Pandemic and recovery hereon

Over the past few decades, the world has seen recessions, wars, and natural calamities; yet, a pandemic of the magnitude that we are witnessing today perhaps only happens once a century. Yet, to say that this event was a Black Swan, an “unknown unknown”, something we didn’t know that we don’t know, would be inappropriate. Afterall, many new virus outbreaks such as H1N1 and Ebola have happened within the last decade. The market reaction to the ‘small’ virus has been anything but small. Several trillion dollars of evaporated market cap, widening credit spreads, volatility across assets zooming to record levels, and so on clearly suggest that this was a tail risk that markets weren’t ready for.

Markets are reacting as much to the lockdown and its economic fallout as to the pandemic itself, with billions of people across countries locked down in their homes. Correia et al. (2020)’s study on non-pharmaceutical interventions (NPI) such as lockdowns during the 1918 Flu pandemic across the US found that cities that adopted lockdowns earlier and for longer not only had lower mortality, but also grew faster than others in the medium term. India therefore may have done the right thing by imposing a country wide lockdown earlier on. There will however be economic consequences as the world deals with triple shocks simultaneously- supply shock, demand shock and oil shock. Aggressive policy intervention will be critical in limiting the damage.

The government has announced a Rs 1.7 trillion stimulus, aimed at easing the bottom of the pyramid through the lockdown. At 0.8% of GDP this is modest compared to several other countries that have undertaken much larger stimuli; the US for example has approved a package of 10% of GDP. We hope that on the other side of the lockdown, there will be much more help forthcoming from the government. The pain that several businesses, especially smaller ones, face around their very survival and the corresponding rise in unemployment, need to be addressed. While poverty in India has usually been associated with rural India, this crisis has brought to fore the plight of the urban poor, who will need focused support as employment situation continues to worsen.

Targeted support to industries most impacted such as travel and hospitality should be considered. At a time when fiscal pressures are binding, we may have to be creative in our policy response. For example, measures such as BS-VI relief for automobile industry or granting extra FSIs to real estate developers may be of immense help. Over the past few years, corporate balance sheets have improved but risk appetite stays low, while household balance sheets have gotten stretched. So, the onus is on the government to lever up to support the economy.

There will be worries on debt levels but it is important to note that debt to GDP typically rises in any crisis. Growing the economy out of trouble with the growth in denominator taking care of this ratio is the only way to go. The RBI, however, must absorb the supply to keep yields down. While this may lead to concerns around our ratings and the currency, at a time when most countries will be doing the same, the relative pressure should be less severe. The RBI has indeed been bold in resorting to a deep rate cut along with several liquidity-boosting measures including targeted long-term repo operation (TLTRO). The central bank has also allowed a three-month moratorium on term and working capital loans.

While 90-days moratorium will be of great help, lost revenues will stretch balance sheets for several businesses. At the same time, smaller financial institutions, especially NBFCs, may face severe liquidity crunch as they offer moratorium on the asset side while facing borrowing hurdles on the liability side. Further, as growth plunges and defaults rise especially in small businesses and retail loans, there is a heightened risk in the financial sector. A large scale, one-time restructuring may be necessary to tide out this crisis even as philosophically this goes against the tenets of AQR and IBC.

The RBI, in addition to the system level liquidity, should focus on credit availability across the spectrum. Especially, active intervention to protect financial sector entities is the need of the hour, as any risks there will have far reaching implication on economic activity and we will stay stuck in the vicious cycle. Of late, even faith in some of the larger private sector entities has been shaken. We cannot and should not ignore the role reflexivity plays especially in the financial sector. To revive faith in the financial system, bolder measurers need to be taken. For example, can the central bank directly lend to these entities and publicly disclose the amount lent to assuage market concerns? Financial sector significantly impacts the real economy and must be protected at all costs.

Oil Prices and Its Repurcussion

As the world grapples with the Covid-19 crisis, the price war between Russia and Saudi Arabia has created an Oil shock as well. While falling oil is positive for India with estimated savings of US$ 1.5bn per dollar decline, there are several deeper impacts too. For example, US is the largest producer of oil and a large part of its Shale Gas industry could potentially be at risk creating trouble for the world’s largest economy. Impact of weak global growth on India along with reduced FPI appetite and flows are likely to weigh and offset direct benefits from reduced oil bill. Yet, to capitalize on reduced prices, we should aggressively use our forex reserves to create oil reserves or perhaps consider an Oil ETF financed through investor money. Gold monetization is another possible way to channelize resources.

FPIs pulled out nearly US$ 15bn from Indian markets in March, their highest ever outflow. With domestic savings rate steadily declining and at multi-year lows now, we have stayed heavily dependent on foreign capital. Recent moves such as increasing FPI limit in corporate bonds and opening-up certain government securities under the fully accessible route are welcome steps. Statutory FPI limits of Indian companies having been increased to the sectoral foreign investment limit effective April 1, 2020, should help India’s weight in MSCI EM equity index. Yet we also need concerted efforts to rev up domestic savings to provide us with the much-needed risk capital, partly through a rethink on taxation on capital gains and dividends, and partly through regulatory measures.

World After Covid-19

On the other side of the Covid-19 crisis, the world will be a changed place. Versus an increasingly polarized world order and a trend towards deglobalization earlier, the crisis will hopefully lead to more cooperation and multilateralism. As trillions of dollars will now be spent on healthcare, coordination on this front should rise substantially. Just as there hasn’t been a world-war since 1945, hopefully coordinated effort will ensure no such pandemic in the future. The case for just-in-time and super concentrated supply chains may weaken, as reliability is weighed against efficiency, in turn leading to more multilateralism. And yet with rising distrust of China, India should prepare itself as a strong alternative. Apart from healthcare, this could also turn out to be the tipping point for digital technologies as their adoption explodes (so cyberwarfare becomes the next big threat to watch out for?). We must be prepared to capitalize. Even as survival is the immediate priority for the country, we mustn’t lose sight of revival and capitalizing on opportunities.

The unprecedented crisis will lead to unprecedented global stimulus. As has been our long-held view, with monetary policy having reached its limit globally, fiscal policy will do the heavy lifting. Universal Basic Income could become almost a reality in most countries. Quality of political leadership will be vital in ensuring that fiscal policy is less wasteful and more of job creation through productive investments, infrastructure creation, and spends on social causes like education and healthcare. Either way, this will mean more money with the masses. This should help correct the massive income inequality and wealth disparity, which were partly aided by ultra-loose monetary policies. Wage growth for the masses would mean broad-based economic recovery unlike the shallow economy of the past decade, and an accompanying pick-up in world trade which should be positive for emerging economies.

Summarum

In the near-term, markets will have to navigate the pain of the crisis and its aftermath. On fixed income, the challenge is of massive liquidity on one hand and deteriorating credit conditions on the other. We stay long duration. On equities, heightened volatility should continue in the near term as investors keep an eye on evolution of Covid-19 on one hand and policy response on economic stress on the other. However, several valuation measures such as market cap to GDP and long-term earnings-based yield spread are in the vicinity of GFC lows suggesting attractive entry points for long term investors. While the outlook for forward earnings stays uncertain, we stay bottom-up in our approach by focusing on resilient businesses that should emerge stronger on the other side.

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