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Opinion | Package is first in a multi-phased policy response

Reforms are unlikely to help if the financial sector plumbing is not in order

An assessment of Indian government’s economic stimulus package and its impact should begin by posing a basic question: How should it respond to the covid-19 shock? In our view, the policy response needs to be delivered over multiple phases: Survival phase, growth revival, fixing the financial plumbing and reform kicker.

In the first phase (what the economy is currently enduring), the policy response should focus on addressing the severe cash-flow shock dealt to businesses and individuals due to the sudden stop in activity. Indeed, the government’s package has attempted to address the survival needs of firms and vulnerable segments of the population. For MSMEs, 100% guaranteed loans, subordinated debt and equity infusion can provide liquidity. For vulnerable segments, higher allocation under the rural employment guarantee scheme, free foodgrain and additional credit for farmers are important for livelihoods. To address the credit risk challenge as reflected in the widening chasm between the haves and have-not borrowers, the special liquidity scheme and partial credit guarantee scheme for shadow banks should help. The suspension of fresh initiation of insolvency proceedings for one year should also provide some breathing space for cash-strapped firms, and help prevent an imminent wave of bankruptcies. These survival phase policies have low multiplier effects (they only replace depleting cash), they are not a growth stimulus and they will not lead to a revival of growth. Similarly, the government’s announcement of long-pending reforms in agriculture, coal mining and power distribution companies in Union territories, and for public sector enterprises are positive, but they are unlikely to resolve near-term economic problems.

However, by providing a cash lifeline, these survival phase measures are essential to ensure the temporary shock does not result in a permanent damage to the economy via corporate bankruptcies and sustained high unemployment. In our opinion, structural reforms send a signal that the government wants to attract more risk capital to raise medium-term growth. To be sure, demand stimulus is missing from these announcements, but this is not a surprise, as they may not deliver an anticipated bang for the buck, when coronavirus infections are still rising. For example, tax cuts will be saved due to the public fear factor and restarting infrastructure projects could risk escalating infections and undoing the benefit of past lockdowns. The economic package announced so far is just the first in what is likely to be a multi-phased strategy.

In the second phase, when the majority of the economy is able to return to a “new normal", the policy focus is likely to shift to “reviving growth". Cash-flow support offered during phase one may keep businesses alive, but private sector demand will likely be weak and the government should step in with a demand stimulus aimed at consumption, investment, or both. The pipeline of infrastructure projects should get activated, as it boosts both demand and supply. In the third phase, a comprehensive one-time solution to deal with the bad debt situation is likely to be necessary, as the aftermath of the pandemic is likely to result in a significant deterioration in the asset quality cycle for both banks and NBFCs. Without fixing the financial sector, medium-term growth will continue to face hurdles. The sequencing of these phases can differ, but the survival phase precedes growth revival, and reforms are unlikely to help if the financial sector plumbing is not in order. Even as the economic package is now behind us, the policy response is far from over.

(Sonal Varma is Chief Economist, India & Asia, ex-Japan, at Nomura.)

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