Through the Covid-19 pandemic, India has differed from the world in three distinct ways. One, over the past few weeks, India seems to have broken the link between rising mobility and Covid-19 cases. Despite rising mobility, the number of new cases has fallen (see graphics). Although it is true that certain areas (like Delhi) have seen a new wave and things may worsen as winter progresses, so far the fear of increased mobility around the Diwali festival stoking cases has not come to bear at the national level. And the fatality rate continues to fall as the recovery rate rises.
Two, India has seen amongst the smallest fiscal support packages globally. In fact, central government expenditure has not grown in the year so far (0% y-o-y, y-t-d).
Three, high inflation seems to be a bigger problem for India than elsewhere (see graphics). In fact, CPI inflation has been outside the 2-6% tolerance band for seven months in a row. As we had expected, the dominant narrative that inflation will fall as lockdown-led supply constraints ease has not come to bear.
And we believe these three differences will mould the outlook for the economy in 2021.
Growth recovery: Strong rebound
The break in the relationship between rising mobility and cases bodes well for economic growth, in our view. A combination of pent-up goods demand, festival-led demand and elevated financial savings seeking an outlet, led to an improvement in economic growth in 2Q. For the second half of the year, while festival-led demand may wane, it could be partly offset by rising government expenditure. The government has announced new support packages in recent weeks, and tax revenues have also risen. Both of these could be supportive of some rise in spending.
With the coming of the vaccine, economy activity, particularly high-touch service activity, could get a shot in the arm. A combination of vaccination, herd immunity (for instance, in parts of Mumbai) and rising recovery rates bode well for growth in 1HFY22.
Small fiscal support: Links with inequality
It may seem at first glance that India got away easy. It was able to get on a recovery track, despite limited fiscal spending. In fact, core GVA which excludes public services rose faster than overall growth in 2Q. But a deeper look suggests that low fiscal spending could potentially leave behind other problems such as inequality. After all, a large fraction of the fiscal support packages around the world have been directed towards safeguarding the vulnerable—poorer households, labour markets and small businesses. Although it is true that in India, too, there was a focus on poor households and small businesses, some parts were not covered (like the urban poor), and overall outlays were small. Indeed, demand for the rural employment guarantee programme continues to outstrip supply.
The rising inequality between large and small firms could also be a driver of the rise in individual-level inequality. Let us explain. The corporate results in the quarter ending September were telling. Large listed firms saw a larger rise in profits. A combination of cost-cutting, lower interest rate environment, access to buoyant capital markets, and formalisation of demand are likely to have helped.
Sadly, the smaller listed firms did not do as well. And the unlisted informal firms, typically with low economic buffers, are likely to have faced acute economic stress.
In fact, it can be argued that large firms benefited in part, at the cost of smaller/unorganised firms. This could have happened in two ways. One, there has been a case of demand moving from small firms to large ones. Two, small firms tend to be vendors of large firms and delays in payment or non-payment of bills can hurt.
But, most worryingly, small firms are more labour-intensive than large firms. In fact, the informal sector employs around 85% of the labour force. If small firms do poorly, it impacts a large number of people. Data shows that small firms have cut staff costs by much more than large firms.
All of this could weigh on demand over time (though there are many channels at play, and the exact impact on growth may not be straight forward). We are already seeing early signs (passenger vehicle sales doing better than two-wheeler sales). Indeed, rising inequality is a scar that the pandemic is likely to leave behind.
Elevated inflation: Beware services inflation
But this is not where it ends. Rising inequality could have other side effects. It could stoke inflation in our view.
Let us explain. India has had a troubled past with services inflation. What we learned was that once it takes a stronghold (for instance, in 2011), it remains elevated for a prolonged period (it averaged 7.7% in the 2011-13 period). Services are non-tradable, and price pressures can’t be traded away as is possible with goods. And raising supply capacity takes time. Think health and education services, for example.
For three reasons, it is possible that services inflation rises quickly in 2021.
One, as large firms and their employees do relatively well through this period, they are likely to demand more services, stoking services inflation. Consumption patterns show that the rich in India tend to consume more services than the poor. And rising inequality could, therefore, stoke prices.
Two, as a vaccine comes into play, there could be a wave of pent-up (high-touch) services demand in the same way there was a wave of pent-up goods demand in 2020.
Three, many service providers did not do the regular annual price reset in 2020, and may do it jointly for two years, once demand picks up.
If inflation does become persistent and leads to tighter monetary policy, that could weigh on growth over time.
Growth versus macro stability: Coming full circle
Putting all of this together, India’s experience over the past few months has differed from the rest of the world. And these differences could shape the outlook for 2021.
One, growth could recover smartly. Two, lack of fiscal support could stoke inequality. Three, the rise in inequality along with pent-up services demand could stoke inflation.
Alas, India will have come full circle. For a while it worried more about growth than inflation. But as growth recovers, inflationary worries could reappear.
Indeed, inflation control could be the main task cut out for policymakers in 2021. We no longer expect a 25bp repo rate cut in this cycle, and see the repo rate remaining at the current 4% for a prolonged period.
Instead, RBI may have to take steps to gradually drain the excess liquidity in the banking sector, provide a floor for short end rates (which have fallen below the reverse repo rate), and finally narrow the policy rate corridor by raising the reverse repo rate. The corridor is 65bps wide at present, versus 25bps in early 2020 (and before). So, technically, the reverse repo rate could be lifted by up to 40bps over time.
(Excerpted from HSBC Global Research report ‘Where India differs from the world’, dated December 11, 2020)
Bhandari is chief economist India and Chaudhary is economist, HSBC Securities and Capital Markets (India) Pvt Ltd; Mehrishi is an associate