Think Tank

India: Economic Impact of Covid-19

Ananth Narayan, Associate Professor of Finance at SP Jain Institute of Management and Research

Unlike with the 2008-09 Global Financial Crisis (GFC), India entered the Covid-19 crisis on a weak footing. Growth was slowing, the fiscal position was precarious, a number of key sectors were distressed, as was the financial system. Given the severity of the crisis, the Indian economy will undoubtedly suffer a body blow and it will take time to recover. The silver lining, however, is that Covid presents a unique opportunity to unleash bold reforms. At recent online sessions of the India CEO and India CFO Forums, Ananth Narayan, Associate Professor of Finance at SP Jain Institute of Management and Research, outlined what the next few quarters could be like for India.

A weak financial system, with crisis-ridden NBFCs and an overhang of NPAs...

…chronically stressed sectors such as power, real estate, shipping, airlines and telecom...

...and a lack of jobs

Entering the crisis weakened...
In at least three ways, the Indian economy entered the crisis far removed from being in the ‘pink of health’:

  • First, the very engine of economic growth – the financial ecosystem – was fragile, and poorly placed to extend credit to industry or consumers. This is despite India having a much smaller banking loan book than China: 50% of GDP compared to over 200% in China. Officially, banking non-performing assets (NPAs) are pegged at 8.6% of advances, but the real number is closer to 12%. This is because of the generous forbearance that is allowed for loans to MSMEs and certain classes of real-estate. Moreover, unlike with banks, NBFCs are not subject to proper asset quality reviews and hold large volumes of non-performing loans themselves.
  • Second, several key sectors – including real estate, power, airlines, shipping, telecom, automobiles and a large proportion of MSMEs – were in a state of chronic distress. At 68.6%, capacity utilisation in December 2019 was at a historic low.
  • Third, there are simply not enough job opportunities for a young and growing population. India’s ‘demographic dividend’ is considered to be one of its greatest advantages. However, it has been unable, so far, to reap this dividend. In fact, the workforce participation rate is just 34% (and declining), and women account for just 17% of GDP. There is also a huge under-employment issue, with 44% of the population engaged directly in agriculture, which accounts for just 16% of GDP. Rural youth unemployment is a staggering 20%.

India is already running a huge fiscal stimulus

...and with a history of ‘print and spend’
Some might criticise the government for being fiscally too prudent even in the face of a devastating crisis. The reality is that it has been following a ‘print and spend’ policy for years. Officially, the fiscal deficit (Centre + states) is 5.9% of GDP; in fact, after including PSU borrowings, it is closer to 9.7%. At the same time, domestic corporate and household savings were just 6.5% of GDP in FY19, while net FII inflows into debt and equity have averaged less than USD 3 billion a year for the last 5 years. (In March alone, there were FII outflows worth USD 16 billion from India.) Thus, to bridge the widening gap between government borrowings and savings, the RBI had been printing money, purchasing government bonds and transferring large surpluses to the government. This helped to prop up growth. In fact, were it not for the 12.5% growth in government spending in the third quarter of FY19, economic growth would have been under 3%, compared to the official 4.5%.

There are no guiderails on which to base forecasts, but the prognosis is weak

Bracing for an economic ‘body blow’
In forecasting the impact of Covid-19, the only historical reference point is the Spanish Flu, which occurred a century ago, went on for three years and came in three separate waves. Thus, India is today flying blind in many respects. What is certain, however, is that it will face significant economic stress and perhaps social unrest. Many economists are projecting FY21 growth at 1-2%, but realistically, the economy is likely to contract mildly (~-1%). Moreover, unemployment will balloon, the fiscal deficit will widen dramatically, inflation will perk up and the Rupee will come under downward pressure. This outlook rests on several assumptions:

Most of the economy is locked down and will take time to recover

Contract workers and the self-employed will suffer the most

The government will be forced to ‘print and spend’ even more…

…but it cannot do so endlessly

Risks on the horizon: inflation, a rising CAD, a falling Rupee…

…and possibly, a ratings downgrade

  • 64% of the economy has been under complete lockdown for over a month, with no guarantees as to when it will open up. These sectors which will open up only gradually, operating perhaps at 70% of capacity in the first month, at 90% three months down the road, and may thereafter grow at a 5% rate for the remainder of the year. The 36% of the economy that has remained ‘open’ – agriculture, food products, healthcare, utilities and public services – can at best hope to grow by 5% for the year as a whole. None of this accounts for the impact of the lockdown on the financial health of companies.
  • Currently, just 17% of India’s workforce is salaried. 37% of workers are casual/contract labour on daily wages and 46% are self-employed. Thus, roughly 83% of the workforce comprises of self-employed and daily wage workers, who are likely to face deep distress. This will filter down into businesses across multiple sectors, and into the financial system. Over a quarter of all fresh advances – including loans for commercial vehicles, construction equipment, transport, hospitality and MSMEs – are likely to come under scrutiny solely because of Covid-19. This could cause NPA levels in banks and NBFCs to spike to 20% or more.
  • On account of these factors, the government will have no choice but to ‘print and spend’ on a bigger scale. This spending will be used to provide emergency medical relief; put money and food into people’s hands; ensure critical government services such as power, water and municipal services; shore up MSMEs; and bail out banks and NBFCs. All of this will cost a minimum of 2-3% of GDP. Factoring in a collapse in tax collections and disinvestment receipts (which are budgeted at Rs 2.1 trillion), and even if non-essential capital expenditures get deferred, the overall deficit will jump to 16% of GDP or higher.
  • Unlike the developed world – Europe, Japan and America – India is in no position to endlessly ramp up spending. The US plans to increase the deficit to 10% of GDP, and Japan to as much as 20%. However, India does not have the advantage of printing a ‘hard currency’ that can be ‘exported’. Further, while ramped-up public spending might temporarily spur growth, the excess demand it generates will not necessarily translate into domestic output or jobs. Instead, in the absence of domestic capacity, it will push up imports.
  • In the short run, the RBI has adequate reserves to prop up the Indian currency. Moreover, while exports and remittances have collapsed, so have imports. This means that India will probably see a current account surplus rather than a deficit this year. However, a bit further out, excess liquidity will drive up inflation, fuel the demand for imports, push up the CAD and pull down the currency. Still, considering that the Rupee was over-valued by nearly 16% before the crisis, a gentle depreciation may actually prove beneficial.
  • A large fiscal deficit also raises the risk of a ratings downgrade. India is currently at the lowest investment grade (BBB-), and were it to fall by one notch, it would enter the junk-bond category. Not only would this be a political ‘hot potato’, but it would also cause foreign investment to dry up.

India is at a crossroads, but is likelier to opt for reforms than populism

Post-Covid: Strong policy reforms are imperative
Today, the government finds itself at a policy crossroads. In the worst case, it could respond to the crisis by reverting to 1970s style populism, which might include re-imposing the wealth tax, hiking income tax rates, creating a new ‘licence Raj’ and even closing off the economy to imports and foreign investment. Hopefully, though, it will use this as an opportunity to drive through critical reforms in several areas, including land and labour laws, contract enforcement, judicial processes, infrastructure, and other constraints that hamper the ‘ease of doing business’ in India.

Focus areas: the financial sector…

…stressed industries…

…factor market reforms…

…and health and education

  • The financial sector needs to be cleaned up so that it can start funding economic growth. This might include setting up a ‘bad bank’ that absorbs stressed assets, and following that up with governance- and market reforms
  • Chronically stressed sectors such as power, real estate, airlines and shipping, telecom and MSMEs need to be made viable. For MSMEs, the government may choose to provide a line of credit or guarantees to the extent of taxes paid by the entity in the previous year. Essentially, this would enable a flow of funds at reasonable rates, guaranteed by past tax payments.
  • Factor market reforms are required to create jobs and make India a more attractive investment destination. India should also leverage today’s favourable external conditions, such as subdued oil prices (to build up its oil reserves) and anti-China sentiment (to position itself as an alternative destination). However, China’s loss will not automatically be India’s gain. Even during the Sino-US trade war, it was countries such as Vietnam and Bangladesh, with their stronger factor markets, that drew in supply chains from China. India must also be aware that as the world moves from globalisation to localisation, any fiscal stimulus that is not accompanied by reforms will simply drive up imports. The imperative is to be able to manufacture domestically, thus creating jobs and output that cater to the local economy, and which in time, may even produce a surplus for export.
  • Focus on healthcare, nutrition and education. On the one hand, this will mean building employable skills that can secure jobs for India’s most important assets – its youth. On the other hand, it will mean spending more on fostering a healthy and productive workforce. Currently, nearly 40% of five-year-olds in India are under-nourished and the money spent on well-being of the youth is abysmally low. Changing this would go a long way.

India still enjoys goodwill abroad

Turning crisis into opportunity
The silver lining for India in this time of crisis is that it continues to enjoy immense goodwill abroad. However, it will need to capitalise on this by focusing on health and education, and bringing in major economic reforms. If any government can achieve this, it is the NDA, which enjoys enormous political capital and a strong track record that includes the Insolvency and Bankruptcy Code (IBC), the GST, and corporate tax cuts. Finally, as the 1991 reforms proved, there is no better time than a crisis to effect sweeping change.