The government must work on a credible fiscal consolidation strategy once crisis settles. For now, fiscal support must be spent such that it can be credibly redeemed
Five things are evident about the corona shock. One, the core ‘lockdown’ response to manage the pandemic inflicts ruthless economic damage, within and outside India. Two, the devastation spans sectors, firms, businesses, services and consumer spending, production, capital, and labour markets. Three, the loss is impossible to quantify due to high uncertainty about its extent, duration, and persistence. Four, fiscal interventions on a massive scale need to be undertaken urgently, along with monetary and regulatory measures. And five, the government had no fiscal latitude whatsoever, even before the virus shock.
A preceding article (bit.ly/3dsCRBt) in these columns focused on the need to be mindful of debt in crafting a fiscal response to the virus shock. In spite of the debt buildup, massive fiscal support is an urgency demanded on both moral, and real economic grounds. The perverse paradox here is that minimal loss of health and lives is achieved through the maximum economic sacrifice! The devastation is induced as the state is compelled to enforce lockdowns and closures, bringing most economic activity to a standstill. Such stoppages at this scale, and for an unknown duration, were not seen at the time of the 2008 financial crisis. It is far more extensive, having direct and second-round effects on output and employment, some of which could become permanent, and compounded by the global lockdowns.
The virus shock, thus, exceeds the 2008 one manifold. Output growth then fell 4.57 percentage points, to 3.1% in FY9 (FY05 GDP series). But, public, private, and household balance sheets were in good shape—healthy, and profitable. The financial sector, and banks were strong and resilient, and this helped weather the 2008 crisis, which arose from financial sector troubles abroad. India stood out then with a sharp recovery. By comparison, the virus shock strikes in a much weaker, more vulnerable context: A three-year long slowdown, all segments—government, financial, private non-financial, and household sectors—strained and indebted, and a vulnerable financial system. These point to lowered bounce-back abilities. Notwithstanding, fiscal policy has to carry the weight of response, given its reach and impact.
How to quantify, and devise the corona stimulus are difficult questions. Quantification is near impossible because of the high uncertainty. Whether the government should absorb all, or some of the losses to business and consumers is a hard choice. Which sectors to support, and how much, is yet more difficult—this choice is as much political as it is economic. Targeting, particularly when four-fifths employment is informal, is equally difficult. Economists have advocated various measures, and the government is probably studying these.
As regards the size of the corona stimulus, perhaps the 2008 crisis shock—the magnitude of fiscal response (about 2% of GDP), and after-effects on balances, growth outcomes, balance sheet effects, and so on—could be useful indications.
The guiding principles of the corona stimulus must be twofold. One, all expenditures should be sensible. And two, the expenses should be consistent with a plan for how to redeem these. Because the pandemic’s duration remains uncertain, it might be useful to think in terms of immediate fiscal response. The first line of fiscal intervention has to be urgent income support, aimed at those most vulnerable to the sudden stop in activities. If, it extends longer, the government will have to balance a maximum offset of the temporary shock for a quicker rebound to avoid a chunk of it descending into a permanent output decline. This question will surface a bit later as the horizon clears. Sectors, firms, and businesses will have to be provided relief for the death or destruction of the weak and weakened raises the spectre of permanent loss of output and jobs.
How to finance the stimulus? The government’s deficit will overshoot by a mile as all revenues—tax, nontax, and disinvestment—will shrink from lockdowns, and collapse in asset values. But, that does not decouple overspending now through issuance of fresh debt and future repayment. Policymakers are guided to an excellent recent article on this by Keynes’ biographer, Robert Skidelsky, (bit.ly/2J71Xrr). Borrowing to finance a stimulus to support and revive comes with risks, which have played out very recently, i.e., crowding out, and negative effect on growth. Despite lower borrowing costs with help from the central bank’s LTROs, future interest payments will mount high.
Therefore, debt, relative to annual economic output, will rise. The critical question here is that of debt sustainability. This is forward-looking, and depends more on trend than on cycles supported by macroeconomic policies, or productivity increase that generates sufficient and stable primary surpluses to lower the debt-GDP ratio. The price will be paid either through more inflation, or raising taxes if future trend growth fails to rise on a sustained basis. This is why rating agencies differentiate in debt tolerance for emerging economies, and that for countries like Japan. The latter can sustain debt even at 200% of GDP because of long periods of stable growth from trade and rise in productivity, which provides confidence to investors.
India does not have that advantage: It has had only eight years of rapid growth, insufficient rise in productivity for significant raise in per capita income levels, and has never run lasting primary surpluses. Debt-GDP levels have benefited from cyclical factors alone. Its history is marked with low policy efforts that repeatedly drive fiscal situation to distressful levels; in the last decade, political economy has excessively inclined towards unproductive current spending. Investors, who are not benevolent, do not overlook these. It is also not certain if potential or trend output has lowered; certainly, the inability of GDP growth to recover to pre-crisis rates, and repeated falls after macroeconomic stimuli have worn off, suggest so.
So, a credible redemption plan is necessary. We suggest budgeted expenditures as the starting point. The clarity of immediate fiscal response, viz. income support, helps distinguish between current and capital spending, components of which should be quickly identified to switch towards a corona stimulus. Welfare spending that overlaps with stimulus objectives can be fully reoriented—the largest, or food subsidy expense, can be substantially subsumed under this. Capital expenditures with longer payoffs can be postponed, along with temporary diversion of other, inessential spending.
But, this may not be enough. Over the next few years, the targeted income relief can be financed through a phased reduction of the food subsidy. Even a 20 bps reduction, to a manageable 0.3% of GDP, will release permanent resources to recoup excess spending now, structurally improve public spending quality, reassure investors, and avoid adverse market reaction. Bailout or relief to organised sectors, firms, and businesses can also be attached with strings, e.g., equity-sharing, future sharing of profits through higher taxes, privatisation proceeds, and so on. The government should consider telling the public this is a crisis in which future pain, or burden sharing, is required for economic recovery and restoration.
The Finance Commission is reported to have set up a panel for fresh fiscal consolidation roadmap for the Centre and the states, recommend definitions of deficit and debt for overall states, general government and public sector enterprises, and all explicit and measurable sovereign liabilities, and make consistent the definition of stocks (debt), and flows (deficits). No doubt, the panel will examine these issues.
For now, the government should provide urgent fiscal support that is spent sensibly, and can be credibly redeemed.
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