GS Paper: GS3

The economic crisis in the wake of the pandemic is different from past crises. In the past, the financial crisis led to economic shock. This time its economic shock that that is causing the financial crisis. This also means that our response to this crisis should also be different. This article elaborates on the fiscal and monetary policy response to the crisis.

Pattern followed by economic crises

• There is a well-established pattern to economic crises in emerging markets (EMs).
• First, because of loose fiscal and monetary policies, the economy goes into a demand overdrive.
• Demand overdrive spikes inflation and widens the current account deficit (CAD).
• Then, CAD is financed by foreign capital chasing the promise of even higher growth and asset prices.
• At some point, the overdrive is perceived as unsustainable, which triggers a reassessment of growth, inflation, and financial stability.
• Domestic and foreign investors stop new investments, large capital outflows ensue.
• Banks stop giving new loans and rolling over old ones on fears of worsening credit quality.
• Growth collapses and a full-blown economic crisis follows.
• The 1995 Mexican, the 1997 Asian, the 1999 Russian, the 2008 sub-prime, and the 2013 Taper Tantrum are all examples of such crises.
• In the case of India, the 1981-82, the 1991-92, and the 2013 crises all had the same characteristics.

Pattern in response to such crises

• The first response is to restore confidence in policymaking.
• It means large increases in interest rates, massive withdrawal of liquidity, and deep cuts in fiscal deficit.
• Just before the crisis assets [which reflects in bank’s balance sheets] are severely overvalued on inflated views of growth, profits, and income prior to the crisis.
• So, the second step is to restart the economy by restructuring the tattered balance sheets of banks, firms, and households.
• This means debt restructuring and bank recapitalisation aided by privatisation, closures, and mergers.
• These measures often need to be bolstered by structural reforms.
• The economic crisis makes it easier to forge the political consensus for the reforms.

But the economic crisis caused by pandemic is different

• Why is it different?
• Because, before the COVID-19 outbreak far from overheating, Indian economy was slowing down.
• The financial system had virtually shut off the flow of credit as it wrestled with its bad debt burden.
• This is not an instance of a financial crisis turning into an economic shock weighed down by damaged balance sheets.
• Instead, this is an instance of an economic shock that could turn into a financial crisis if the damaged balance sheets are not repaired.

So, should the response also be different?

• Yes.
• Do the opposite of what is done in a typical EM crisis: Cut interest rates, increase liquidity support, and allow the fiscal deficit to widen.
• The RBI has done the first two generously, although with the coming disinflation, it needs to cut interest rates much more.
• But, what about the fiscal policy of the government?

Fiscal policy of the government: Doing not enough

• The government’s approach to fiscal policy, however, seems ambivalent.
• The overall fiscal support from the government will be limited to 2 per cent of the GDP.
• So all the revenue shortfall and the pandemic-related budgetary support must add up to 2 per cent of the GDP.
• If the revenue shortfall is more than 2 per cent of GDP, then total spending will need to be cut.

Why fiscal policy matters for balance sheets

• In this crisis, the causality of damage to balance sheets runs opposite.
• Balance sheets will be damaged not because of prior excesses but because of the collapse in incomes during the lockdown.
• Consequently, debt doesn’t need to be restructured to resume the flow of credit and get the recovery going.
• Instead, what is needed is adequate income support to households and firms.
• Such support will provide the needed time and space for the recovery to take hold.
• Which, in turn, would repair much of the damage to the balance sheets.
• But the fiscal response so far has been inexplicably restrained.

What should the government focus on

•  What matters today is the assurance of medium-term growth and not a few higher or lower points in this year’s fiscal deficit.
• To do that, the government needs to allow the deficit to rise.
• This extra deficit should help accommodate the decline in revenue and also provide adequate income support.
• Some have argued that the government, instead, needs to offset the decline on private demand by increasing public spending.
• This is an odd argument.
• It would mean letting demand collapse and then compensating it with higher government spending.
• Instead, using the same resources to ensure that private demand did not decline was the more natural and efficient response.

What should be the RBI’s response

• The RBI, too, has a very large role to play.
• As elsewhere, it is now the only entity that has a strong enough balance sheet to provide any meaningful support.
• The RBI is keeping markets flush with liquidity and low interest rates.
• However, the RBI also needs to undertake extensive quantitative easing to keep bond yields from spiking given the likely large increase in deficit.
• Because of the depth of the growth shock, bad debt will rise.
• The natural instinct of banks is to cut back credit because of worsening credit quality.
• To prevent this from happening, the RBI will need to extend substantial regulatory forbearance on accounting norms, provisioning rules, and, if needed, even capital requirements.
• In addition, like the US Fed and the ECB, the RBI might also need to provide liquidity directly to corporates.
• As of now, banks are providing liquidity to corporates supported by government guarantees as proposed now.

Consider the question “The economic crisis brought by the corona crisis is not like the ones we faced before. This crisis is about an economic shock turning into the financial crisis. So, what should be fiscal and monetary policy interventions to tackle the crisis?”

Conclusion

This is not a crisis like the ones before. This time around, we need to weigh not the cost of taking these measures but the cost of not taking them.