Indian economy needs strong immunity boosters

Prof D. Tripati Rao, IIM Lucknow opines that India needs to swiftly move from fiscal “Band-Aids” to counter-cyclical fiscal boosters to prevent the economy slipping into a stagflationary spiral with a permanent loss of potential GDP.

IBT: India’s GDP decline in the June quarter by 23.9% has been worse than projections. What are the main areas where the economy has fallen short of the already weak expectations and why?

Prof. D. Tripati Rao: While it was expected that Q1 FY’21 GDP growth will slump due to the stringent lockdown of the economy, yet the recently released CSO data on industrial performance has set the bearish speculation going forward for FY’21. With a 23.9% decline in Q1 FY’21 over 5.2% growth in Q1 FY’20 i.e., a decline in GDP from Rs 35.35 lakh crores in Q1 FY’20 to Rs 26.9 lakh crores in Q1 FY’21. All but one of the four major sectors of the economy are showing the sharpest decline, trespassing all contraction projections and painting an alarming picture. The construction sector has witnessed the steepest decline of 50%, followed closely by manufacturing with 39% and tertiary sectors with 21% decline. Only a slight streak of silver lining is agriculture, forestry and fishing, which registered 3.4% growth.

Apart from the broad sector-wise numbers, CSO also released a few more industry-specific figures. Real estate and professional services have contracted by a cumulative 5.3%; infrastructure like electricity, gas, water supply and utility services slipped by 7%; trade, hotels, transport, communication and broadcasting services contracted by a major 47%; mining and quarrying shrunk by 23.3%; and public administration – defence and other services – declined by 10.3%. Bank credit, as one would have expected, has grown by 6.4% and deposits, too, have multiplied with an increase of 11.5%. However, GFCF (Gross Fixed Capital Formation) continuing a secular decline, fell from 32% to 22.3%.

There has been a minor increase in exports as a percentage of GDP from 20% in FY’20 to 21.2% in Q1 FY’21. Imports have fallen from 23.4% to 18.3%. As far as consumption goes, PFCE (Private Final Consumption Expenditure) fell on a YoY basis from 56.4% in FY’20 to 54.3% and GFCE (Government Final Consumption Expenditure) shot up from 11.8% to 18.1%. These numbers make it ample clear that the pandemic has a pervasive effect, cutting across industries and sectors and through the multiplier effect, further contraction of aggregate demand.

GDP contraction turned out to be much sharper than the several policy analysts and think tanks predicted. They had cautioned about a GDP contraction varying between 16-21% during the past couple of months. Usually most of these projections are done by taking the formal sector’s performance as a proxy for the activities of the informal sector.

But considering that the informal sector contributes close to 39% of the GDP and is under deep stress due to disproportionate impact of the pandemic, such a proxy-based estimation makes the predictions go haywire and official estimates turned out to be much lower than the early projections.

IBT: How do you view the pace of the recovery given the numbers emerging post-June in terms of manufacturing, services, infrastructure, consumer demand, farm activities, consumer demand, foreign trade, investments (public and private), etc? What do you view as the key drivers of a possible economic revival in coming quarters?

Prof. D. Tripati Rao: While the manufacturing PMI recovered from 27.4 in April to 47.2 in June, it slipped again to 46 in July and continued to contract due to subdued demand and supply chain disruptions. So also, the sales of passenger and commercial vehicles as well as petrol consumption, which saw their biggest decline in Q1, started showing green shoots of recovery towards the end of June. But this can be more due to the “pent-up demand” and the comeback for actual demand might take a while. Tractor sales improved as the agriculture sector provided the only beacon of hope with above normal monsoon in the early stages (except north-west India), leading to increased rabi crops sowing.

The reverse migration from urban to rural areas due to the lockdown led to a surge in work under MGNREGA during May, June and July. In July alone, around 31.5 million households were looking for work engagement under MGNREGA – a 71% y-o-y growth. However, with 88.1 million hectares sown under Kharif corps until July 31 – a 14% jump over last year, demand for MGNREGA is expected to taper off in the coming months, as labour will move to fields.

Informal employment has seen a rise of 2.5% in July 2020, but salaried jobs have declined by 18.9 million (22%). The higher share of salaried jobs (58%) in the urban sector compared to the rural sector (42%), explains the rising urban unemployment and subdued consumption demand. Curiously, CPI remains at an elevated level even when WPI followed a downward movement, mainly due to heightened food and vegetable prices – reflecting supply chain disruptions due to continued localised lockdowns.

While the external account remained choppy, exports reflected a YoY growth of -2.1% in July, but non-petroleum exports registered a 5.1% growth. Imports continued to contract by 21.9% in July. India witnessed a current account surplus (CAS) for the quarter ending March; for the first time since 2007 and after 51 quarters. CAS or trade surplus due to import contraction, but not due to export growth, is not much to cheer about and reflects further weakening of domestic absorption capacity and aggregate demand contraction. Overall, due to a “dollar deluge” out of combined shrinking of trade deficit and capital inflows, central banks, perforce have to get into buying mode. This has resulted in continued accretion in forex reserves.

Besides the swift monetary stimulus measures, fiscal policy levers were pressed into action, mainly with a 6-month loan moratorium launched on March 31, 2020. However, localised lockdowns slowed the speed of recovery, with India’s cases reaching 3 million. Moreover, fiscal measures, mainly through credit guarantee, proved to be of meagre relief to the monumental economic distress that the pandemic has unleashed.

It’s quite obvious that the economic slowdown was an inescapable consequence given the nature of the calamitous negative shock. The economic revival is bound to be treacherous, especially when the pandemic is showing little signs of dying down. Even after the national lockdown was lifted, states have continued to impose restrictions on movement and activity and are still continuing to do so intermittently.

Hence a more direct and specific active fiscal interventions in various formal and informal sectors was necessitated and soon the government launched the Rs 20 lakh crore-worth Atmanirbhar Bharat economic aid package. The government has announced multitude of counter-cyclical fiscal policy incentives with considerable focus laid upon easing the liquidity crisis specifically keeping in mind MSMEs and the economy at large.

While the veracity of fiscal package can only be fully assessed in the following quarters; given the benefit of hindsight, the quantum and nature of fiscal aid package increasingly appears to be nothing more than a Band-Aid! On the whole, on the back of subdued aggregate demand, what is clearer is that the economic contraction is expected to be negative for FY’21 cumulatively.

IBT: What is your outlook on India’s economic growth trajectory in the current fiscal year? What are the downside risks that could impact this projection?

Prof. D. Tripati Rao: The world has not witnessed a crisis of this magnitude or nature in recent memory and we need to acknowledge the severity of the situation while making any forecasts for near-term too. It is for the first time in 40 years that GDP has registered a negative growth or a decline. IMF too observed that the GDP contraction of India is the steepest among G20 countries.

With the current double-digit decline in GDP, growth can decline by 5-7.5% for the fiscal cumulatively with a further downward bias. Added to this, with CPI inflation remaining at an elevated level due to supply chain disruptions, a stagflationary-like scenario is emerging. Fiscal borrowings have increased and fiscal limits have been reset. The sources of revenue have been drying and with the downside risks weighing on, there is a general pessimism in the economy. Amidst a negative supply shock, we seem to be caught up in a vicious cycle of slowdown in aggregate demand and income generating activity leading to loss of output growth; leading to lesser fiscal revenue realisation, which in turn is leaving lesser and lesser space for fiscal maneuverability!

Further, we also need to understand that the pandemic is currently becoming widespread rapidly with every passing day. Therefore, even if there is no nation-wide lockdown, there will be several glitches that will prevent the economy to perform to its potential.

Self-imposed restrictions on social distancing especially are very relevant for high touch segments such as, travel, tourism, hotels, etc. and will remain for a considerable time. Some countries have also witnessed a second wave of the pandemic, reminding us of continued threat and uncertainty.

To draw a parallel analogy, it appears that the economy was already limping with a lack of immunity even before it was afflicted by COVID-19 pandemic, and therefore, what was needed was a series of aggregate demand stimulus booster doses, as immunity supplements, for it to fight with negative supply shock in the first place. The fiscal Band-Aids (automatic stabilisers) such as direct cash transfers, moratoriums, conditional credit guarantees and interest subventions only provide a temporary relief as a basic support mechanism. Hence, this poses a finer challenge in prioritising countercyclical fiscal stimulus measures over fiscal Band-Aids to ensure that the recovery is steady and sustained, so that the overall damage to potential output can be obliterated.

IBT: Government spending is a critical aspect of economic revival. But given that fiscal deficit has exceeded the budgetary target in 4 months, what are the options in front of the government?

Prof. D. Tripati Rao: Reiterating the factual numbers, GFCE shot up from 11.8% (FY’20) to 18.1% in Q1 FY’21. When the PFCE fell on a YoY analysis from 56.4% in FY’20 to 54.3%, increasing government consumption is an affirmative sign. On the other hand, government expenditure in public administration – defence and other services – declined by 10.3%. As per analysts, this decline is most likely to have been due to segments like education, which have been inactive during the lockdown. Additionally, most departments of the central government functioned at a budget that was 15-20% lower than the estimate. With holding back of dearness allowances and perquisites, an attempt was made to divert funds for the rising COVID-19 numbers.

In May 2020, it launched a suite of financial recovery measures under the Atmanirbhar Bharat package constituting Rs 20 lakh crore, which included, among others, Rs 3 lakh crores for automatic collateral-free loans for small businesses, Rs 20,000 crore liquidity support to the MSME sector, additional Rs 50,000 crore set aside for making equity infusion, revamped credit guarantee scheme covering the borrowings of even the lower rated NBFCs, HFCs and other micro lenders, government provision of 20% first loss sovereign guarantee to state-run banks, and an additional outlay of Rs 40,000 crore for MGNREGA.

Given this slew of measures, the obvious and immediate concern was that of a rising fiscal deficit. However, of the Rs 20 lakh crore aid, since most of the incentives were in the realm of credit guarantees and interest subventions, the estimated fiscal outgo for the government actually would be around Rs 3 lakh crores only. While at the outset, the fiscal target was 3.5% of GDP, the revised targets could be in the range of 6.5%-7.5%; considering not just the expenditure that has overshot forecasts, but also the inability to realise estimated revenues (taxes, interests, etc.). Against the set borrowing limit of Rs 7.8 lakh crores, GoI has come close to exhausting it with its market borrowing cumulatively amounting to Rs 7.72 lakh crores so far. And in May, we already have seen that the market borrowing limit was revised to Rs 12 lakh crores for the fiscal.

How would GoI deal with borrowings? One view that’s increasingly echoing is that GoI makes a departure and monetises the debt. Another view is that the government should now be borrowing tactically, considering the legislative route to promise or show intent to alter debt structure and set debt reduction targets for the future.

Further, there could be a one-off resource mobilisation by PSUs selling excess holdings of prime lands in urban pockets. Complementing with it, the government could also opt for expenditure rationalisation on extending tax rebates, optimizing spend on MGNREGA and increasing public investment in infrastructure to generate employment as well as to revive and sustain growth.

IBT: Some experts have expressed a fear of possible stagflation? How does the scenario for this look in your view, and what steps do you suggest to keep inflation and unemployment numbers under control?

Prof. D. Tripati Rao: A stagflation is an economic environment where high level of unemployment coexists with an inflationary trend. This situation is borne out primarily not due to a demand-pull but due to a cost-push inflation. The cost-push inflation emerging out of a negative supply shock constricts the capacity of the economy to mobilise factors of production and produce to the potential level of output.

The pandemic and subsequent lockdown have precisely set this causal chain, where labour supply and liquidity have been squeezed, negatively impacting the supply side and therefore pushing up prices. Unemployment too registered a sharp spike at the outset of the lockdown, shooting up from 7% to 27.11% in the first week of May. However, by the June 21, the rate has come down to near about 8% to almost resemble the pre-COVID levels.

Inflationary pressure will continue during the second half of the fiscal with food and vegetable inflation pushing up CPI due to continued supply disruptions. However, at present, a small rise in unemployment consistent with inflation level does not alarm to an impending stagflationary scenario, per se. But GoI must not dilly-dally any more in anticipating for an elusive V-shaped recovery. Instead, it should pre-empt a swoosh-shaped recovery and carry out, in coordinated fashion with RBI, a direct fiscal intervention pressing counter-cyclical fiscal levers to ensure that long-term potential output is not lost at any cost because of the permanent damage of productive capacity; which is what defines the trails left behind by major supply shocks!

IBT: When and how do you see the element of discretionary consumption stepping back into the equation?

Prof. D. Tripati Rao: Beginning in the last week of March, 2020, the lockdown lasted for over 2 months, thereby spiking unemployment and depressing discretionary consumption. However, by the end of June, 2020, the unemployment rates fell back to pre-lockdown levels of near about 8%, mainly due to rise in rural employment.

The rural unemployment dropped to 7.3% by the last week of June, 2020 and was only slightly higher than the pre-COVID rural unemployment level of 6.8% due to a significant increase in MGNREGA allocations. Besides, the Garib Kalyan Rojgar Yojana with an increased Rs 50,000 crores also stabilised rural consumption levels.

Out of 139 million internal migrants, the pandemic and the lockdown has gravely affected close to 40 million people as per the World Bank. With displacement and unemployment came the inevitable income loss and decreased consumption levels. Individual households almost immediately postponed their discretionary expenditure, which includes spend on consumer durables, jewellery, recreation, automobiles, among others. As per one report, an estimated US$ 45 billion of discretionary expenditure was forecasted to be stuck during the lockdown.

ET Money estimates that by June, travel expenses fell by 95%, shopping by 37%, entertainment by 61%, dining out expenses by 83%. Non-discretionary expenditure, which includes all essentials, groceries and other household expenditure, too, fell by 30% by June, 2020. As for fixed expenses like house rents, premiums, EMIs, etc, the fall has been at around 11.5%. Around 67% of discretionary spend comes from urban India and the balance 33% comes from rural areas. But in terms of population composition, it is quite the opposite – with rural India constituting 66% and the balance 34% by the urban population.

Therefore, to be able to revive consumption expenditure to normal levels, livelihoods have to be restored. While the recovered rural employment levels give some comfort, this needs to be further sustained by big scale public investment in infrastructure and counter-cyclical fiscal measures. All in all, credit availability will thwart liquidation and augment aggregate demand, and prevent the economy from falling into the vicious cycle of a downward spiral of a monumental negative supply shock and in turn, will spur economic revival.

IBT: What manufacturing/services sectors should be in focus from a policy perspective to hasten the revival in your view and why?

Prof. D. Tripati Rao: There have been some signs of economic revival in the recent weeks. We have seen that while private consumption has contracted, government consumption has increased. Also, exports increased and imports contracted. Now the imperative is to how to minimise income losses and in turn stabilise consumption through another slew of monetary and fiscal measures. Evidently, a mere loan moratorium has not proved to be very effective, necessitating an active fiscal intervention to ramp up production activities and to make liquidity available.

Fiscal fire power in the form of increased public investment in infrastructure has been the traditional Keynesian tool in the times of economic downturn. Increased public investment augmenting production capacity and income levels could revive discretionary household spending, and hence, aggregate demand.

On the supply side, it is pertinent to note that a calamitous negative supply shock of this nature brings about a temporary loss of output, but if not addressed urgently, can also lead to permanent loss of productivity or what is termed as, loss of potential output. While ensuring liquidity, credit guarantees and tax rebates, migrants should be facilitated to come back to the urban centres of activities.

Already, a large number of MSMEs have shut down during past few months, so government aid may be very instrumental in preventing further closures as well as permanent loss of potential output. This can also bring down the cost-push inflation. As per latest MOSPI statistics, CPI in July was 6.9%, of which non-core food inflation constituting a substantial portion, ranging between 11-19% across pulses, meat, etc. RBI’s monetary easing may facilitate flow of lending to farming sector. However, the central bank has pushed the pause button, apparently misreading the elevated non-core CPI. The hard-hit cyclical sectors such as, automobiles, steel and construction may need a policy package for revival. Finally, only our collective will for survival may see through the “act of God; if it is!

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Prof. D Tripati Rao is currently Chairman, Executive Education (MDP), Indian Institute of Management Lucknow. He has obtained his Ph. D. from the Department of Economics, University of Mumbai under the auspices of RBI Monetary Economics Endowment Research Fellowship and M.Phil degree in Applied Economics from CDS, Trivandrum, JNU. Prior to joining the institute, he was with XIMB and T.A. Pai Management Institute, Manipal. He has been teaching Macroeconomic Environment, Managerial Economics and World Economy, International Trade and Business to both Post-Graduate students and FPM Scholars since 2005. The views expressed here are his own.

Prof. Rao gratefully acknowledges the valuable inputs received from his students Ms. Vanga Deeksha Reddy and Mr. Ishan Mittal, IIM Lucknow.