Global Economy

THE PANDEMIC WILL LEAVE SOME ECONOMIC SCARS GLOBALLY; GIVEN THE UNCERTAINTY IN THE GLOBAL ECONOMY AND POLITY, OUR POLICYMAKERS MUST AVOID DOGMA AND REMAIN AGILE

“Hope 2021 is better than 2020” sets a really low bar when it comes to New Year wishes, but as the battered global economy limps back to normalcy, it is likely that 2021 will be better, particularly now that we have vaccines. The question is, how much better?

Unlike some past pandemics that reshaped economies with their high fatality rates, the economic impact of Covid-19 was primarily through the administrative interventions to slow its spread, as governments bought time to understand it better, and for the development of vaccines. So then, if lockdowns caused the economic slowdown, should not their lifting bring economic normalcy? Unfortunately, economic recessions can also impair productive capacity, somewhat like a piece of metal that once bent cannot be fully straightened again: firms shut down, households and firms lose assets or take on more debt to survive the downturn which then affects their ability to consume or invest for several years, consumer and investor sentiment weakens, and economic relationships break, like between employer and employee and suppliers and customers.

To minimise the economic scars and to keep financial markets functional, policymakers the world over used exceptional fiscal and monetary policies in 2020, many of which are likely to last well into 2021. This is different from the response to the crisis a decade back, when fiscal tightening and monetary easing was the strategy. Fiscal measures socialised losses (that is, spread the burden over all current and future taxpayers) through the government handing over cash to individuals or subsidised loans to small firms so that they did not lose their economic potency. Monetary policies kept interest rates low even in the face of extraordinary levels of uncertainty and unprecedented government borrowing. The resultant step jump in global debt to GDP will have its own longer-term implications, but the immediate damage was contained. It is reasonable to expect a bounce in economic indicators in the western hemisphere as the weather warms and vaccinations ramp up.

Despite the strong policy measures, however, the global economy ex-China is not expected to reach pre-Covid levels of output till 2022. In addition to the inevitable damage to businesses for reasons discussed above, business and consumer confidence are likely to take time to recover. In China, for example, which was the first affected and the first to lift lockdowns, and also had the least economic loss in 2020, it has taken several quarters for discretionary consumer spending to normalise after all restrictions were lifted. Adding to that uncertainty are impedi

ments to production brought about by supply chain disruptions which could take a while to settle down.

First, as shortage of even a few components can stall production and thus demand for all components, globally distributed supply chains are at risk. Some car factories in Europe, for example, had to stop production recently due to a shortage of automotive electronics. This fear also triggers hoarding, as lost production is much more expensive than inventory-holding, exacerbating shortages. Second, there has been a services-to-goods switch, as services that used to be a large part of consumption baskets, like travel and tourism and eating out, have been restricted, and goods consumption much less so. Even within goods, demand for a few categories like laptops and servers is above normal, and upgrades for domestic appliances have been brought forward, whereas wardrobe refreshes for premium clothing have been pushed back. Third, even as productive capacity was still restricted, large consumption stimuluses drove demand for goods back to pre-Covid levels: by June in the US, and a few months later in the EU. In China, aggregate demand has been boosted by stimuluses for infrastructure and real estate.

Shortages driven by these factors have been amplified for raw material suppliers in a classic demonstration of the supply chain ‘bull whip’; that is, the further away from end demand a product category is, the greater the volatility in perceived demand. Say, automaker ‘A’ decides to temporarily suspend its ‘just-in-time’ system and increases component inventory levels to three weeks of supply instead of the normal two weeks. Its supplier ‘B’ would then see above-normal demand, and would not only raise output, but also add to its own parts inventory. Its supplier ‘C’ would thus perceive even stronger demand. In categories like steel, which are at the end of several long supply chains, an abnormal surge in demand is driving extreme shortages, pushing prices up, which itself triggers hoarding instincts as buyers stock up before prices rise further. The suppliers to steel mills, like iron ore, have seen prices rise to levels unimaginable a year ago, and close to all-time highs. This is how a bull whip works, as the end of the whip travels at hundreds of kilometres an hour even if the handle is moved relatively slowly.

As very few can separate the cyclical, seasonal and structural elements of demand for a commodity, the current demand surge is also fuelling fears of spiralling inflation. Theories of sustained strong demand for metals like copper have started doing the rounds, for example, as a switch to electric vehicles and ‘green energy’ is expected to drive a quantum jump in demand for the metal. While that may indeed play out over the coming decade, current demand is not ‘normal’, and once inventories have built up, demand can fade sharply, like the downward leg of the bull whip. In the interim, though, rising prices have catalysed a debate on inflation and the impact of higher inflation on central bank policies as well as financial market stability.

Once activity levels normalise post vaccination, and global growth rebounds (Credit Suisse expects 4 per cent growth in global GDP this year), resumption of services consumption can unwind the above-normal demand seen for some goods. This could, in fact, alter global trade balances meaningfully again: the US trade deficit, for example, has risen this year, widening trade surpluses of its trading partners. A reversal of this trend, as US demand switches to mostly locally sourced services could impact export demand in its trading partners.

While the recent surge of portfolio flows to emerging markets is boosting sentiment and providing much-needed policy space, it is early to extrapolate that these would last, and are anything more than tactical adjustments in global portfolios. The commonly held notion that low interest rates in developed markets imply strong capital flows is not backed by data. In the past decade, despite near-zero interest rates in the US and negative deposit rates in the EU, outbound portfolio flows from these economies were weak. There were three reasons for that, in our view. First, the quantum of annual household financial savings in the US and the EU in 2019 (that is, pre-pandemic) was broadly at the same level as 15 years ago; the surge in bank deposits during the pandemic, driven by forced as well as precautionary savings is likely to be temporary. Second, contrary to what many expect, despite deposit rates going negative in the EU, the share of incremental household savings deployed in deposits has increased meaningfully there and has been unchanged in the US despite near-zero rates. Households are putting less into asset classes that can invest in foreign equities—pension and mutual funds in the US, and insurance and investment funds in the EU. Third, allocations to equities by pension funds in the US and institutional managers in the EU have not changed materially. Low rates have pushed institutional allocations to alternative assets in the EU (like private equity or real estate), not equities.

That said, the balance of payments (BoP) surplus that India is currently experiencing, which has driven foreign currency reserves higher by more than a hundred billion dollars in just nine

A PRUDENT SPENDING PLAN TO BUILD HEALTH OR URBAN INFRASTRUCTURE CAN IMPROVE THE SUSTAINABILITY OF ECONOMIC GROWTH

months, is likely to stay elevated, in our view, notwithstanding the surge in trade deficit in December. Left to itself, this can create problems. As the RBI continues to buy the surplus dollars in order to prevent the rupee from appreciating, it ends up issuing rupees far in excess of what may be necessary. This increases the risk of bubbles in financial assets that do not help much when they are forming, but can hurt when they deflate, or worse, burst. Further, continued intervention in currency markets exposes the country to the risk of being penalised for currency manipulation. The solution may lie in policies that boost domestic demand and thus organically bring down the BoP surplus. At a time when the financial markets are primed for higher fiscal deficits, a prudent spending plan, say, to build health or urban infrastructure, can improve sustainability of economic growth and also prevent economic distortions. Another advisable step would be the Centre permitting state governments to incur higher deficits for one year for capital expenditure.

Leaving the fear of the virus behind is also likely to increase people’s focus on a nearly universal fallout of the pandemic: sharply higher wealth and income inequality. Not only in India, but globally, upper-income households have exited the pandemic with better balance sheets (their consumption was more impacted than income), whereas lower-income households have had to shed assets or take on debt (their incomes saw a deeper impact, even as their consumption could not be cut, given how little of it is discretionary). Credit Suisse global strategists expect global equity markets to rise another 15 per cent in 2021, which implies the wealth inequality is likely to worsen further. One only needs to look back at the period after the financial crisis of 2008 that drove significant political churn. These changes are also likely to affect geopolitics; for example, the new US administration signalling a return to multilateral fora like the Paris climate change agreement. The world was changing rapidly even before the pandemic, and many such changes have likely been speeded up but have not manifested yet. In India, the pandemic exposed gaps in the government’s policy toolkit: a policy cushion for the urban poor like MNREGA is for the rural jobless, and support for informal enterprises. Some policy experimentation is of the essence.

India’s surprisingly low infection-fatality rate has helped a much faster than expected rebound in the local economy, with administrators as well as people losing their fear of the virus and speeding up the process of normalisation. Further, the launch of schemes like the production-linked incentive (PLI) signals a meaningful departure in India’s industrial policy, like working with ‘champions’, incentivising growth in downstream production and making the (correct, in our view) assumption that upstream supply would follow; and reveals a pro-growth mindset. After many years, India’s medium-term growth outlook is likely to see upward revisions. Nevertheless, given volatility globally in politics, economies and financial markets, policymakers may need to eschew dogma, and stay agile. ■

CURRENT DEMAND FOR COMMODITIES IS NOT ‘NORMAL’ AND CAN FADE SHARPLY ONCE INVENTORIES GET REBUILT. THE INFLATION FEARS IT HAS STOKED MAY ALSO NOT LAST