Massive intervention in the capital markets to greatly enhance liquidity and reduce the policy rates would be necessary. Otherwise the financial sector would tumble like nine pins.  We suggest a rate cut by 1.5% and massive injection of liquidity well above the reverse sterilization requirement following from the capital flight out of India.  A fiscal stimulus package of around 2.5 to 3.0 % of GDP with large cuts in the GST, tripling of the allocations under NREGS to include an urban oriented employment scheme and around an additional Rs. 1.2 lakh crore for direct expenditures by the Central Government

 

The COVID19 situation is essentially a massive negative shock to the financial sector, to the payments mechanism (potentially), and to aggregate demand and to supply; not to speak of its vast impact on specific sectors. In its combination of all these impacts, it is for the first time that the world has witnessed anything of this nature. Moreover, India unlike in 1997 or even in 2008 is far more open so that while the crisis is international in origin and some of the impact is unavoidable much would depend upon the response of the government and the RBI. Here we confine ourselves to the impact on the economy that is of an immediate nature, and the counter actions that are required if our economy has to come out with the least amount of damage. The medical and human side is being taken care by the government about as well as it could have been.

MONETARY MEASURES

The first impact is on the financial sector, as the FIIs and others pull out their investments. These have been averaging at the rate of around billion dollars a day or more from both the bond and equity markets. While DFIs have been buying in part the impact of the pull out can never be compensated by the DFIs investing, since not only is the pull out on a scale that would hurt the DFIs if they have to fully compensate the sales leading to pull out, but the two are not equivalent when considered at the macroeconomic level. Pull out by the FIIs reduce the NFA (since the RBI cannot allow the rupee to drop precipitously at this juncture – certainly not more by than 10%) the base money is affected to the extent of the pullout in rupee terms (the fall in the NFA), which reduces the liquidity (M1, M3) in the system by the extent of the pull out times the money multiplier which is (1.3, 5.54) respectively. Thus a three times liquidity effect is likely when the pull out takes place without “reverse sterilization” i.e. without compensating expansion of domestic credit (DC)  through open market operations. Other operations such as rupee dollar swap, and short term repos do not have the same impact since they do not take into account the multiplier effect of the pullout, or are at best temporary.  Indeed, repos are not the way forward since the requirement of even the replacement equity is not temporary, nor is it small for the fine tuning that the repo window is all about.

Hence the minimum OMO that needs to be done is to the extent of the cumulative pull out. To the extent that the pull out is on a day by day basis, it is important for the RBI to change tack and do OMO on a daily basis at least matching the extent of the pull out. This is imperative. Other measures like reduction in CRR and SLR would not be quick acting, nor would they have the same measured effect.

Moreover, it is important for the RBI to reduce the “policy rates” the repo and the reverse repo, since otherwise the open door aspect of the reverse repo would mean that the domestic BSFIs would park the additional liquidity at the reverse repo, which rate is well above what should be in the current context of monetary policies in the advanced countries. There have been instances when the low end bond/t-bill rates were well above the repo implying that the RBI was in effect attempting to determine both money and rate which is not possible without a credit rationing. 

In times of high uncertainty the demand for liquidity rises. In India this was already high before COVID19, given the problems with the financial sector and the uncertainties with regard to the policies in a number of real sectors including the auto sector.   It is inevitable that the only action possible by the central banker would be to feed this demand, unless of course the government could have reduced the uncertainty in important sectors.   Now the uncertainties added by COID19 further increase the demand.

Cashflow insolvency in a large number of economic activities following the shutdown and other similar responses to the COVID19 in India, is inevitable. To keep these entities from becoming balance-sheet insolvent would be extremely important. At this juncture, the usual credit (actually credit*duration by both reduction of credit and of duration between business entities) is likely to decline since there is uncertainty of who would go bankrupt ultimately. To compensate for the same (even if it can be done so only in part) would require additional liquidity injection, above the usual when considered in relation to the nominal GDP.

 

The reduction of over 150 basis points decline in the repo could be best done timing the same with further adverse headwinds from the external world. However, at all times it would mean that the necessary OMO needs to be done with the repo window held wide so that the low end bond yields are always collared by the repo and the reverse repo. As the rates come down it makes sense to narrow the distance between the two. Holding the repo window open would reduce the uncertainty in the financial markets and even buffer some of the uncertainties emanating from global capital markets. The immediate task therefore would be to carry out OMOs to bring the low end bond yields by 50 basis points as the repo is brought down to 4.65 and the reverse repo to 4.40.

 

For quite a while until the uncertainities in the advanced (reserve currency) countries –especially the US - reduce considerably,   net outflow from India and other emerging economies, but in a highly variable way is likely. Hence once the rate is brought down by 50 basis points, it may be necessary to put the same on auto-pilot which is done by opening the repo window wide, and carrying out OMOs before the banks have used their excess SLR through the repo. The free securities held by banks and on OMO in relation to their deposits should begin to fall as the repo rate and yields fall and uncertainties reduce, allowing them to lend more.

 

Exchange management is an integral part of monetary management. The RBI has been responding to the outflows by increasing the sale of dollars /dollar designated assets. This is as it should be. The rupee has fallen to about Rs 75 to a dollar. Since the dollar has appreciated on account of capital flight back to dollar designated assets and to dollars relative to all other currencies, continuing to hold the rupee at Rs 75 is seemingly suggested, since the macroeconomic understanding is that exogenous capital flows (especially of the short period variety) should not be allowed to determine the rates.  However, since India faces the COVID19 with countries like Vietnam and China which have large undervaluation built into their currency levels over a long period, it would be desirable to let the outflows push the rupee down gradually to about 80-85, but then to be able to hold the same at that level, without threat to the dollar holdings of the country as a whole.

 

As interest rates fall the slope of the yield curve should also fall. To achieve the same quickly, OMOs that purchase bonds of maturities all the way to 10 years would help. This may be necessary to nudge the local capital markets into expecting that the RBI is serious about low interest rates.  For the banks which have had to face much uncertainty, the yields on government bonds of longer duration would have to fall.

Following the first reduction in interest rates by 50 basis with the associated expansion in liquidity,  the RBI would have to expand its mandate to be able to buy the stock and debt of AA rated finance and other companies, including some of the banks. Next it would have to bring the rate down by another 100 basis and prevent the rupee from rising even if there are short term surges in capital inflows.

 

FISCAL MEASURES

 

The lockdown is expected to bring down sales in the overwhelming number of industries to a standstill at least for a month with zero or negative growth over the coming quarter at the very minimum. Overall growth is likely to fall to 2 % from its projected and budget assumed 5%. It may already be at 4% or thereabouts thanks to the mess in the financial sector and the massive slow down  going on to a quarter at the very minimum. The spending multiplier effects are likely to be large and quite quick unlike during the demonetization when the consumption spending reduction was much delayed, since there were expectations, among much of the informal and smaller businesses, that the economy would revive once “black money” had been replaced. In contrast, the effects of the shutdown are likely to be across the board leaving almost no economic activity unaffected directly. That it would quickly kill demand  through the spending multiplier is only to be affected. The immediate effect is likely  to result in a fall so severe that many businesses are likely to go insolvent and would have to sell their assets to meet even  their holding out operations. Only a quick reversal of the shutdown (in less than 2 weeks which the virus is unlikely to oblige)  can negate this conclusion

 

With a prolonged shutdown even larger fiscal stimulus than the suggested 2.5 to 3.0% of GDP would be required.

 

The more medium term measures which are likely to become functional once the shutdown is over would be to use the workable instruments to increase spending in a very significant way. A fiscal stimulus that is at least of the order of 2.5 to 3.0% of GDP would be required.  Without any intervention strategy the growth may well go negative. We have made the assumption that the growth is likely to decline to at least 2% in real terms over the previous, a decline of nearly 8% in nominal terms from the budgeted GDP for 2020-21.

 

The good thing is that the demand multiplier in a recession to fiscal stimulus is large being between 2.0 and 3.0 as revealed by the fiscal stimulus that was put into place in the wake of the global financial crisis. Assuming a value of 2.5 the estimates of a fiscal strategy have been worked out.

 

The core of the strategy has to be around significant cuts in the GST (indirect taxes), and large spending on NREGs like programmes which can prevent employment and poor people’s income from falling.

 

  1. 15% GST cuts across the board indefinitely. Assuming a GST to GDP ratio of 6.6% this should amount to a stimulus of 1.2% of GDP (2020-21 Budgeted). (Approximately Rs 261,000 crore)
  2. Additional 20% cut in GST for automotive vehicles across the board valid for a year. This should add a further 0.10%
  3. Additional 20% GST cut in construction services, housing valid for a year. This should add a further 0.12%.

 

Besides these tax measures, additional spending on the NREGS and NREGS like urban employment guaranteeing 200 days of employment at around Rs 200 per day amounting to Rs 120,000 crores (current proposals are for Rs 60,000 crore) should substantially improve the employment situation. Restoration of NREGS back to up to 200 days asking for rural India, and an urban equivalent with the possibility of routing the same through private infrastructure /construction companies /real estate companies must be considered.

Credit support to airline companies on a per seat basis (of planes operated) and per plane for mothballing, assuming deviations from a normal low load factor, similar support to star hotels for lower deviation from a certain capacity utilization are all necessary.   Similarly direct spending as and when the needs come up with regard to the various needs would be necessary.

 

The sequencing of these expenditures is also important. Immediate would be GST cut. Next would be the support to falling industries over and above what the RBI can do by buying up the stock/debt  of AA rated finance companies. Government could co-work with the RBI to support the credit needs of non-finance companies. In less than a couple of months it should have put in place the employment support schemes broadly on the lines of the NREGS.

 

The employment support in the urban areas, can be done through private construction / infrastructure companies. It would be very difficult for the government to actually try and reach out to the small and informal economy except through policy. Direct action would be messy and beyond the scope. Thus at best a moratorium on loans of restaurants, entertainment, and related businesses with strong collateral is all that is possible.

 

The fiscal deficit on a ceteris-paribus condition through the above measures is likely to rise 5.7% of GDP. However if even a credit of $10 per barrel on account of the fall in oil prices is taken into account, the fiscal deficit is likely to 5.2%. Actually a significant part of the same can be financed through the bond purchases of the RBI. Inflation  concerns in such a strategy should not be allowed to constrain the fiscal stimulus. Core inflation would only fall with the demand knockdown. Inflation in some scarce items due to temporary scarcity could rise, especially in areas where the price elasticity is small, but the policy maker should not be waylaid by such concerns.

 

Thus in the aggregate about Rs 5.5 lakh crore of fiscal stimulus is quite justified as on date. It can only increase further unless India is miraculously spared by the virus!

 

Table: A Fiscal Stimulus in the Wake of COVID19 for India (Figures in Rs Crore unless stated other wise)
   

Budgeted real GDP growth (2020-21)

5%

Likely Real GDP growth without strategic action (2020-21)

2%

Budgeted fiscal deficit (% of GDP)

3.5%

Nominal GDP Budgeted

22,282,034

Nominal GDP at likely 2% real growth

21,873,189

Fiscal deficit likely with no stimulus and low oil prices

3.0%

Proposed Measures

  

15%% across the board cut on GST rates

260,771

(1.2% of the GST 2020-21 Budget)

  

Additional cut of 40% for motor vehicle industry

22,282

(0.1% of the GST 2020-21 Budget)

  

Additional cut of 40% for other labour intensive industries

26,738

(0.1% of GST Budget 2020-21)

  

NREGS/ Urban oriented employment guarantee scheme/s  (In addition to budgetary outlay of Rs 60,000 crore)

120,000

(0.5% of Nominal GDP Budget 2020-21)

  

Direct spending (additional on construction, income support, interest subvention etc)

127,259

(0.6% of Nominal GDP Budget 2020-21)

  

With fiscal measures above

  

Nominal GDP growth rate (% per annum)

13.8%

Real GDP growth rate (% per annum)

8.8%

Fiscal deficit (% to GDP)

5.7%
   

Tax gain of $10 i.e. Rs 750 per barrel of oil imported

123694

Fiscal deficit with stimulus and low oil prices (% to GDP)

5.2%

Size of fiscal stimulus (% to end-year realisable GDP)

2.4%