Five months into the lockdown, the Covid-19 pandemic is nowhere near its end, while the economy continues to steadily deteriorate. The pandemic is unprecedented in modern India, but its economic impact is familiar: a toxic mix of poor growth, high inflation, and numerous bad loans, similar to the period after the 2008 Global Financial Crisis. This means we can look to the 2008 crisis for lessons that can help us avoid policy mistakes, especially with respect to inflation and bad loans.
Let’s first consider inflation. In the aftermath of the Global Financial Crisis (GFC), the Reserve Bank of India (RBI) responded aggressively, lowering the policy rate by more than 4 percentage points in just one year, to 4.75 per cent in October 2009. At the time, the RBI felt it was safe to relax its monetary policy stance, since the wholesale price index (WPI) inflation had collapsed. But the respite in inflation proved temporary, and soon the WPI was rising at a double-digit pace, causing inflation expectations to soar. Bringing this situation under control proved to be difficult. It was not until 2013, when policy rates had been increased to painful levels, that inflation finally began to subside.
In retrospect, the RBI made two mistakes. First, it focused on the WPI, even as more comprehensive indices were signalling towards growing inflationary pressures. The erstwhile Consumer Price Index-industrial workers series exceeded 12 per cent, as early as 2009-10. Second, and more critical, even after the WPI itself began to rise the RBI was slow to respond, since it always had reasons to hope that the increases would be temporary.
When the current Narendra Modi-led government came to power in 2014, it seemed determined to not let such a harrowing episode be repeated . Accordingly, it introduced into law a new monetary policy regime, committing the RBI to keeping inflation within a 4-6 percent range, as measured by the Consumer Price Index (CPI) — not the WPI. If inflation did exceed 6 per cent for three consecutive quarters, the RBI was required to explain to the government, in a report, what it was doing to bring inflation back to target levels.
The RBI now finds itself in precisely the situation that the law was meant to safeguard against. CPI inflation has exceeded 6 per cent for the past 10 months. But the reaction of the RBI has been the same as it was after the GFC. The central bank has been reluctant to increase interest rates, on grounds that high inflation triggered by supply side constraints is temporary. Without doubt, prices have been pushed up by supply disruptions during the lockdown period, and these will eventually disappear. But the process of restoring supply chains might easily take a year, by which time high inflation expectations could become firmly entrenched. Hence, there is a risk that despite all the efforts to ensure post-GFC mistakes never happen again, they are about to be repeated.
Bad loan crisis
So much for inflation. What about bad loans? After the GFC, slower growth and higher interest rates rendered unviable many of the investment projects initiated during the 2004-08 boom. This made it impossible for many firms to repay their bank loans. The RBI responded with a series of restructuring schemes, which failed to resolve the problem. Instead, the schemes facilitated an ‘extend and pretend’ policy which enabled the banking sector to hide bad loans for years.
The delay in resolution of the stressed assets triggered a prolonged phase of low investment-low growth in the economy, and high risk aversion in the banking sector, from which the economy still hadn’t recovered when it was hit by the Covid-19 pandemic. As these consequences became apparent, the Modi government brought in the Insolvency and Bankruptcy Code (IBC), mandating that bankrupt firms be resolved expeditiously, and in a transparent manner, essentially by auctioning them off to new, financially stronger, owners.
For a time, the IBC was indeed able to whittle down the stock of bad loans. But the Covid-19 shock generated a new wave of stressed assets, which according to the RBI’s latest Financial Stability Reports is likely to propel nonperforming assets (NPAs) to a new peak of 12.5 per cent by March 2021, even under a favourable scenario.
It is unclear how exactly the authorities plan to deal with this problem. So far, the government has suspended the initiation of fresh insolvency proceedings for a year, while the RBI has announced a resolution framework and has appointed a committee to recommend financial guidelines for the resolution plans.
If the new restructuring guidelines encourage the same ‘extend and pretend’ strategy chosen after the GFC, the outcome will be the same as before. Or possibly worse, given that in 2008 the corporate and banking sectors were comparatively stronger, whereas even before the virus hit in 2020, they both had been substantially weakened by years of balance-sheet stress. Hence, the effects of delaying resolution this time might be more serious. If the banking sector gets paralysed, unlike the post-2008 period, borrowers will no longer be able to turn to the non-banking finance companies (NBFCs), since the NBFCs are also in a weak condition now.
India, thus, stands at a crossroads now. Soon, the Modi government and the RBI will need to decide whether to deal quickly and decisively with the economic problems that Covid-19 has created, or wait and watch in the hope that they will disappear over time. The stakes in this decision are high, since it will determine the course of India’s economy for the next decade.
Looking back, the GFC episode makes it clear that the decisive strategy is superior. What is unclear is whether this lesson has truly been learned. And we all recall American philosopher George Santayana’s admonition: if we do not learn from history, we are doomed to repeat it.
Rajeswari Sengupta is an Assistant Professor of Economics at the Indira Gandhi Institute of Development Research (IGIDR) in Mumbai, India. She was a member of the research secretariat for the Bankruptcy Law Reforms Committee (BLRC) that recommended the Insolvency and Bankruptcy Code for India.
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