The Morning After
Policy interventions will have to be intelligent: Striving to create deep, but temporary, safety nets during COVID-19 without generating imbalances and distortions thereafter
Two things are becoming clearer with every passing day. First, only aggressive containment measures have a chance of flattening the COVID19 outbreak curve. To be incentive-compatible, however, lockdowns need to be accompanied by commensurate income support — especially in emerging markets with incomplete and leaky safety nets — for populations to comply with lockdowns. Second, the global economic crater from this “sudden stop” of activity will be much higher than imagined. The global economy is on track to contracting (at an annualised rate) by almost 15 per cent and 7 per cent in the first two quarters of 2020, respectively. This is almost twice as deep as the recession during the global financial crisis. That said, the depth and duration of the recession will depend not just on the size of the shock (the severity of lockdowns around the world) but on whether the policy response is able to dampen the amplification of the initial shock across credit and labour markets, thereby minimising any hysteresis.
Given the size of the economic crater facing the world, it’s no surprise that policymakers — particularly in developed markets — are throwing the kitchen sink at it. The US fiscal stimulus of 10 per cent of GDP is its largest in recorded history. The Fed has moved from being the lender of the last resort of the banking sector to becoming a commercial bank of the last resort to the broader economy, directly lending to small and medium enterprises (SMES) and purchasing corporate securities, backstopped by equity from the Treasury. In the UK and France, credit guarantees of almost 15 per cent of GDP have been rolled out.
With developed economies doing “whatever it takes”, emerging markets have naturally been emboldened to follow suit, especially since they must contend with more low-income households and lower social insurance. Lockdowns can save lives. Policy buffers will have to salvage livelihoods — as best they can. We’ve therefore seen a raft of monetary and fiscal packages rolled out across emerging markets.
India’s policy response commenced last week. The first order of business was to provide some income support so that India’s largely informal and migrant workforce can buffer the economic hit of the 21-day lockdown. More support may be required, depending on the length of the shutdown and the consequent economic impact, to make it incentive-compatible for daily-wagers to stay at home.
Like the Fed, the RBI has also unleashed its bazooka. First, the repo rate was cut by 75 basis points, but the effective rate cut was closer to 100 basis points because abundant liquidity will ensure overnight rates trade below the bottom of the policy corridor, which was cut 90 basis points. Second, a three-month moratorium on repaying interest and capital was allowed, providing the much-needed forbearance to borrowers. Third, with credit spreads widening sharply, the RBI will provide term liquidity to banks to buy investment-grade corporate bonds. Credit spreads of highly rated companies immediately compressed by 50-100 basis points. Given the economic shock that awaits the world and India, these measures were much needed to simultaneously preserve financial stability and ease financial conditions.
But if the economic hit is worse than expected, more may need to be done. SMES have received forbearance for now. But with revenues having dried up and firms still having to pay wages, their working capital requirements may well increase. But precisely because SMES are most at risk, banks will be reluctant to lend to them. This is where the sovereign will need to step in with temporary, partial-loan guarantees to ensure credit flows to these sectors and a liquidity constraint doesn’t morph into a solvency one, creating more stress in the labour market. Similarly, targeted long-term repo operations — while necessary — are likely to exacerbate the “flight to quality” with the difference between the “haves” and the “have-nots” growing. So policymakers may need to be creative about providing some liquidity down the credit curve as well. All told, more policy support may be needed both for low-income households, SMES, and non-banking financial companies to shepherd them through the shock, and ensure financial-sector stress is not amplified.
That said, it’s easy to make a laundry list of what more the state can and should do. But in emerging markets — where fiscal space is not unlimited and currencies don’t benefit from the exorbitant privilege of the US dollar — policy constraints are more binding.
So while policy must undoubtedly do “whatever it takes” in the heat of a crisis, interventions need to be designed to be targeted, temporary and — where possible — state-contingent.
If not, distortions will mount. Remember 2008? Global monetary policy “normalisation” was so shallow after the global financial crisis that the consequent “search for yield” had led to a large build-up of leverage outside the banking system. That very leverage is exacerbating the “sell-at-all-costs” Minsky moment currently underway, tightening financial conditions, and rendering partially ineffective the policy response to this crisis. In India, too, the massive fiscal and monetary stimulus after 2008 may have been warranted at the time, but its glacial withdrawal years later sowed the seeds of India’s “Taper Tantrum” crisis in 2013.
We mustn’t forget those lessons in the heat of the moment. Undoubtedly, fiscal and monetary policy must strive to ensure that the COVID-19 shock does not amplify through credit and labour-market channels. But interventions have to be designed mainly as insurance to households, small businesses, and the financial sector to shepherd them through the shock, not indiscriminate spending or open ended-guarantees that either distort allocative efficiency or cause macro imbalances at the other end of the pandemic.
On allocative efficiency, it’s possible that some small businesses are not economically viable in the new world that awaits them when the dust has settled after the pandemic. Conversely, opportunities in other sectors may open up. Some creative destruction and resource re-allocation are inevitable. Policy must, therefore, be self-correcting: Provide a backstop during and in the immediate aftermath of the crisis, without distorting the resource re-allocation that is inevitable at some stage.
Preventing imbalances is equally important. With interest rates close to zero in developed economies, debt sustainability may still not be imperilled despite the massive fiscal deficits that COVID-19 will generate. But the starting point is very different in several emerging markets. With higher primary deficits, higher interest rates — and now much lower nominal GDP growth — debt sustainability may well become an issue if deficits run amok, even if central banks are buying the incremental issuance of government bonds. If debt sustainability becomes an issue, then fresh challenges await emerging markets — from rating actions to capital outflows that constrain monetary policy and induce macroeconomic instability — after the COVID19 shock has passed. Therefore, indiscriminate fiscal spending to mechanically “make up” for the lost output from stalled private demand may not be sustainable in many emerging markets, especially if these economies are also experiencing a negative supply shock from the health/closure of some SMES. A positive demand shock is not the optimal response to a negative supply shock.
None of this is to say that monetary and fiscal policy must not intervene aggressively in real time to buffer the economic shock of COVID-19. They absolutely must. But as history repeatedly reveals, policy stimulus is much easier to inject than to withdraw. Policy interventions will, therefore, have to be intelligent in emerging markets: Striving to create deep, but temporary, safety nets during the crisis without generating imbalances and distortions thereafter. In the heat of the moment, we shouldn’t forget the morning after.