The Shape Of India’s Exit From The Covid-19 Crisis

Exit From An Economic Crisis – The Stylised Version

A severe economic crisis can affect a country’s growth trajectory in two ways, as depicited in the chart below. Firstly the immediate bust causes a level shift in gross domestic product (GDP per capita), which is especially related to shocks on the labour market and lower investment. Secondly, changes in the growth rate of the trajectory are related to damage to three factors: labour, capital and productivity, with the latter being the most important.

Two recovery scenarios: V versus U

We apply this framework to India’s economy in two scenarios. Our baseline scenario is a relatively strong recovery from the crisis in 2021, a so-called V-shaped recovery. This is based on the assumptions that the lockdowns are successful in containing and phasing out the virus, that there is no re-emergence of the virus requiring new lockdowns, and that the financial system and supply side of the economy survive the current crisis largely unscathed.

Our second scenario is that social distancing measures will be necessary beyond May. A recent study shows that even in the event of apparent elimination of Covid-19, social distancing measures could be necessary up to 2022 in order to prevent a re-emergence of the virus. In this social distancing scenario it would be sectors that find it hardest to adapt (like transportation and hospitality) that would suffer most. Taken with the possibility that – via knock-on effects – demand remains subdued in 2021, output might not rebound as sharply and the recovery could end up showing a U- or even L-shape.

Possible Exit Trajectories

The chart that follows shows the exit trajectories in the two scenarios discussed above plus a benchmark scenario showing the hypothetical trajectory without Covid-19 in green. In the benchmark scenario we expect GDP per capita in 2025 to arrive at Rs 1.43 lakh. In our baseline scenario with a clear V-shaped recovery (in orange), the economic losses in terms of missed economic growth compared to the benchmark would end up being approximately Rs 11 lakh crore in 2025. This means that, on average in 2025, the Covid-19 crisis will cost each Indian Rs 8,000 of missed wealth.

In the social distancing scenario with more of a U-shaped recovery (red line), economic losses pile up to Rs 23 lakh crore, which means GDP per capita in 2025 ends up being Rs 16,000 below the ‘no corona’ benchmark.

What Mechanisms Are Behind These Two Crisis Exit Trajectories?

The Covid-19 crisis presents the Indian economy with a complex interaction between supply and demand shocks. We examine the effects on the labour market, capital stock, and productivity.

Labour market

The size of the knock-on effects on demand, both in the short term and long term, partly depends on developments on the labour market. CMIE data shows that unemployment in India surged from 8.7 percent in March to 23.5 percent in April.

Employment usually does not pick up in tandem with production and part of the unemployed labour force will be unable to find a job immediately. Eventually, downward pressure on real wages will make sure that the labour market eventually clears, but in case of a rigid labour market like India’s, this will take quite some time and the risk of a ‘jobless recovery’ is substantial.

In addition, CMIE data shows that participation rates plunged from 41.9 percent in March to 36.6 percent in April. This could indicate that people facing unemployment in the formal sector are resorting to work in the informal sector.

Finally, young Indians especially might face what economists refer to as scarring effects, which can occur when people are forced to accept jobs below their skills level with a consequent rise in the share of people that become ‘trapped’ in lower-paid jobs. Some studies find that (early) unemployment spells result in a ‘wage penalty’ of 13-15 percent.

Capital

During an economic crisis, uncertainty and a higher risk premium lead to lower investment, and consequently lower capital accumulation. The lower level of the capital stock after the crisis also results in a downward shift in GDP (per capita) levels. Capital destruction can occur in case of an asset quality shock, for instance. This does not mean that capital goods are actually destroyed, rather that investments made before a crisis turn out to be worth much less than originally thought. The crisis then results in the contraction of some industries whose capital is not suited to changes in the economic environment. Shocks to capital and investment are amplified in case of a financial crisis. We currently do not expect India to face a financial crisis thanks to far-reaching interventions by the Reserve Bank of India, but we do foresee that the Covid-19 crisis will put a brake on growth of the capital stock.

Productivity

Damage to productivity is the most important factor in relation to changes in the growth rate trajectory. Quite how the Covid-19 crisis will affect productivity in the long run is very uncertain. Geopolitical challenges and changes in business models may have both negative and positive effects on future productivity growth. There are three aspects which we believe might affect Indian productivity growth after the dust of the immediate bust has settled: a higher share of zombie firms, de-globalisation and less investment in innovation.

Zombies

The Bank for International Settlements has calculated that a 1 percent rise in the share of zombie firms (inefficient or unprofitable businesses) in a country reduces productivity growth by 0.3 percentage points. A weak banking system often results in a higher share of zombie firms, because weak banks facing stressed balance sheets have an incentive to rollover debt to zombie firms in order to prevent a write off of these loans. We expect non-performing loans at Indian banks to rise in the aftermath of the Covid-19 crisis, which also raises the risk that that more zombie firms will be able to continue their operations, if they survive the crisis.

Innovation and de-globalisation

What also might weigh on productivity going forward is a retraction of globalised dispersed chains. As a result, economies are likely to become less open, with emerging markets benefiting less from international knowledge spillovers. Even before corona, we already expected that globalization would be put in reverse due to the U.S.-China trade tensions and U.S. attempts to undermine the World Trade Organization. The corona crisis, in our opinion, will speed up reshoring of activities that are currently performed overseas by multinationals as integrated supply chains unravel. And while India might perhaps benefit from firms exiting China or diversifying overseas manufacturing activities, we feel that the impact of globalised reshoring and a general lower foreign investment appetite will outweigh the potential benefits.

Finally, we expect lower productivity growth in the aftermath of Covid-19 as cash flow constraints and higher operating costs force firms to critically re-assess budgets for research & development and innovation.

Strike While The Iron Is Hot

The second chart, earlier in the article, shows a rather gloomy perspective for Indian economy in the years to come, but a more positive outcome is possible. On May 12, Prime Minister Modi announced a substantial crisis package of 20 lakh crore, including reforms of land, labour, liquidity and laws. Although it is too soon to assess the full economic ramifications of this package, the government is clearly using the current crisis as an opportunity to tackle India’s structural weaknesses. If the crisis and reform package would be successful in addressing the rigid land and labour laws and ailing banking sector, we do not rule out that India’s economy could even emerge stronger from the Covid-19 crisis. The case of Sweden in the 1990s is exemplary how a policy and reform agenda focusing on strengthening the banking sector, fostering industry competitiveness and labour market modernisation can really make a difference.

Of course, the success of crisis policy depends on proper execution, so perhaps it would not be such a bad idea for Narendra Modi to give Stefan Löfven a call one of these days.

Hugo Erken is head of International Economics at RaboResearch Global Economics & Markets.

The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.