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Business News/ Opinion / Views/  The paradox of India’s stimulus response to the covid-19 crisis

The Indian economy is limping back to normal. There will be a permanent loss of output as a result of the pandemic. It is unlikely that output will get back to pre-covid levels before the end of the next financial year. That is two lost years, and a permanent output loss of around $350-400 billion.

Much has already been written about the cautious fiscal response of the Narendra Modi government over the past six months. New editions of the World Economic Outlook and the Fiscal Monitor by the International Monetary Fund (IMF) provide some useful international context to analyse Indian fiscal policy.

The multilateral lender estimates that the Indian fiscal deficit will widen from 8.2% of gross domestic product (GDP) in fiscal year 2019-20 to 13.1% of GDP in fiscal year 2020-21—or by 4.9 percentage points. This is broadly comparable to the average fiscal expansion among emerging markets, of 5.8 percentage points. The fiscal action by advanced economies has been much stronger. Their combined fiscal deficit as a percentage of GDP is expected to go up by 10.9 percentage points.

The Indian fiscal response is thus much weaker than what has been seen in advanced economies, but it is broadly in line with the average for emerging markets. However, there is a paradox here. The composition of the Indian fiscal response seems to resemble what has happened in advanced economies rather than the typical behaviour in emerging economies. This uncomfortable fact has received less attention than it ideally should.

A fiscal expansion has two components. First, there is an automatic cyclical response to any change in growth trajectory. A sharp decline in growth—or a full-blown economic contraction—leads to lower tax collections by the government. Some parts of the spending bill also increase.

Second, there is the discretionary fiscal response. A government decides that it has to act to either support a weakening economy or cool down an overheated one. In the former case, this would mean some combination of tax cuts and higher spending. A fiscal response should thus be analysed in terms of not just a change in the total fiscal deficit, but also how it is divided between these two components—the non-discretionary automatic stabilizers and the discretionary fiscal impulse.

What has India done till 11 September, the date till which the IMF has analysed the fiscal accounts of its members? The discretionary fiscal impulse in India has been only a modest 1.8% of GDP, or a little more than a third of the total fiscal expansion. In other words, most of the fiscal expansion this year is likely to come from a decline in tax collections and other types of automatic stabilizers, rather than government action. In comparison, almost 60% of the fiscal expansion in emerging markets has come from discretionary policy. (It is important to point out that India’s fiscal federalism complicates some of these comparisons.)

There is another way to compare fiscal policy responses to the pandemic. How much of the response consists of traditional “above the line" measures and how much is liquidity support from“below the line" measures as well as contingent liabilities? The former should generally be accounted for in national budgets, while the latter are usually kept off these ledgers.

Governments across the world have used both this year. The latter has been especially important during forced lockdowns to prevent enterprises from failing, a possibility that can have serious implications for a subsequent economic recovery. Hence, there have been credit guarantees, payroll support, equity infusion and special liquidity schemes.

The IMF data shows that the Indian fiscal response has been overwhelmingly of the latter type. The discretionary fiscal impulse of 1.8% of GDP is dwarfed by “below the line" fiscal support amounting to 5.2% of GDP. In this, India resembles advanced economies rather than its emerging markets peers, which have banked more on direct fiscal action than stuff like credit guarantees or liquidity provision.

Most emerging markets have depended more on traditional fiscal expansion than on items that are outside government budgetary accounts—3.4% of GDP versus 2.5% of GDP, respectively. China’s fiscal impulse of 4.6% of GDP is far larger than the 1.3% of GDP that it has spent on credit guarantees and the like. Actually, the Indian strategy has been closer to what has happened in advanced economies, where the two are more or less in balance. Countries such as Germany and Spain have depended very heavily on indirect support while others such as the US and Australia have done it the other way around.

Why has India been so cautious? Various competing explanations are well known. We entered the crisis with far less fiscal firepower than other major economies. The government is wary of a sovereign credit-rating downgrade in case the fiscal situation deteriorates further. Unlike other economies, India is also battling high inflation, which means that a demand stimulus in the midst of a severe supply shock would have added to price pressures. The Narendra Modi government is by nature fiscally conservative.

These are contentious issues. This column has earlier argued that India has more fiscal space right now than commonly assumed. A rise in precautionary savings across the country will lead to higher demand for safe assets such as government bonds, at least till there is a sustained rise in the private sector. The Indian fiscal response till now—more automatic stabilizers than discretionary policy measures, more indirect than direct fiscal action—should be seen against this backdrop.

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Updated: 21 Oct 2020, 06:12 AM IST
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