Historical Perspective
Memory of global financial crisis of 2007-2008 is still fresh. It was caused due to depreciation in subprime mortgage market in US. It further developed into international banking crisis. This crisis was of similar intensity as Great Depression of 1930. It was followed by global economic downturn. The housing market in USA created an asset bubble in the year 2006. Banks bundled bad home loans with good ones and sold them as mortgage-backed securities. If these banks/financial institutions had gone bankrupt, business activities and the economy would have ground to a halt. Therefore it called for massive government intervention. The USA government had to bail out “too big to fail” banks using TARP. Total cost came to USD 1488 Billion.
Due to COVID-19 crisis this time USA government has announced a rescue package of USD 3 Trillion which is 10% of GDP of USA. In contrast Indian government has so far announced relief package which is only 0.8% of Indian GDP.
Crisis of 2008 – Lessons for India and Actions Taken
After the economic crisis of 2008, developed economies focused solely on fostering growth. They did not allow fears around inflation and deficits to affect their decision to focus on growth. But in Indian context, when we focussed on growth we allowed financial instability from twin deficits, banking stress and inflation to set in. This led to our own economic crisis of 2013. Few private sector banks and cooperative banks are examples of what happens when indiscriminate lending is resorted. Even today there is weakness in our financial ecosystem due to which there is massive recapitalization effort by government. Case of YES Bank is a prime example. We are still vulnerable to financial shocks and many banks are going through stress.
After the crisis of 2008 Indian exports and growth fell sharply. So various steps were taken to support growth.RBI slashed interest rates and bond yield dropped. Central government expanded the fiscal deficit from 2.5% of GDP in Financial Year 2008 to 6% in Financial Year 2009 and 6.5% in Financial Year 2010. As a result of various measures taken, India’s GDP growth in the year 2010 rose to pre-crisis levels. But this recovery came at a severe cost to financial stability – which in turn sparked a fresh crisis. Fiscal spending alongside low interest rates stoked inflation and imports. Current Account Deficit also deteriorated sharply. Rising crude oil prices, political scams and policy paralysis added fuel to fire. So the economic growth slumped back. Therefore lesson learnt is that this time we need to be careful in this regard. Probably we should have compromised on short-term growth, and focused more on controlling our fiscal deficit and inflation. We should also have regulated the banking system to keep it in better health.
Effect of decline in economic activity
When there is decline in economic activity contraction in business cycle takes place and GDP moves downwards or there may be decline in growth of GDP. There are fluctuations in economic activities which is followed by large number of businesses becoming uncompetitive and going bust. The economic equilibrium gets disturbed and supply and demand mismatch happens. Economic activities (GDP) such as corporate investment decisions, interest rates, consumption, foreign investment, government spending, net export activity etc decline. If companies expect economic activity to slow, they may reduce employment levels and save money rather than invest. Recessions have psychological aspects also wherein consumer confidence takes a hit. In this scenario consumers do not want to spend and businesses do not want to make capital expenditures or hire people.
All the resources at the disposal of rich nations have proved insufficient to deal with Corona Pandemic. The governments who were slow to respond and never resorted to complete lockdown are facing the consequences. USA and Italy are only two such examples. However in India there has been lower probability of widespread infection despite Nizamuddin Markaz. To be honest lower number of infected people in India is also due to insufficient number of testing of the population. In coming weeks central and state governments will have to prepare contingency plans to minimize damage to long term prospects of the economy.
- Indian government has locked down social and economic activity in all parts of the country. Residents have been told to stay at home and non essential businesses have been shuttered for time being. This has been done to contain the outbreak and break the chain of virus spread.
- The underlying assumption is that economic activities can be powered down without causing extreme disruptions. It has been assumed that there will not be widespread business failures or joblessness. It is also hoped that economy can be brought back up to speed after the disease abates.
- Some industries will be affected more than others due to the lockdown. Travel & Tourism, Hotel Industry and Aviation etc will be badly affected due to public health measures being taken to avoid spread of COVID-19. There will be significant number of job losses, sharp dip in revenues & profits.
- There will be decline in factory output, retail sales, construction and other economic activity.
- Export orders are being cancelled and funds are stuck for goods & services already exported.
- Activities in country’s key services sector have already contracted as demand in overseas markets has reduced significantly.
- The energy demand will reduce which will result in forex saving.
- Crude oil prices will fluctuate but will still remain low and hence will result in forex saving.
- RBI will take modest actions.
- Central Government will incrementally announce spending packages to help the country through one of the most challenging periods.
In coming weeks and months we will have to prepare for “new normal”. Things will not be the same for a long time. A graded lockdown exit plan is a must to revive economy. Central and State Governments will need to prepare a good business continuity plan by factoring in social distancing and other health safeguards. New export strategy, new markets and new sectors will need to be planned on priority. This is also the time to make progress in Make in India initiative. Government rules should be practical to attract foreign investment in various economic activities.
Central government has announced relief package which is just about 0.70% of GDP. Compare this with relief package announced by USA which is 10% of GDP. Though we can’t match USA but yet, Central Government will have to ramp up the relief package to at least 5% of GDP.
Conclusion
COVID-19 crisis is different from 2008 economic meltdown. That was a financial shock where economic stimulus was provided to lift the economy out of that shock. The economic stimulus increased the demand. But COVID-19 distress is of different kind and needs different response. We are in an unchartered territory. So government will have to prepare a blueprint without background data being available. Social distancing means that there will be restraint on economic activities where large numbers of people work in a small area. Central and State Governments will quickly need to create a bridgehead between the health side restraints and economic stimulus. Otherwise financial relief package will go waste. The relief package should also be aimed at supporting SMEs. Unorganized & informal sector employs around 70% of workforce. Same applies to construction sector, farm sector and agriculture which employ large numbers of migrant labourers. We do not want to let go this workforce of unorganized/informal sector. This workforce needs social protection. To sum up governments need to support SMEs and informal sector through various incentives and fiscal packages. Without the full support of Central and State Governments economies of various sectors will not be able to survive.
