Peering into 2021

Business Standard, 11 January 2021

The light at the end of the tunnel, of the health dimensions of the pandemic, is now visible. There are many difficulties in the conventional data, but a transformation is now unmistakable. As an example, the official data for Bombay showed the first Covid-19 deaths in March, and peaked at 136 dead on one day on 20 June. The values are now at about 3 deaths/day. Each neighbourhood and each community in India is at a different place in the epidemic curve, but we are at a late stage of the epidemic. A reduction of deaths could have come from people huddling in their homes, but this is not the case. Mobility data shows business resumption, and employment has significantly come back from the lows of April.

However, it is not yet time to declare an economic recovery. Household consumption is well below pre-pandemic levels. Interaction-intensive services have not recovered, and the process of reallocation of capital and labour on the production side, to other objects of desire, has not yet completed. Alongside this, households are afraid about the future, and have increased saving. Putting these together, there is large demand shortfall in the economy. The feedback loops of macroeconomics are at work: when households demand less, firms get reduced revenues, which feeds into reduced expenditures by firms and thus reduced household income.

The economic stress of 2020 has generated an inventory of troubled debt contracts. Many borrowers have benefited from moratoriums, which helps for a while, but must inevitably come to an end. At a future date, many borrowers will face difficulties in debt servicing. Among financial firms, many lenders will face balance sheet stress. There will be a surge in defaults of non-financial and financial firms.

We will need institutional mechanisms that process failure in an orderly way. We are in a pre-2016 state when it comes to default by non-financial firms. There is no systematic institutional framework for handling default by financial firms, though RBI has scored two nice recent successes with improvised market-based methods for handling bank failure. Macroeconomic performance in 2021 will be dominated by these three problems: household demand revival, households and non-financial firms that are under stress on debt repayments, and stressed financial firms.

Private projects `under implementation', at Rs.36 trillion in December 2020 was slightly lower than the value of Rs.38 trillion of a year ago. This comes in the context of a sustained decline over a longer period, where the peak value in nominal rupees was observed in December 2011. While a part of the economy is flourishing, many non-financial firms are facing one or more of the three problems: sluggish demand, financial stress in the firm, and constraints in accessing finance. Put together, this has added up to an environment of subdued private investment.

There has been significant growth in public investment, which is mostly in infrastructure. In December 2011, government projects `under implementation' was Rs.34 trillion. This has swelled to Rs.83 trillion in December 2020. This reflects the shift away from private participation in infrastructure. But we must remember that infrastructure assets are a means to an end. The purpose of infrastructure assets is to create enabling conditions for private investment in firms that will utilise the infrastructure of transportation and communications. By 2020, infrastructure constraints were less important in shaping the thinking of private firms. In addition, government-led investment has lower efficiency in translating money into performance.

Labour market data gives us a good insight into macroeconomic conditions. In December 2020, 427.5 million people were employed. This was below the value of 439 million seen in December 2019. This comes in the context of sustained sluggishness of the number of persons employed, visible in the time-series which starts at January 2016. In the meantime, population growth has given more people of working age. This constitutes a fundamental challenge for public policy. Almost all jobs flow from private investment, so solving the problem of employment requires solving the problem of private investment.

Headline inflation, i.e. year-on-year CPI inflation, surged in December 2019. It has been uncomfortably high in the period thereafter. The latest value, of 6.93% for November 2020, remains above the upper bound of the target range from 2 to 6 per cent. However, in an environment where demand conditions in the economy are sluggish, it is hard to argue with the decision of the Monetary Policy Committee about interest rate setting. It is likely that normalisation of the economy will result in improvements in supply and bring inflation back into range.

This is the macroeconomic situation at the start of 2021, which will feed into the budget-making process, the results of which will be unveiled on 1 February. Tax revenues will be subdued. The size of government is small, when compared with the magnitude of the problems faced, in terms of the shortfall of household demand and private investment. Sound, conservative public finance strategy will generate a bias in favour of being careful in spending or running deficits. Despite these constraints, the debt/GDP ratio is likely to continue to rise, through a combination of high borrowing and weak GDP growth.

Policy makers can assist the recovery of the economy by addressing the problems of private investment at the root cause. Many researchers have written, in recent years, about the difficulties of private investment after the peak value of December 2011, and there is a well developed body of knowledge about what has changed. In addition to these long standing issues, there is immediate pressure on resolution frameworks for non-financial and financial firms. Establishing conditions for sustained growth will be assisted by cleaning the slate, through resolution of stressed firms, so that we get back to a large fraction of the overall balance sheet being in healthy firms.

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