Post-Covid recovery: RBI monetary policy must address capital depletion in MSMEs

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By Arvind Virmani

RBI monetary policy committee meeting: More than a year ago, an EGROW research paper discussed the economics of lockdown and the transition to normalcy. The transition played out as we had envisaged and normalisation had occurred by March 2021 as anticipated. Second wave of Covid-19 started in April and we were back into another transition period, characterised by regional, better targeted restrictions in terms of services and selected district lockdowns. In the last shadow monetary policy committee meeting, we had pointed out that public forecasts were following the covid waves, but our analysis of the second wave allowed us to see through it.

The available forecasts were affected by short-term developments resulting in a high correlation between Covid-19 cycle and GDP forecasting cycle. Our analysis of the delta variant, in EGROW foundation research paper, clearly showed that the new variant is not part of the old wave which is more or less over. Based on our dual S-curve model, we predicted that the Covid-19 variant would spread very rapidly and then decline just as rapidly as it grew. This is what happened by end of July.

The key point to note is that people were focusing on the wrong issue. It was not the incompetence of the government or the carelessness of the public which was critical in the second wave, but the high transmissibility and severity of the new variant. This has been proved by the spread of the Delta variant in the UK, Indonesia, other southeast Asian countries, the US and China.

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GDP will rebound faster than predictions

Based on the second wave model, published in May 2021, we had concluded that FY22, Q1 GDP would be much worse than predicted by anyone and Q2 GDP would bounce back much faster. Consequently, Q2 GDP would make-up most, but not all of the losses during Q1. With H2 growth recovery still on track, the full year growth would remain within our six month earlier forecast of 10% +/- 1 per cent, with a downside risk. That is how the economic recovery has played out so far.

In our 2020 paper on fiscal policy during the transition, the emphasis was on logistics disruptions, and supply chain disruptions during the transition period. Logistics problems were much severe in other parts of the world than India. There were problems of sudden stops and sudden starts. The logistic costs of Indian exports went up by only 20 percent, compared to the logistic cost of exports from China to the US, which went up by 100% or more.

In the US, this was aggravated by a shift in demand, from services to goods. Demand for manufactured products and imports of the same shot up. This resulted in unexpected pressure on logistic chain. The logistics of delivering commodities are completely different from services and there was a shortage of ships and containers, and those costs went up. As the covid wave dies down, we will see a reverse shift, the demand will shift back to services. Disruptions in the supply chain are an important factor to keep in mind.

As our analysis indicated, inflationary pressures from logistics and supply chain disruptions would have a large temporary component in India, USA and worldwide, because of its origin in the supply chain disruptions. However, in the case of India inflation is also strongly affected by global petroleum oil and edible oil prices, both of which have increased substantially during the last six months.

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Exports, Investment and private consumption

There has been a surge in exports from India, especially in the Q1 and till July. The macroeconomic issue is to determine how much of this is temporary. There have been many indications in the data and personal observations that supply chain shifts are occurring. Most of the surge seems to be due to the shift in supply chains. This has two elements- incremental demand and diversification and risk reduction.

There is increasing willingness to pay 10-20 percent higher cost of imports from India, to reduce China risk. This willingness is increasing with the unpredictable behaviour of Chinese authorities, ranging from random actions with respect to capital markets and tech companies and severe lockdowns in many cities purportedly based on a few Covid Delta cases numbering in the tens.

The government must make sure, with the help of industry associations, that any new bottlenecks are identified and solved expeditiously, to ensure that this great opportunity is translated into permanent increase in global export shares.

The government’s provision for capital expenditure was increased by 30-34% in the budget. This will finance construction intensive infrastructure in FY22. The momentum was somewhat disrupted by the second wave but will pick up in Q2 FY22 and stimulate complementary private investment. We expect the Digital economy to lead private investment during FY22. However, much of this investment comes under intangibles and will not be visible in the usual indicators of fixed investment.

Doubts remain about the speed of recovery of private investments because of the depletion of private saving/increase in indebtedness of those affected by Covid infections and those with employment/income losses during lockdowns. EGROW’s research paper in 2020 had pointed to the importance of distinguishing between Contact Services, goods and their related services, and non-contact services.

The key new element is the dynamics of the shift in relative demand for goods and services. The shift from savings to consumption took place during the lockdown and transition period was when fears of contagion were high. As vaccination drive proceeds and fears of Covid contagion subside, there will be a gradual shift back to services and a reduction in the pressure on the demand for goods. This will translate into reduced pressure on logistics chain, logistics costs and inflationary pressure on commodities.

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Monetary policy must address capital depletion

In India, a nationwide third wave of Covid-19 is highly unlikely unless there is a new mutation similar to the delta variant. But, regional variations in the number of cases will be observed. The overall GDP is expected to be 10% -/+ 1%, with downside risk higher because of the second wave. Though the second wave is over on a nation-wide level, we may continue to see regional flare ups as have happened in Kerala, Maharashtra and the Northeast.

However, given the learnings from the first two waves (Govt, business, public), the increase in sero-positivity (2/3rd of population) and the higher vaccination levels (1/3 of adults), a nationwide third wave can only happen if there is new Covid variant comparable in transmissibility and severity as the delta variant. Nobody can predict this, but the medical community can ensure that any such variant is detected quickly and contained before it becomes another wave.

The interest rate should, and is likely to, remain unchanged. So too the future guidance on monetary policy.

The government and the RBI must be alert to any capacity destruction and capital depletion in informal enterprises that have taken place under the radar of regular data collection. The formal sector, particularly the corporate sector is flush with cash and have reduced their demand for credit. The medium-large firms in the MSME sector will also have sufficient access to credit once the demand revives.

My concern is for the self-employed and MSMEs which have exhausted their personal and family sources of working capital and may have difficulty obtaining the capital needed to restart their enterprises. The government and the RBI must be on the lookout for sectors, industries and services where capital depletion has happened and ensure that help is provided for restarting their business.

(Dr Arvind Virmani is Chairman of EGROW Foundation, a Noida-based think tank. He has served as Chief Economic Advisor of the finance ministry. This article is the reproduction of his presentation at the shadow MPC meeting organised by EGROW Foundation.)