RBI Needs To Do ‘A Lot More’ Amid Covid-19 Crisis, Says JPMorgan’s Jahangir Aziz

India’s response is broadly similar to many of the other larger emerging market countries where they have serious issues with the capacity of public health. If you look at India, South Africa, Indonesia, Philippines, countries where public health has been stretched, they have not really done well in handling the crisis. I think efforts have been made to try and provide income support etc., however little or large it has been, but ultimately if you do not have the capacity in public health, you cannot really break the link between infection and mobility. Every time you want to increase mobility, infection will go up.

That’s essentially what’s been happening in all of these countries where any attempt to increase mobility has ended up in increasing the infection. It’s surprising that everyone is talking about everything regarding this crisis in terms of your fiscal support, monetary policy support etc. and there has been almost no conversation about what to do with the public health system.

When you go and say that in order for me to combat the spread of a disease, whether Covid-19 or any other kind of epidemic, I have to lock down this economy, then you essentially are conceding that your public health system is not capable of actually handling the disease. Now, obviously, with a breakout of this kind no public health system would be capable of handling it. That is not the point.

The point is that we’ve had four months of the virus and we have had two months of preparation when it had already happened in China and then two months after that before the virus hit India. So, in a six months’ period, we still haven’t been able to figure out how to change the public health system, what to add, what not to add. So every time there is any kind of a break out of an infection, the only option that we have is locking down the economy.

It’s sort of like saying that if there’s a financial crisis, the only way in which you can get the economy going is by locking down the financial sector. That’s essentially what they are saying. I know people haven’t made this analogy, but it’s like going back to 2008 and saying that look we don’t know what the subprime problem is going to be, it’s a new kind of international crisis. So, let us completely close down the financial sector and wait for a solution. That’s basically where we are.

I think it is a problem of the public health system in this case, which means the states essentially have no other option but to lock down the economy whenever there is an increase in infections.

That has been the case right from the beginning. I don’t think that’s new. I think the pressures may be going up but I think that pressure will always be there and I think that pressure will actually become worse in the coming months.

So if you go back and look at India’s growth, for example in the last five-six years, we know that it hasn’t been driven by exports and investment. It’s essentially been driven by private consumption and, in the last three years, public consumption. Both of them are seriously leveraged.

If you look at the leverage in the private sector, it was about 20% of GDP back in 2015 and is at around 28-29% of GDP right now. So, it’s a very leveraged private consumption that’s been driving growth and it’s been a very leveraged public consumption.

Now, if those two drivers of growth are gone, then you have a serious issue about how the recovery will take place. So if you don’t break down the link between infection and mobility, you can’t get consumption up which has been the only real driver of growth in India over the last five-six years. Then there is a question about that the fact that it’s leveraged; which means that even if we can get over this mobility problem, you still need to make sure that there is enough amount of leverage or credit going into consumption. I think that is the next shoe that hasn’t fallen.

The last three-four months of very low incomes is likely to have seriously damaged both households and company balance sheets. When you have damaged balance sheets, banks are going to be very cautious about lending. The banks have already turned very cautious towards lending. Loan to deposit ratios have fallen. I think the banks will become even more cautious about lending. We would have NPAs rising, which means that the fuel to that consumption growth, which is essentially leverage, that itself might not be there.

So it really requires both the government and the RBI to do things that they haven’t done in the past that they are reluctant to do but I think that this is the time to do those unconventional, unorthodox things because otherwise I don’t really see how India or for that matter any of these larger emerging market countries will actually recover.

I think here is the problem that has sort of plagued policymakers in these countries.

So, there is a standard way in which we think about emerging market crisis. We think about emerging market crisis as those created by excesses of loose monetary policy and loose fiscal policy, that lead to overheating of the economy that increases the current account deficit, which is funded by hot money and then there’s a reassessment and a sudden stop of capital.

The orthodox policy response to it is to get back credible policy-making which sort of means that you have to tighten monetary policy, you have to tighten fiscal policy. Then you go and restructure balance sheets because without restructuring balance sheets, you can’t get the recovery going as the economy depends on these new, much stronger and repaired balance sheets to do that. Then you throw in some reforms here and there. I think that’s the template most of these policymakers have been following.

The problem is that this crisis is not like any crisis before. This is a crisis that has been created by economic shock, i.e. the pandemic, which led people to lock down. And if they do not do something to ensure that the recovery takes place, then this economic crisis will turn into become a financial sector crisis and that will not only delay the recovery but it is actually going to push it and affect medium term growth.

So I think the sequencing of events matters. The right policy option is to provide time and space. That time and space requires central banks to ease massively, it requires central banks to ease not only on the monetary front but also on the regulatory front. This is where I was going with the argument that there’s going to be a credit crunch and in the credit crunch, the policy response needs to be regulatory easing more than anything else.

On the fiscal front, the governments are worried about blowing up the budget, etc. I don’t think that you can avoid that. If you are going to seriously allow the fiscal deficit to expand, clearly, the private sector is not going to be able to fund that fiscal deficit, which means that you need serious amounts of secondary market or, if needed, primary market purchases by the central banks. This is true for almost every other country but that’s particularly true in the case of India, Brazil, South Africa-- countries of the world which have very large fiscal deficits. I don’t think we can escape that.

We need to address and treat this pandemic as a crisis which is very different from the previous crises, which means the policy responses are very different from what we’ve done in the past. I think authorities-- both fiscal and monetary authorities in India and elsewhere -- are very hesitant to leave behind what they have learnt about how to respond to a standard emerging market crisis and do the things that are necessary in this crisis.

Let’s look at what it has done to monetary conditions in general and not just money market rates. Money market rates have even fallen below policy rates. But the question is what has happened to the rest of the lending rates and the interest rate curve.

I think it is not just about keeping short end rates down but also the long end. The size of the growth shock is so large that these interest rates are very high compared to the size of the growth shock. Therefore, they need to be brought down. There is this idea that core inflation is 5% and it is above targets etc and therefore we should be worried about inflation and ex-deputy governors have also opined on that. My guess is they are completely and totally missing the point that there is no growth.

The Reserve Bank of India needs to go back and do what they have been doing in the past. In any standard year, if you go and look back, a third to a quarter of the fiscal deficit used to get funded by RBI purchases. The Reserve Bank of India needs to go back and keep doing that and keep doing that not whenever the bond market is under pressure but as a policy decision saying that from now onwards X% of the entire fiscal deficit shall be funded by RBI purchases and put it out there. That’s the way in which you bring down the structure of interest rates.

You do exactly what you just said.

You just go and say that I will bite the bullet and I will do it in the primary market or I will extend the overdraft facility via Ways and Means Advances. I will make the overdraft facility a long term overdraft facility. That’s the least they have to do. I mean, there is much more that the RBI will need to do. The RBI will need to go into corporate bonds, the RBI will need to go into bank loans and that hasn’t even happened. That will happen in the second half of the fiscal year when we get into a situation where the economy recovers, the private sector starts demanding credit and at the same time, the government is also going into the market demanding credit. That’s the witching hour where everyone is going into the market for credit and the RBI will need to handle not just the pressures on the corporate bond market but also the government bond market. The RBI will also have to handle pressures on bank loans.

This is the time when the central bank will have to do the kind of things that they have been very hesitant doing in the past. This is an unprecedented shock. The central banks need to understand that they need unprecedented policies and what I’m saying is that part of the unprecedented policy is to go and say, ‘yeah, I’m going to go into the primary market’. I don’t think there is anyone who will say: No, that shouldn’t be done at this point in time.

Let’s look at inflation dynamics. Does the MPC actually think that core prices will remain where they are? If growth in 2020-21 is -6%  or -7%, the demand destruction has to be very large. The fact that core prices haven’t gone down is because of the lockdown. There has been serious disruption to logistics and distribution. Most of the prices that we see in our CPI basket, whether it’s food or manufacturing, has a very large component of services which is basically logistics and distribution.

The MPC must be able to see that and say that these core prices are a reflection of the disruption in the services side, which is logistics.

I can’t even imagine how one can say that core prices are going up. The economy has had this massive demand shock and core prices will remain where they are? Core prices necessarily have to come down if the demand shock is of the size that we’re talking about.

The MPC can argue that it’s not a demand shock, it’s a supply shock and that this pandemic has essentially completely cut off India’s supply and this is going to reduce India’s potential growth so that the output gaps are not very large. But that’s not what I think the MPC is saying. The MPC on the one hand is saying that this is a demand shock and at the same time saying that the core prices are elevated and they are concerned about it. They can’t have it both ways.

I don’t know about the zero lower bound but what I’ve learned since February of 2018 that there are no effective lower bounds for rates. They have come to points where you wouldn’t ever have imagined even five or two years back. I think that there is no effective lower bound.

So I can’t tell you if we can go to zero but rates have to go down. Rates have to go down just to get the economy back where it should have been.

Just to give you a sense. If we have -6.5% growth in 2020 and that rising to 8% in 2021, by end of 2021, India’s level of GDP will only go back to the 2019 levels. So, for two years, that is 2020 and 2021, when we should have expected an average growth of 5-5.5%, all of that is gone.

I think that we are underestimating what this shock is implying not just for the growth in 2020 but for the ultimate level of GDP in 2021. I think we need to have policies that reflect that.

First of all, let’s start with the idea of restructuring. Why do you need to restructure because of the pandemic? You need to restructure because of the sins that were committed in the past.

Why do you need to restructure because of the pandemic? The pandemic wasn’t preceded by any excesses in any sector. In fact, if there were excesses, we would have been really happy about it. The pandemic is preceded by an economic shock. You don’t restructure because your balance sheet is affected by an economic shock. You restructure when the balance sheet is affected by past excesses, either in investment or in consumption etc. That wasn’t the case or at least that’s not the broad narrative that policymakers follow. So if that’s the case, then why are we restructuring it?

You don’t restructure balance sheets that have not been damaged because of bad decisions and excessive investments or irrational exuberance. You allow those balance sheets to recover by allowing the economy to recover. You provide time and space for the economy to naturally recover. That requires providing regulatory easing, providing fiscal easing, providing monetary easing. If you allow that space to recover, your balance sheets will recover.

I don’t see the need to start thinking about debt restructuring because of the pandemic. The debt restructuring problem is there for India because of the past sins. It’s not because of the pandemic. I think it requires a completely different set of policy responses where you essentially go to the extent of saying that accounting norms shall be suspended, loan classification, shall be suspended and capital requirements will be relaxed. You have to do things of this type.

It is -6.5% real GDP growth for 2021 and for the next fiscal year we see 8% growth. That said, if you do the arithmetic, then at the end of 2021-22 fiscal year, India goes back to the growth it had and the level of GDP it had in 2019. So, India essentially is going to lose the 10% or 12% growth that you would have normally expected those years.

You are going to see a very nice V-shaped recovery in terms of growth rates but in level terms, this is a trend 12% reduction in the level of GDP even in 2021.

I think on the fiscal side, we’re looking at about 13-14% of public sector borrowing. Again, that public sector borrowing estimate is based on the line in the sand, which I don’t even understand why the government has put, that the central government’s additional borrowing will not go above 2% of GDP.