Plan a fiscal response around State spending
While we continue to debate whether the coronavirus disease (Covid-19) is a black swan or white swan event, there is little doubt that it has exposed how fragile the economic system is. The stress caused by the disruption of global supply lines and the lockdown is expected to take a heavy toll on GDP growth.
This could potentially force the world into a prolonged recession. India may have escaped some of the ravages of the virus so far, thanks to early steps taken by the government, including the nationwide lockdown. But it has come at a huge cost to the economy.
Tens of millions have lost their jobs, production has come to a halt and the aggregate demand has reached rock-bottom due to the steep fall in exports, investment and consumption demand.
This calls for an urgent and unprecedented response from the government. While the Reserve Bank of India (RBI) has taken a few welcome steps in this direction, it is doubtful whether the monetary response will be effective in these circumstances. The monetary policy is of little use when interest rates are low, and the economy is operating below full capacity.
It also works indirectly via a network of commercial banks by providing interest rate incentives, so that people readjust their portfolios. Today, because of weak animal spirits and low demand, even the lower cost of capital will not induce businesses to borrow or banks to lend. Banks will be unwilling to lend as they are already burdened with high non-performing assets and will be wary of more defaults due to this crisis. And the lower cost of capital or tax cuts by themselves does not stimulate economic activity if ventures are not profitable due to weak demand.
Just distributing a small amount of money to a larger number of people will also not stimulate the economy. What we need is a massive fiscal response built around direct State spending.
Undertaking a nationwide project of constructing new public health care centres and hospitals will stimulate industrial production, put money in the hands of the people directly involved in the project, in the newly-appointed health workers and doctors and generate consumption expenditure.
Even from an equity perspective, with vulnerable sections being disproportionately affected, there is merit in the government undertaking fiscal expansion via activities that directly build social infrastructure.
Low inflation and low interest rates weaken the “crowding out” argument. But where will the money come from? It cannot be raised by increasing taxes as businesses are already badly hit by the disruption. Taxing the salaried class will further drain consumer purchasing power.
This calls for a large increase in government borrowings including substantial amounts from the RBI at a lower-than-market interest rate. But it appears that the government is facing resistance from the fiscal hawks who are still fixated on the random fiscal deficit target of 3% and is petrified of the rating downgrade by international credit rating agencies (CRAs).
The only thing consistent about these CRAs is their failure to accurately assess the financial situation even of individual companies, leave alone countries. They have failed to predict defaults by large companies like DHFL, IL&FS and the Zee group. This patchy track record is not only limited only to India. In the United States, the Enron saga and subsequent congressional hearings revealed that Standard & Poor’s (S&P) had reaffirmed investment-grade status for the company in October 2001, then downgraded it in November 2001 four days before it declared bankruptcy.
Dubious ratings by CRAs played a key role in incubating the 2008 financial crisis. Back then, questions were raised about the role of CRAs in giving bundles of mortgage-backed securities, which had toxic underlying assets, AAA ratings.
The methodology of CRAs is opaque, questionable and often lacks economic logic. Take China and India. In 2016, India’s rating by S&P was stuck at BBB — despite improvement in growth and macroeconomic stability since 2014, while China’s rating was unchanged at AAA despite historic credit expansion and a fall in GDP growth. Most of the toolkits that CRAs use do not factor in uncertainty.
Since the 1970s, CRAs have worked with the “issuer pay model”, where the issuer of any market instrument pays to get itself rated leading to an inherent conflict of interest. Competition among them and the client’s desire for better ratings often lead to inflated ratings.
Also, the de facto licensing power implies that CRAs obtain a rent to allow borrowers to access debt markets rather than award the certification after due diligence on borrower quality as envisaged in regulation.
At this juncture, there can hardly be anything worse than making economic policy subservient to international CRAs. Instead of trying to focus on speculative financial flows, the State must fulfil its obligation under its social contract.
If the State does not step up to the plate during a pandemic, the battle against the virus cannot be won.