The turbulence in global banking has brought back memories of 2019, when the fear of an impending recession gripped the world. At that time, it was the stretched balance sheets of firms that raised fears of a global meltdown. Now, it is the stretched balance sheets of financial institutions that have raised concerns about an impending credit crunch.
Over the past three years, government finances have improved. In a crisis, the government may be better placed to offer fiscal support now (Shutterstock)
The precise trigger for a financial shock is hard to predict. In early 2020, it was not the collapse of a giant firm that ultimately triggered a global economic meltdown. A small microorganism did it. The unprecedented rescue act choreographed by economic policymakers during the pandemic preempted a 2008-style financial implosion. But it also eroded financial discipline and lit the fires of inflation, contributing to the current phase of instability. As central banks have tightened the money spigots to battle inflation, those addicted to easy money have struggled to adapt.
Hopefully, the economic clouds will clear without causing much damage this time. But what if things go wrong? India’s economic successes and failures during the pandemic provide us a glimpse of what might lie ahead.
India’s economic contraction was deeper than that of its peers in 2020. The recovery in economic output has also been above-average. Among the 10 large emerging markets belonging to the G20 group, only Turkey and China have grown faster than India in purchasing power parity terms between 2019 and 2022, data compiled by the International Monetary Fund (IMF) shows. The 10 emerging market members of the G20 are: Argentina, Brazil, China, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa and Turkey.
Of these 10 large emerging markets, five had a lower average inflation than India in the pandemic period (2020-22). One reason for India’s poorer record of inflation is the sharp increase in public debt. India’s pre-pandemic public debt level was higher than most emerging market peers, and it has only climbed further since then. Only three of the 10 emerging markets have seen a sharper rise in government debt between 2019 to 2022. The rise in inflation has helped policymakers manage the public debt burden since it has eroded the value of government borrowings. But it has also eroded the purchasing power of consumers, hurting demand.
India’s external balances have also deteriorated since the start of the pandemic, even though it managed to avoid the kind of debilitating balance of payments crisis that devastated some of its neighbours. One key index of external resilience is the ratio of forex reserves to short-term debt, which reflects a country’s ability to repay foreign loans. On this metric, India has seen a greater slide compared to most other large emerging markets. Among the 10 large emerging markets belonging to the G20, only China, Russia and Turkey saw a bigger dip in the ratio of reserves to short-term debt in the 2019-22 period, IMF data shows.
On balance, India’s recent macroeconomic performance has been quite average compared to emerging market peers. India went into the pandemic with bloated public debt levels, and that played a big role in shaping India’s policy choices and the eventual outcomes. The Union government was reluctant to raise spending to counteract the impact of lockdowns, as it worried about the strain on its finances. State governments were even more fiscally constrained. The government’s inability to raise spending caused a larger-than-average drop in India’s economic output in 2020.
Had the government managed its finances better in the pre-pandemic period, it could have offered timely and meaningful assistance to citizens to ride out the first few waves of harsh lockdowns. In the absence of State interventions, it was India’s rural economy — primarily agriculture — that acted as an economic safety net. The great Indian countryside absorbed all those migrating back from towns and cities.
Since the Reserve Bank of India (RBI) had worked hard to tame inflation in the pre-2020 period, it was able to offer more substantive stimulus measures. RBI’s activist approach staved off a domestic credit crunch even though its credibility as an inflation-fighting central bank was dented. RBI had to pay this price partly because of the mess in public finances. If the government’s fiscal health were in better shape, it would have been able to offer fiscal support to firms with impaired balance sheets, allowing RBI to withdraw monetary stimulus measures much earlier.
Over the past three years, government finances have improved. The finance ministry’s decision to report budget figures honestly has helped it win back credibility. In the event of a fresh crisis, the government may be better placed to offer more effective fiscal measures now. However, the still-elevated levels of public debt will constrain room for fiscal largesse.
In contrast to the finance ministry, RBI today has less room for manoeuvre than in 2020. It is yet to re-establish its credibility as a capable inflation fighter. Until it puts the inflation genie back in the bottle, it will have to fight any fresh crisis with one hand tied. The time for unconventional monetary measures is over. In conclusion, India’s macroeconomic defences remain a work in progress. The gaps in its defences could be exposed in the event of a big crisis.
Pramit Bhattacharya is a Chennai-based journalist The views expressed are personal
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