India: Extended lockdown causes further economic distress

The Modi government has extended the nationwide lockdown from 14 April to 3 May to stop the spread of COVID-19. At the moment of writing, there are 29,450 confirmed cases in India. However, there is probably some serious underreporting. Roughly 360 people out of every million have been tested in India, whereas this figure is 13,000 in the US, and roughly 25,000 in Italy and Germany (Figure 1). Moreover, India is not ramping up its test capacity, as new tests are conducted on 21 people out of every million, against e.g. 1,540 in Israel and 940 in the US.

The extension of the lockdown also has implications for our economic projections, which were calibrated on a lockdown lasting three weeks. We currently expect a contraction of the Indian economy in Q2 of 8.7% (y-o-y), with private consumption (-6.4ppts) having the largest contribution to the collapse and exports set to decline by 24% (Figure 2). We expect GDP growth for the entire fiscal year 2020/21 to arrive at 1.2% (Table 2). Indeed, the first cracks of the COVID-19 crisis are visible in high-frequency data: vehicle sales contracted by 45% (y-o-y) in March, steel production was down by 13.9% and vehicle exports declined by 24.5% (Table 1). For Q1, we have currently penciled in GDP growth of 2.7%, although our nowcast models point somewhat higher growth of 3.0%, but we are still waiting for additional March data.

Of course, the longer the lockdown, the more devastating the impact on the Indian economy will be. In a risk scenario where global lockdowns are extended by another 3 months – which we consider to be an upper boundary of how long governments are willing and able to impose a lockdown – large emerging economies such as China (-3.2%) and India (-3.8%) are also expected to contract in 2020 (see our revised global economic outlook for more information).

Policymakers around the globe are currently on the horns of a dilemma: either take steps to open up the economy in order to prevent a further economic meltdown, but run the risk of a re-emergence of the virus; or keep lockdowns in place with a serious risk of causing all kinds of other social disruptions. We think many EM’s are forced to open up the economy sooner than many developed countries for a number of reasons.

First, EM’s, such as Indonesia, South Africa, India and Brazil have a higher share of people with low incomes, who have little savings, no unemployment benefits and in some cases even no access to shelter, food and clean drinking water. Consequently, the quarantines could spark social unrest in these countries. Second, high fiscal deficits and interest costs put a brake on debt issuance by EM governments in order to finance fiscal measures to mitigate the negative impact of the corona crisis. In India, for example, interest costs account for almost a quarter of the government’s expenditure. Finally, EM’s such as India are dependent on foreign investment to finance part of their current account deficits. Without sufficient portfolio inflows and foreign direct investment, a balance of payment crisis is just around the corner.

The RBI has taken a number of important policy measures the last couple of weeks: policy rates were cut by 75bps late March and it started a second round of Targeted Long-Term Refinancing Operations (TLTRO 2) of INR 500bn to channel liquidity to non-banking financial companies (NBFC) and microfinance institutes (MFI). The TRTRO 2.0 auction held on 23 April underwhelmed, which might be related to an underlying problem that definitely is causing the RBI a headache: extreme risk aversion in the financial sector. Due to this risk aversion, we currently see massive liquidity hoarding by Indian banks. According to Bloomberg, since mid-April banks have parked 7 trillion of liquidity at the central bank in return for bonds. Obviously, uncertainty and the gloomy economic outlook is fueling the risk aversion and banks prefer to keep funds at a risk-free spot against weak returns compared to lending to firms or investing in bonds of NBFCs. Consequently, liquidity in the system has been under stress (Figure 3) ever since late March, although this is also partly related to ending of the fiscal year.

The RBI already cut its reverse repo rate by 25bps earlier in April to discourage banks to park liquidity at the central bank. Going forward, more measures are probably necessary to stimulate credit growth in the economy. We expect a cut of policy rates by another 90bps in June (Figure 4), but other far-reaching options are possible as well, e.g. a cap on the reverse repo window or even debt monetization. Although the Fiscal Responsibility and Budget Management Act of 2003 prevents the RBI from trading in the primary market for government securities, this is possible under special circumstances, such as a national calamity or a decline in real quarterly output by at least three percentage points below the average of the previous four quarters. Currently, the RBI has not explicitly taken a stance as far as debt monetization is concerned.