India’s COVID-19 Response: Reform Road to Recovery

India’s early and repeatedly extended lockdown means its economy will probably experience negative growth this year. Despite this, even as it begins to re-open the economy, the Modi government has avoided releasing a large fiscal stimulus to restart growth. Instead, the government has decided to gamble, taking a longer view by implementing large-scale domestic economic reforms and incentivizing foreign investment. In this note, we provide an overview of the measures taken to date to shore up India’s economy and their implications for achieving Prime Minister Modi’s ambitions for domestic reform and increasing foreign investment in India.

Conservative fiscal stimulus package

India’s nation-wide lockdown, imposed early and stringently, has unsurprisingly plunged the economy into recession. After a fifth, though partial, lockdown extension, most private estimates predict that this fiscal year (ending March 2021) will see the Indian economy contract, by as much as 5%. The central bank and Bibek Debroy, chairman of Prime Minister Modi’s economic advisory council, have said they expect negative growth. With the lockdown still being lifted in fits and starts until at least the end of June, the full extent of economic damage will not be clear for a while.

In mid-May, the government announced a series of fiscal and regulatory measures to counter the economic fallout of COVID-19. This followed an earlier economic package in mid-April that combined monetary and relief measures equal to 0.8% of GDP. While there was market speculation of a stimulus 5 to 10 times larger, the government had concluded weeks back that it lacked the fiscal capacity for a large stimulus. But Modi did have the political capital to weather a year of recession and, therefore, the ability to consider a more gradual return to growth. The size of the government’s fiscal package in actual disbursements is small: the average of over a dozen private estimates put it at 1% of GDP. Even with that amount, India’s central fiscal deficit will double to at least 7% of GDP because of lower revenues.

There were a number of reasons for this decision. One was political. The stimulus after the 2008 financial crisis led to a bad loan crisis and a slew of corporate corruption scandals, the sort of thing Modi had campaigned against in his two election victories. Another was the conclusion that there was no shortage of liquidity in the economy. Banks had $800 million in excess funds while the increase in cash in circulation in the first five months of this year already exceeded the entire increase of 2019. The central bank warned that further liquidity would mean inflation and higher interest rates. There were also concerns that ballooning the fiscal deficit would cost India its investment grade credit rating. Officials also said, given the uncertain trajectory of COVID-19, they would prefer to keep some financial ammunition in reserve. All of this reinforced Modi’s personal preference for fiscal conservatism. The overall policy goal was to encourage the resumption of credit flows rather than the printing of money.

The bulk of the May financial package provides relief for small and medium-sized businesses, which have been hit hard, as well as increased welfare payments to the rural poor. It has held back from sector-specific bailouts because it is not clear which industry is deserving and how much they should receive. The government also decided that giving money to big business at a time when destitute workers were still migrating out of the cities was politically unpalatable.

Reform measures to attract foreign investment

The limited fiscal package serves as an economic band-aid for the next few months. A more long-term response is incentivizing more foreign investment to spur later growth.

The Modi government assumes it won’t receive much foreign capital in the rest of the year, but is not worried about balance of payment issues, as the collapse in oil prices and healthy foreign exchange reserves gives India considerable leeway. With global central banks all opening their wallets, the assumption is there will be considerable financial spill-over into India if it shows some fiscal discipline and exchange rate stability.

The bigger gamble is the hope that India can attract foreign investors, notably in electronics, healthcare, and textiles, and expand India’s shrunken manufacturing sector. In order to attract more of this type of investment and spur domestic firms in these areas as well, the government has announced plans to simplify India’s labyrinthine labor laws, leasing measures to get around land acquisition hurdles, further easing of restrictions on foreign investment in sectors like defense, and has outlined ambitious privatization plans along with other investor-friendly reforms. One of the state’s goals of these incentives is to shift supply chains in high-value manufacturing like electronics and healthcare away from China. However, Indian officials say they only expect bits and pieces of such chains to move, and over a five-year timeframe.

Reform measures to boost domestic productivity

The other element of Modi’s post-COVID economic policy is to use the opportunity created by the crisis to implement a dizzying array of stalled domestic economic reforms. Growth revival, Debroy wrote in an article, “would depend on factor-market reforms and productivity increases.” One set of reforms is tailored to specific sectors and is designed to boost domestic productivity over the medium to long term. These reforms include abolition of rigid agricultural marketing laws to give farmers greater freedom in terms of prices and sales. The government is also pushing rules and laws to end the perpetual losses that bedevil the power sector, as well as privatizing dozens of state-owned firms in sectors like banking and energy.

Many of these are reforms were announced previously but foundered because of state-level or bureaucratic resistance. Having invoked the Disaster Emergency Act to tackle COVID-19, the central government has amassed considerable executive power. It is now using the pandemic to arm-twist state governments to consider difficult reforms such as streamlining India’s jumble of labor laws. For example, invoking central government financial regulatory powers, New Delhi has said it will not grant permission to states to borrow more money from the market unless they implement major reforms. Recognizing this is not sustainable, Modi is persuading states ruled by his own party to move ahead of the curve on market reforms, garner public funds and private investors, and force opposition-ruled states to go along so they can be the main beneficiaries of a hoped-for post-pandemic recovery.

A gamble for long-term recovery

Modi is taking a gamble by banking on structural reforms and foreign investment to restore economic growth rather than a more traditional fiscal stimulus. “How we implement all this in terms of laws and regulations will be the real test,” admits one of his ministers. Many economists have argued the present policies do not sufficiently compensate for the collapse in short-term demand caused by the lockdowns, so it could be years before consumers and investors will be confident enough to spend. The government seems conscious of this possibility and has not ruled out a larger stimulus if the situation warrants. Either way, India’s recovery will be a long and painful one and will define the character of Modi’s second term.