India: Economic growth set to plunge as uncertainty rises

On 17 May, the National Disaster Management Authority (NDMA) and the Ministry of Home Affairs (MHA) announced lockdown 4.0, lasting until the end of May. Restrictions have been eased further, although public metro transport, education, and shopping malls remain off limits. Moreover, in highly crowded areas, so-called ‘containment zones’, only essential activity is allowed. Finally, Indian states can override national guidelines and keep more stringent lockdowns in place, if desired. Despite these first steps in reopening the economy, based on Oxford University’s COVID-19 stringency index, India’s economy has far from returned to normal (Figure 1). As such, we expect economic growth to contract by 2.9% in fiscal 2020/21.

India’s mysteriously low mortality rate

What might complicate a rapid reopening of the Indian economy is that the number of infections is still rising. Currently, there are 150,000 confirmed cases and daily cases are still on an upward trajectory. Surprisingly, the virus mortality rate in India (2.9%) is substantially lower than the global average (6.5%), despite a relative weak healthcare infrastructure and densely populated areas (see Figure 2). There is no clear-cut answer to what is behind India’s low mortality rate and several explanations by experts have been floated. First, India has a relatively young population (compare Figures 3 and 4): the median age is 28 against, for instance, 48 in Italy.

Secondly, the numbers of corona deaths might be underreported, as the deceased in India are not always tested for COVID-19 post mortem. Third, some studies argue that tuberculosis vaccination (BCG), which is compulsory in India, might protect against COVID-19. However, others conclude that more randomized clinical trials are necessary to draw hard conclusions. Despite a relatively low death toll, the toll on the Indian economy is expected to be far from low.

A glimpse of the first cracks in the Indian economy caused by the COVID-19 pandemic will be visible on 29 May, when India’s Central Statistical Office (CSO) will release the GDP figure for Q1. Based on high-frequency data (Table 1) and our nowcasting models, we expect growth to arrive at 1.2% (y-o-y) for Q1 this year (Figure 5).

In March, car sales contracted by 45% (y-o-y), tourist arrivals fell by a staggering 66% (y-o-y) and industrial production shrank by 18% (y-o-y), see Table 1. This foreshadows the plunge that India’s economy is expected to face in Q2, which we currently estimate at -19.6% (y-o-y), followed by two weak quarters due to a subdued pickup in demand (Figure 6). For the entire fiscal year, we expect contraction of -2.9% (y-o-y). In this figure, we have factored in the mitigating impact of the recent stimulus package of 20 lakh crore (see more on this later in this Special).

In our current forecasts we have penciled in a relatively strong recovery from the crisis in 2021, or a so-called V-shaped recovery. This is based on the premise that the virus will not re-emerge, that no new lockdowns will be required and India refrains from a so-called six-foot economy. The relatively low mortality rate in India supports the case that both the central and local governments would choose to phase out restrictive measures entirely. In a V-shaped recovery scenario, the economic losses in terms of missed economic growth would end up being 16 lakh crore (USD 218bn), or INR 11,500 per capita (compare the orange line to the green line in Figure 7).

A U-shaped recovery, however, is a clear risk and would become more likely in case of unfavorable labor market dynamics, a financial crisis, rising protectionism, and a rise in the share of zombie firms. In this case, the economic losses would end up being 29 lakh crore (or INR 20,000 per capita). For more information about the risk of a U-shaped recovery, we refer to this Special.

There is also a scenario where India might emerge stronger from the COVID-19 crisis. This could be the case if India were to benefit from geopolitical (trade) tensions between China and the US, which have recently flared up again. Moreover, the exit from the crisis depends on the policy response of the Indian government and the central bank. We take a closer look at both elements below.

COVID-19 has clearly weakened China’s position as a global manufacturing hub. Foreign firms were already thinking about leaving China due to rising Chinese factory worker wages and uncertainty caused by US protectionist policies aimed at China. On top of those developments, COVID-19 has painfully showed the vulnerability of globally integrated supply chains. Although the magnitude of firms shifting their supply chains out of China is unclear at this time, it is clear that the US administration is actively thinking about developing policies to push companies into leaving China, for instance by using tax incentives and re-shoring subsidies. Meanwhile, Indian policymakers are pushing an agenda to benefit from this development. According to Bloomberg, the Indian government has reached out to more than 1,000 US firms and offered incentives to relocate activities to India.

It remains to be seen if foreign companies planning to relocate their global activities are taking the bait. Certainly, India has an abundance of land and skilled talent, and offers access to a market of 1.4 billion potential consumers. In our ‘Where Will They Go (WWTG) index’ India is ranked fifth and even tops the list if we include market size (Figure 8).

However, what does not bode well for India’s attractiveness as a manufacturing hub is that it pulled out of the Regional Comprehensive Economic Partnership (RCEP), after negotiating for over seven years. The consequence is that exporters operating in India will face tariffs and non-tariff hurdles when shipping goods to RCEP countries, whereas firms located in RCEP member states do not face higher costs when trading with each other. The decision to abandon RCEP talks fits the protectionist stance of at least part of the Modi administration, which prefers economic nationalism over foreign investments.

What also makes a major manufacturing shift towards India less likely are rigid labor laws, as well as notorious bureaucracy and red tape. Some states, such as Uttar Pradesh, Madhya Pradesh and Gujarat, have begun easing labor laws under the National Disaster Management Act. However, this is a temporary solution and an overhaul of labor laws, receiving broad-based support of all stakeholders, is something which should be arranged on a national level.

All in all, we think it will be difficult for India to haul in large flows of FDI going forward and a wave of global retraction of economic activity and lower foreign investment appetite will outweigh the potential upsides (see Figure 9).

20 lakh crore stimulus package and reforms

On 12 May, Prime Minister Modi announced a second stimulus package, following up on the 23 March Pradhan Mantra Garib Kalyan package of INR 1.7 lakh crore (USD 22.5bn). Total stimulus (including central bank measures) is raised to 20 lakh crore (USD 270bn). On 17 May, Finance Minister Sitharaman revealed the details of the additional plans, broken down in five tranches (Table 2).

In the short-term, the additional measures announced in package 2.0 partly follow up on package 1.0 in alleviating immediate stress for the most vulnerable: for instance by providing more food aid to migrant workers, housing support for the urban poor and special credit for street vendors. Moreover, farmers will receive finance support for crop loan requirements, as well as a credit boost through Kisan Credit Cards. A large chunk of the package also consists of liquidity support and measures (e.g. a loan guarantee scheme for micro, small and medium enterprises - MSME) to mitigate the working capital crunch at firms.

Tranche 3 especially focuses on the F&A sector, including, for example, an INR 1000bn Agri Infra Fund to finance cold-chain storage and post-harvest management. Reforms of the F&A sector have also been announced. One that especially catches the eye is an amendment of the Essential Commodities Act (ECA), which puts a leash on storage capacity, resulting in much unnecessary waste. Lack of storage also means that when farmers bring their produce to the market there is excess supply, which causes prices to plummet and lowers farmer income. More storage capacity might obviate this problem and guarantee price stability.

The government also aims to introduce new legislation enabling farmers to sell their produce to parties outside of the Agricultural Produce Market Committee (APMC) and reduce inter-state trade barriers. This will enable farmers to get better prices for their produce and raise farmer income as well. Reforms in tranche 4 include privatization of the coal mining sector and the power sector and an increase of the FDI limit in the defense manufacturing industry from 49% to 74%.

According to our calculations, the entire package will prop up growth by 1.8ppts in fiscal 2020/21. The package underwhelms in providing direct industry support for those that have been hit hardest by COVID-19, such as the hospitality sector, tourism, the entertainment industry and transportation. In our view, what is a missed opportunity is that the package does not include land and labor reforms or measures aimed at formalizing the economy or improving legislative quality.

Monetary policy should consider unconventional tools

On 22 May, the Reserve Bank of India (RBI) lowered the repo rate from 4.4% to 4% and the reverse repo rate from 3.75% to 3.35%. The statement was accompanied by a list of additional measures, such as an extension of a loan moratorium by another three months (from 1 June until 31 August). The question is whether lower policy rates are effective at the current juncture, as risk aversion among banks to lend to corporates is still high (Figures 10 and 11). Moreover, there is a real risk that bankruptcies will surge in the upcoming period and that banks are facing a significant deterioration of their loan portfolios. This, in turn, would result in even more risk aversion and, ironically, might lead banks to increase their capital buffers instead of lending more.

Currently, only the government can mitigate the economic fallout of the COVID-19 crisis. However, the government is struggling to raise sufficient funds against the backdrop of foreign investors pulling out of emerging markets. In addition, investors and banks currently prefer to hold on to liquidity against a low return (the reverse repo is 3.35%) over corporate lending or bond investments (the ten-year government bond yield currently stands at 5.73%).

This underlines the importance of the RBI stepping in to support fiscal stimulus directly (debt monetization). The RBI can assist the government by using the escape clause in the Fiscal Responsibility and Budget Management Act (FRBM) and start buying bonds in the primary market for government securities.[1] Some might worry that India would return to the 1980s and 1990s, when the RBI was also financing government spending directly, which resulted in double digit inflation but former RBI governor Raghuram Rajan explains why this is not necessarily the case under the current risk-averse environment. Most of the money that the RBI would generate and the government would then spend in the real economy would end up with the banks sooner or later and be parked again at the RBI. However, there is a tipping point when the economy is finding its way up again and banks use excess liquidity (caused by debt monetization) to prop up lending. So the RBI should remain vigilant if this policy is adopted. In addition, Rajan argues that the government ultimately should return to fiscal prudence in order to prevent rating downgrades which would definitely spook international investors. By the time the economy is back on track and commercial lenders feel more comfortable to prop up lending, the RBI can resort to conventional methods and lower the repo rate further. For now, we expect another 50bps cut in Q3.

[1] The escape clause can be triggered under special circumstances, such as a national calamity or a decline in real quarterly output by at least three percentage points below the average of the previous four quarters.