown requires formulating a

comprehensive policy package that boosts the demand and repairs the

corporate balance sheets.

In the coming years, Indian economy will have to deal with a number of

possible risks.

• Given the stock market boom was based on a handful of stocks, a

sharp stock market correction was waiting to happen. The wealth

effect following the market correction in the last two months will drag

down the economy.

• Organic balance sheet repair takes a long time. According to Richard

Koo, typically once the non-financial firms start deleveraging, it takes

about five years for balance sheets to get repaired to the point where

the normal lending resumes.

• The NBFC crisis is far from resolved and there is a turmoil in some of

the large banks like Yes Bank. Some of these institutions have multi-

trillion balance sheets and their spillover impact will be considerable.

While an organic revival of the corporate investment cycle will take its

time, the government can take a number of steps to alleviate some of the

distress and facilitate recovery.

First, the changes in the Income Tax Act to address the concerns outlined

in this essay should be made. Even if small in effect, these changes are the

proverbial hundred dollar bills lying on the road to be picked up. A fiscal

reform agenda should prioritize them.

Second, there should be credible signalling that the vulnerable financial

entities will be supported by the central bank in case of systemic stress. If

there are problems in the direct rescue then it may be implemented via an

intermediary bank with a strong sovereign commitment.

Third, the flexibility built in the Inflation Targeting regime should be

exploited by explicitly targeting the upper bound of its mandated range

(i.e 6%). Perhaps some explicit guidance revealing the Central Bank’s

tolerance level may help.

Fourth, a coordinated fiscal and monetary policy support may be needed.

To an extent, RBI is already doing it through simultaneous purchase of

long term bonds and selling of short term securities (Operation Twist). The

technical problems like shortage of short duration securities must be dealt

with, if need be by the changes in the relevant legislations.

Finally, in the medium term, the Government should think about the ways

of improving the potential growth rate. A predictable and prospective

taxation and regulatory regime may alleviate some of the uncertainty and

help in the economic revival.

Avinash M. Tripathi works for the Azim Premji University, Bengaluru.