Context

Amid the gathering global crisis, its time India minds its own house.

Panic and dislocation in Global markets

• Panic at the level of the 2008 crisis: Global markets haven’t witnessed such panic and dislocation since the global financial crisis of 2008.
  • Global equity markets have collapsed, the US’s 10-year bond is at its lowest level ever, and crude prices underwent their largest single-day fall in 30 years.
• Interaction of three global shocks: The market mayhem is the upshot of three global shocks interacting with each other.

What are the three global shocks?

• Negative demand shock due to Coronavirus: A negative demand shock around the world. As the coronavirus proliferates globally, households and businesses are understandably becoming risk-averse, and the consequent “social distancing” is expected to exert significant demand destruction around the world.
• Negative supply shock emanating from China: The widespread industrial closures in China on the back of the COVID-19 outbreak will impact imports and supply chains in other countries, and thereby constitute an adverse supply shock for the rest of the world.
  • The magnitude of the shock: The 20-point drop in manufacturing output in the February PMI and the 17 per cent contraction in Chinese exports across January and February, suggests that the shock was large and immediate.
  • Supply shock likely to fade: That said, with the virus, gradually being contained in China, this supply shock is likely to fade even as the demand shock in the rest of the world widens and deepens.
• Positive oil supply shock: The failure of oil producers to agree on production cuts has led to a price war with production increases on the anvil.
  • Cumulatively, crude pieces are down almost 50 per cent — about $30/barrel — since January.
  • A positive supply shock, which even adjusting for the concentrated stress in the oil sector, is growth-additive for the world and particularly for India.
• India specific shock: There is a fourth India-specific force at play. The resolution and reconstruction of YES Bank was inevitable, but, at least temporarily, it is likely to result in a “flight to quality” in India’s financial sector, with resources moving from the financial periphery to the core.
  • Banks and NBFC may face difficulty in mobilising resources: To the extent that the periphery — smaller private banks and non-bank financial companies — will find it harder to mobilise resources, financial sector risk aversion could rise again.

Implications for India’s macroeconomic stability

• Significant negative impact due to export: India is a much more open economy than is widely believed with exports constituting almost 20 per cent of GDP. Therefore, the impact of the demand destruction around the world will not be trivial.
  • 40 bps decrease in the growth: If global growth is marked down by 100 basis points in 2020, which increasingly appears to be the case, we estimate that this would shave off about 40 bps from India’s growth through the export channel alone.
  • The cumulative drag to growth from exports and tourism would be a meaningful 60-70 bps.
• Positive impact due to oil price shock: The near $30/barrel decline since January constitutes a large positive terms of trade shock for India — equivalent to about 1.3 per cent of GDP even accounting for reduced remittances from the Middle East.
  • Meaningful mitigant: If oil prices remain at this level for long, it would constitute a meaningful mitigant to India’s macro headwinds, boosting activity, dampening prices, creating fiscal space and reducing external imbalances.
• Offsetting the negative impact of trade and tourism: Every $10 reduction in crude prices, boosts growths by about 20-25 bps.
  • Therefore, the $30 decline in crude, if it holds, should boost growth by about 60-70 bps, thereby largely offsetting the negative hit to growth from external trade and tourism.
• Space for monetary easing: Furthermore, crude at $35-40, along with the global demand destruction is expected to generate large disinflationary forces, opening up space for monetary easing.
• CAD would disappear: Finally, India’s current account deficit would virtually disappear, for the first time since 2003-04.

The growth offset conditioned on coronavirus spread

• The assumption in the offset: The above-mentioned growth offset, however, assumes that the coronavirus does not spread within India.
  • If India witnessed a rapid domestic proliferation, heightened risk aversion by economic agents could meaningfully hurt domestic demand.
• A thought experiment on the impact on the economy: Discretionary services constitute about 35 per cent of GDP and have been growing at 8 per cent a year.
  • If that growth rate were to halve, that alone would deduct 140 bps from growth, and swamp any growth tailwinds from lower oil prices.
  • Furthermore, a “sudden stop” of demand to certain sectors may necessitate fiscal/liquidity support to ensure these don’t magnify into more disruptive credit events for the financial sector.
• The best antidote to prolonged growth hit: The best antidote would be to aggressively contain the virus domestically, as authorities appear to be doing.
  • The experience from other countries suggests aggressive containment early in the process (isolation, quarantines, contract tracings, cancelled gatherings) reduces the growth rate of the virus from exponential to linear.
• Macroeconomic outlook: The key to India’s macro outlook is whether the crude price decline can sustain and whether India can avoid a sharp domestic proliferation of COVID-19.

Way forward

• Pass the oil windfall to the public: Given current fiscal pressures, it’s tempting to advocate that the public sector appropriate much of the windfall. But with consumption under such pressure, there’s a strong case to pass this on to households.
  • A sharp cut in domestic fuel prices will boost household purchasing power and aggregate demand thereby creating contemporaneous counter-cyclical pressures.
• Stick to the asset sale plan: While the turbulence in equity markets could understandably delay the government’s asset sale programme, it should not be allowed to derail it, given the criticality of asset sales to this year’s fiscal math.
  • Absorbing all the oil windfall through higher taxes as a substitute for asset sales would be a suboptimal mix.
• Continue with the reforms: The salutary effects of falling crude prices — which would boost India’s macros relative to other emerging markets — should not mask the imperative to continue with reforms, particularly recognising and resolving any further financial sector stress proactively.

Conclusion

Global markets are witnessing their most acute volatility since 2008. All we can do is mind our own house amidst the gathering global storm.

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