COVID: Flattening the (economic cost) curve

The salient lesson emerging from COVID-19 is clear: Only aggressive, almost draconian, social-distancing measures will help linearise an otherwise exponential spread of the virus. Countries that have acted early and aggressively appear to have contained the proliferation. Those that have fallen behind the curve, are seeing their health-care systems overrun and their cities forced into complete lockdown.

As India’s cases rise above the three-digit mark, policymakers are understandably clamping down: Malls, movie theaters and schools are being shut down and travel restrictions are getting more acute. These measures are being complemented by self-imposed restrictions on the part of risk-averse households and firms that are cutting out all things discretionary. If the COVID-19 outbreak continues to grow, the containment may have to get more acute.

But flattening the outbreak curve will necessarily entail steepening the economic cost curve in the short run. As the medium of exchange that underpins all economic activity is progressively shut down, the economic costs could quickly mount. Take the case of China. The lockdown in China meant that GDP growth shrank a staggering 40 per cent in the first quarter (quarter-on-quarter, annualised). Think of this as the economic cost necessary to contain the virus. Absent this, if the virus had continued to proliferate, the cumulative economic cost would have been much much greater, quite apart from the incalculable human and social toll. Countries therefore will have no choice but to take a very sharp  and hopefully short — hit.

As India’s cases rise above the three-digit mark, policymakers are understandably clamping down.

But very sharp economic shocks — even in the short run — can lead to non-linear dislocations. If a “sudden stop” of demand manifests in vulnerable sectors (travel, leisure, hospitality, real estate) pressure on small and medium enterprises — whose ability to withstand sharp shocks is limited — can rise very rapidly, threatening their economic viability. This, in turn, risks job losses, especially in the informal sector. Such job losses, in turn, constitute adverse income shocks for households which accentuates the original demand shock, and further propagates the stress. Meanwhile, stressed firms increase the likelihood of adverse credit events, thereby increasing the risks for the financial sector, accentuating risk aversion, and potentially resulting in a greater “credit crunch” that prolongs and magnifies the original COVID-19 shock.    

Policy as insurance

This is where policy — fiscal, monetary, regulatory — needs to step in. Policy cannot stop the spread of COVID-19. But it can cushion the economic blow, by ensuring that the shock does not amplify through credit market channels (which will result in more financial sector stress and risk aversion) or labour market channels (which will accentuate the original demand hit). The immediate role of policy is therefore to provide economic insurance, especially given that India lacks unemployment insurance in urban areas, which are likely to be the epicentre of the shock.

What could some of this insurance look like, if needed?

*Regulatory forbearance, liquidity windows and partial loan guarantees — so that working capital and credit flows —to SMEs particularly in hard-hit sectors;

*Tax postponement or tax holidays to certain classes of firms or sectors that are badly impacted;

*If the shock extends to the point that there is evidence of serious dislocation in the labour market, temporary cash transfers to Jan Dhan accounts or income tax refunds to low-income households could be used as income support. Ideally, a targeted cash-transfer to BPL households would be first- best, but the logistics of getting this infrastructure ready in real time will be challenging;

*Also, if the endeavour is to get purchasing power into people's hands quickly to avoid second round effects —especially in urban areas that will be badly hit — why not pass on a substantial fraction of the oil windfall to households? Oil prices also have an automatic stabilising property, with prices expected to fall in line with the quantum of demand destruction witnessed globally (holding supply constant).

*Finally, it will be important to ensure that MGNREGA — India’s employment insurance in the rural economy — does not face supply constraints. A prolonged hit to urban areas could precipitate reverse-migration to the rural economy, which would increase the demand for MGNREGA.

Because the shock is likely to be very heterogeneous across sectors, it’s important that measures are targeted. Targeted measures, however, can often be distortionary, subject to rent-seeking and taking on a life of their own, much after the initial shock has faded and intervention justified. It’s therefore important that measures are not just targeted but also temporary (state-contingent where possible), and transparent to minimise distortions.

Policy in the wake of a global recession

Even as policy’s immediate goal is to ensure the COVID-19 shock does not lead to adverse second round effects, its eventual goal will be to pick up the pieces after the COVID-19 storm passes. We now expect deep and broad-based demand destruction around the world in the coming months, likely pushing the global economy into a recession.

If the global economy is in recession, India will not be able to fully escape the storm, though the positive terms of trade shock from lower crude prices would likely provide an important buffer. But, as around the world, monetary and fiscal policy will have a role to play, especially since financial conditions have tightened so sharply around the world and in India.

That said, given the large global disinflationary forces currently at work, space for monetary easing in India is likely to open up. For that to be efficacious, however, policymakers will need to double-down on improving transmission to the broader economy, by rationalising small savings rates, injecting more capital where needed, and quickly recognising and resolving stressed balance sheets, so as to reduce lender risk aversion.

Fiscal policy will face its share of pressures. On the one hand, expenditure pressures will inevitably rise to bolster health care systems and undertake targeted interventions to cushion the economic blow. On the other hand, a COVID-19-induced growth hit will make the budgeted tax targets harder to achieve. Furthermore, given India’s starting points, a very sharp widening of the deficit could tighten financial conditions, thereby reducing the efficacy of any monetary easing.

So while fiscal authorities must do whatever it takes now, we must not give up on asset sales later this year when markets stabilise, even if valuations are less than at their peak. This will ensure fiscal policy remains counter-cyclical without becoming counterproductive.  

Once the dust settles… don’t miss the forest

Finally, once the firefighting is over, the crisis has hopefully passed, and the dust has settled, COVID-19 is likely to intensify the backlash against globalisation but also underscore the perils of concentrating production in any one country or region. This should simply precipitate the diversification of production outside of China. India must seize the moment, and through necessary reforms — real and financial — attempt to become a contender for this capital and technology on the other side of this global pandemic.        

The author is chief India economist at J.P. Morgan. Views are personal

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