Economics in the Time of Corona (COVID-19): Digging into the Past Can Help
The year 2020 has commenced on a very bad note. The novel Coronavirus, now COVID-19, emerged in mainland China around January and has spread to over 170 countries. In a world where the existing body of work on economics was struggling to explain prolonged economic headwinds since the 2008 crisis, the pandemic has ensured that this struggle continues for some more time as there is no settled link between models of economics and those in epidemiology.
 
The peculiarities of the post-2008 world were always visible and, yet, were conveniently ignored. The rate of interest remained low in most parts of the developed world, but economic growth never picked up to what was its potential. The unbated expansion of money supply did not deliver inflation and prices of commodities, manufactured goods continued to fall, while those of financial assets rose. However, the final link appears to be snapping with the conterminous fall of the Dow when the Federal Reserve of the US cutting the benchmark interest rate to near zero,.    
 
Then, financial markets saw something that was unheard off in standard textbooks of finance—sovereign bonds carrying a negative interest rate. The new trend has caught up and around a quarter of all bonds issued now have negative interest rates. A negative interest rate is a virtual deathknell for banks, unaccustomed to charging a fee for placing deposits with the bank. 
 
Back at home, just like COVID-19, the economy was showing asymptomatic signs of distress. Even though the savings rate was falling, the growth outlook continued to be optimistic. Then slowly, the decline in consumption, which was already visible in sticky GST (goods and services tax) revenue collection, also became pronounced. The price of capital goods fell dramatically relative to other prices in advanced and emerging markets and developing economies alike, notes the IMF (International Monetary Fund) in April 2019. Yet, investments continued to remain stagnant.  
 
In a bid to steer the economy to a higher growth path, the RBI (Reserve Bank of India) adopted an inflation targeting framework in 2016, when it was not delivering desired results anywhere in the world. Since the adoption of inflation targeting, the repo rate has been cut to 5.15%, but surprisingly, both the GDP growth and repo rate have moved in the same direction—southwards. The rate of transmission continues to be weak, and even when MCLR (marginal cost of fund-based lending rate) credit has not picked up. Now, RBI is reviewing the flexible inflation targeting framework internally! 
 
Since we live in the time of Corona, it may be useful for us to adopt a trick quite well known to doctors, but not to economists. Doctors, at times, treat antibiotic resistance by prescribing an older version of the medicine, which is no longer prescribed. Thus, going back in the annals of economic history may provide a good vantage point to revisit some of the naïve assumption we make today.
 
Apparently, there is one problem with this approach. It is not clear which lens of economic theory is best suited to view India—is it the new Keynesian lens, neo-classical or neo-liberal etc. But if we ignore this for the time being, then literature of the Austrian School provides some useful insights. 
 
In his work, the Theory of Money Credit & Interest Rate, Ludwig Von Miss investigated the theoretical possibility of reducing interest rates to zero. This, of course, is true only under the assumption that fiduciary media enjoy the confidence of the public. But if the time preference (that is willingness to postpone or prepone future consumption) becomes agnostic to changes in interest rates no amount of policy rate change will impact real activity. The present state of affairs is no different. Hence, at time of Corona, RBI must think twice whether it should reduce interest rates further in response to the COVID-19 crisis.
 
Another scholar from the same tradition, a son of the soil, BR Shenoy, wrote two important papers in 1932 and 1934 on how the price of consumer goods and capital goods interact to determine overall price level. He challenged the Keynesian notion that banks have the direct capacity to determine the price of capital goods.
 
He conclusively demonstrated that the “banking system in whatever way it may behave cannot directly influence the price of capital goods.” Mr Shenoy’s logic suggests that to emerge out of the slough of a credit cycle, savings must be promoted, which internally adjusts the current account. The policy must address the reasons for erosion of profitability in the domestic capital goods sector. A combination of the above will reverse the deflationary trend and expand the GST base.
 
Sadly, the entire range of policy responses is exactly in the opposite direction. The effort is not to promote household savings but consumption. As a result, deposit rates have been slashed across the board. A better option would have been to link deposits of the government sector, private corporate sector, financial sector and foreign sector (with respective shares in the total of 14%, 12%, 8% and 10%) to an external benchmark, say G-Sec, while leaving household deposits at fixed rate.
 
This would have brought 44% of the banking system’s liability to market-based pricing, enabling better transmission on the asset side. Measures like operation twist would have a better chance of success if the liability side of the banking system is linked to an external benchmark as explained above.  
 
In conclusion, there is a long way to go before an economic understanding of India, on its own terms, will develop both in RBI and in the government. The voices of those rare experts who understand India on its own terms never make it to the menu of options. Hopefully,  these voices will get seriously heard in the time of Corona which has opened a window of opportunity to initiate serious structural reforms. 
 
(The author is an economist in the banking system. The views expressed here are personal)
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    COMMENTS

    Ramesh Popat

    8 months ago

    will India's rating be the same as it is?

    chandragupta

    8 months ago

    Such a pleasant surprise to see someone write about Austrian School of Economics, Ludwig von Mises and even B.R.Shenoy! You have hit the nail on the head - the entire mainstream economic thinking is wrong. Until the world gets rid of this, global economic problems will not be solved. But who wants them to be solved?

    S&P lowers India's growth prospects to 5.2% in 2020
    Global credit rating agency Standard and Poor's (S&P) on Wednesday lowered the forecasts for India to 5.2 per cent from the earlier 5.7 per cent.
     
    In a statement S&P Global Ratings said: "We lower our forecasts for China, India, and Japan for 2020 to 2.9 per cent, 5.2 per cent and -1.2 per cent (from 4.8 per cent, 5.7 per cent, and -0.4 per cent previously)."
     
    According to S&P, the timing of a recovery depends, most of all, on progress in containing Coronavirus spread.
     
    "Even if major progress is made during the second quarter, after a sustained period of stressed cash flow many firms will be in no position to resume investing quickly. Households that have either lost their jobs or have worked fewer hours will spend less. Banks will be busy managing the deterioration in asset quality. There will be pent-up demand but the longer the crisis drags on, the weaker it will be," S&P said.
     
    Citing its report titled "Asia-Pacific Recession Guaranteed" S&P said the economic growth in 2020 in the region will more than halve to less than three per cent as the global economy enters a recession.
     
    "An enormous first-quarter shock in China, shutdowns across the U.S. and Europe, and local virus transmission guarantees a deep recession across Asia-Pacific," Shaun Roache, the chief Asia-Pacific economist at S&P Global Ratings was quoted as saying in the statement.
     
    According to S&P, by recession, it means at least two quarters of well below-trend growth sufficient to trigger rising unemployment.
     
    "Our estimate of permanent income losses is likely to at least double to more than $400 billion," said Roache. "For credit markets, a key question is how these losses are distributed across sovereigns, firms, banks, and households."
     
    According to the statement, China is gradually recovering from an enormous economic blow early in 2020. February data confirm a huge shock to activity in the first quarter. Investment accounts for about 45 per cent of China's economy -- and fixed asset investment in January and February combined plunged by almost 25 per cent compared with a year ago. Over the same period, industrial production and retail sales fell by 14 per cent and 21 per cent.
     
    "These are unprecedented numbers," said Roache. "This not only confirms a hard hit to China's growth but indicates that the authorities are not smoothing the data."
     
    External shocks from the fallout of global viral spread add a new dimension. People flows from the US and Europe will be decimated for at least two quarters, heaping more pressure on the tourism industry.
     
    The global policy response, including the Federal Reserve's policy-rate cut to zero and the Bank of Japan's scaled-up asset purchases, will help cushion but not quickly reverse these shocks. Local measures aiming to support vulnerable sectors and workers may help but their effect will wane the longer the crisis lasts.
     
    The amplifier of the real economic shocks, which has taken an outsized role, is tightening financial conditions. This could tip an economic recession into financial stress, said S&P.
     
    "If lingering uncertainty results in a strong preference for US dollars, policymakers in Asia's emerging markets may be forced into a damaging round of pro-cyclical policy tightening," Roache said.
     
    "The countries most vulnerable to capital outflows remain India, Indonesia, and the Philippines," he said.
     
    "The scars that may be left on balance sheets and in labour markets threaten a more drawn out U-shape recovery in Asia-Pacific," said Roache.
     
    Disclaimer: Information, facts or opinions expressed in this news article are presented as sourced from IANS and do not reflect views of Moneylife and hence Moneylife is not responsible or liable for the same. As a source and news provider, IANS is responsible for accuracy, completeness, suitability and validity of any information in this article.
     
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    COVID-19 Could Adversely Affect Output and Prices. India Needs Both Monetary and Fiscal Policies To Handle the Pandemic, Says SBI
    India has, till date, responded quite well to the coronavirus (COVID-19) crisis, though the financial markets have been significantly impacted. Though India has already taken a plethora of steps to prevent the spread of coronavirus, all eyes are now on the rise in active cases in the current week and next, as global experience shows the jump in second week of active cases is around seven times compared to first week. State Bank of India (SBI) says it thus expect aggressive social distancing to be implemented by government and states immediately.
     
    In India, the number of active cases rose to 114 with 15 fresh cases in a single day. SBI says, when we analyse the occurrence of active cases in seven most affected countries apart from China, we have found out that in the second week, the number of cases jumps almost seven times compared to in the first week. In some countries, like Iran and Spain, even the active cases rose to 13 times in second week compared to in the first week.  
     
    Interestingly, the report points out that corona has affected population age-wise, shows that maximum fatality (74%) has been in the 65+ age group. This has the potential to lead to a demographic change the world over, feels Dr Soumya Kanti Ghosh, group chief economic adviser of SBI.
     
     
    According to Dr Ghosh, There is no standard theory on how to tackle a pandemic situation like COVID-19. "The policy prescription will depend upon the possible impact across the sectors due to inoperability in sectors impacted by the pandemic.
     
    "A global package looks expensive as the importance of individual sectors in the overall forward-backward linkage is not the same. A sector specific response notably the strategic sectors along the domestic global supply chain appears more cost effective. Concomitantly, there is need to revive consumer demand. This may be done through an employment generating package targeting the efforts to contain spread of virus," he added.
     
    On the demand side, Dr Ghosh from SBI says, "inoperability analysis for three sectors namely transport, tourism and hotels show significant impact on demand and hence output. On an  aggregate basis, we estimate that the impact of a 5% inoperability shock could be 90 basis point (bps) on GDP from trade, hotel and transport and transport, storage and communication segment, that could be spread over FY20 and FY21, with a larger impact in FY21."
     
     
    On the supply side, SBI says, China is an important source of critical inputs for many sectors. "Supply shock is akin to higher price of inputs which in turn affects the price of all the commodities up the supply chain. The impact of supply perturbations in the system in terms of cost-price increase in output due to increase in prices of value-added input brought about by shutdown in China or assumed price escalation of 5% is maximum for - chemical and chemical products, electrical and non-electrical goods, metals and metal products, textiles and transport equipment about 7-8% increase in prices," it added.
     
     
    SBI feels, a simultaneous demand and supply shock to the economy will also have implications for the banking sector. It says, the demand side shock is expected to lead to an output loss of 1.2% in banking and insurance combined.
     
    According to the report, during the current COVID-19 outbreak, a combination of monetary and fiscal policy could be the best option.
     
    "In particular, on the monetary side, the first best option is maintaining a proactive liquidity regime and facilitating stability in financial markets through unconventional measures. The monetary stance may be eased temporarily through a rate cut by Reserve Bank of India (RBI) to accommodate the possible surge in liquidity demand and shock-related price increases. An adequate supply of cash notes to banks needs to be ensured that can meet a sudden increase in the demand for liquidity." 
     
    "RBI may also need to consider a degree of prudential forbearance in specific sectors like hotel, aviation, transport, metal, auto components and textiles. Furthermore, given the risk of using currency notes in times of pandemic, incentivizing digital payments further could be an effective solution in the current circumstances," it added. 
     
    SBI says it believes the arguments of RBI cutting rates has more to do with coordinated policy actions by the central banks. "More crucially," it says, "deposit rate cuts and hence lending rate beyond a point is counterproductive and actually creates perverse flows into liability products that are offering higher interest rates.
     
    "This could always be a recipe for future problems, if assets and liabilities are not properly matched, as the experience of Yes Bank shows." 
     
     
    In addition, pandemic shock has an embedded adverse supply shock angle as China is the supplier of many critical inputs. "Hence only a rate cut in current situation with no fiscal measures will lead to asset bubble and possibly no correction in demand. Concomitantly, there is need to revive consumer demand," the report says.
     
    Commenting on fuel prices, Dr Ghosh says, on the fiscal side the nearly 30% fall in crude oil prices could lower the petrol prices by Rs12 per litre and diesel prices by Rs10 per litre in India from their present prices. The additional revenues of Rs35,000 crore-Rs 40,000 crore accruing to Centre from increasing the excise duty could be spent on providing relief to people at the lower strata who will lose income because of shutdown of commercial activity in states.
     
    After the success of its $2 billion USD and Indian rupee sell-buy swap (RBI has received bids worth $4.67 billion), RBI has announced one more round of USD/INR sell-buy swap. "This is a welcome move as it will address dollar shortage and also push up the forward premia in the process. This could discourage speculation and clearly address the pounding of Indian markets with foreign institutional investors (FIIs) selling around $9.2 billion beginning 20th February," the report added.
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