Economy of India recovers from second wave of Covid-19

The FY 21-22 outlook has been revised downwards by us (Table 1) over the past months as a result of the second wave of Covid-19 infections (Table 1). Luckily, it seems that the economic collateral damage has been much less than during the first wave last year. People have been able to learn, adapt and overcome the economic challenges linked to lockdowns, thereby limiting the economic impact. The Indian economy showed its ability to bounce back quickly after the first wave and seems able to pull this off once more. If we look at the latest mobility data in Figure 1, we see that mobility levels are approaching Q1 levels. This underscores our expectation that the lion’s share of the economic pain of the second wave will be concentrated in Q2.

Nonetheless, higher mobility and subsequent economic activity were the trigger of the rise in new Covid-19 cases of the second wave in India. The sharp bounce back in mobility could lead to growing fears of a third wave of virus infections. These fears are fuelled in particular by the fact that the current vaccination rates in India are not sufficient for herd immunity and therefore offer little safeguard. However, the current situation is somewhat different than in February. Contamination is mainly determined by the behaviour of the population. The second wave was partly triggered by very opportunistic behaviour in the wake of the first vaccinations. People might continue to be more cautious going forward, as many experienced the devastating medical impact of the second wave. Furthermore, in Figure 2 we present a high frequency indicator showing Google search data on the search terms “no smell” and “fever”, which are highly correlated with new infection rates and a good proxy for penetration of the virus. At the time of writing, we cannot distinguish an upward trend (yet), underpinning expectations that the risks of a large new outbreak in the coming weeks are limited. But given the downside risks related to exponential growth in infections, we should remain cautious.

The spike in inflation (percentage, y-o-y) in May was much higher than anticipated, breaking the 6% upper limit of the RBI inflation target band. The increase in prices was due in part to supply chain bottlenecks from the second wave and to high commodity prices, including the low base of oil prices last year. The increase in inflation leveled off in June and seems to have peaked, also with regard to the high base of Q3 last year. This takes some pressure off the RBI. Moreover, inflation needs to be above the RBI target for three consecutive quarters before it is deemed to have missed the target. This gives the RBI some flexibility going forward. This leads us to believe that the RBI will retain its current accommodative stance for some time to come: it will probably only start tightening when uncertainties around the corona virus fade, when the Indian economy is back on a sustainable economic growth path and the inflation picture becomes clearer.

Nevertheless, external factors could influence RBI policy. Rate hikes in advanced economies, particularly by the Fed, could adversely affect the INR if they lead to a reverse in capital flows as seen during the “taper tantrum” in 2013. This would put pressure on the RBI to tighten monetary policy to prevent currency depreciation. Such a scenario has the potential to really distort the economic recovery of India, which of course the RBI wants to prevent.

But how realistic is such a scenario? First of all, we do not expect a scenario similar to the 2013 “taper tantrum” since the Fed is aware of the potential negative consequences of a surprise in this regard. Therefore, chair Powell speaks about an advanced notice, which will signal any changes in policy before announcing a decision on a change in asset purchases. In our recent special we closely examined emerging market vulnerability of 18 EMs. For India there are some mitigating factors, which could safeguard against sudden exogenous shocks. These will be especially relevant if the current account surplus fades as a result of domestic economic growth, increasing domestic demand and imports. Figure 4 shows that India has a relatively low foreign currency-denominated public debt. The foreign currency debt of private sector is also relatively limited. This limits the potential impact of sudden currency depreciation on cost of debt for companies and the government. Furthermore, Figure 5 shows that India has built solid FX reserves over the years, not only relative to peers, but also compared to 2013 when FX reserves were around USD 250 billion and are currently exceeding USD 500 billion. This resulted in growth of import cover of “only” 6 months in 2013 compared to 15 months currently. Both of these factors limit vulnerability to external shocks, which gives the RBI more flexibility and autonomy to adapt their policy to the Indian economy as they see fit.