Editorial & Opinion

India: Dissecting Slowdown And Likely Recovery

India: Dissecting Slowdown And Likely Recovery 1

·         With the latest extension, India will be in lockdown for nearly two months

·         Urban areas are the most affected, but activity can resume gradually

·         Consumer discretionary sectors (production and services) are likely to be worst hit, while agriculture might lend support

·         Tough global conditions impede export recovery

·         A stringent lockdown necessitates strong fiscal support. We draw parallels to the response to GFC

·         Rating action is a concern

·         Shielding corporate balance sheets and financial sector stability will be priorities when normalcy returns

·         Few thoughts on the post-pandemic priorities and return to normalcy

The Indian government has extended the nationwide lockdown for two more weeks, until May 17. With this, the lockdown would be in effect for nearly 60 days (since March 24). As of late-April, the number of confirmed cases in India stands at more than 40,000 and over 1k fatalities. The pace of rise in cases (day to day) is moderating (see chart), but the absolute numbers continue to rise.

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In the latest advisory, the country will be divided into zones – red zones i.e. where number of active cases are high and rate is doubling, green where there have been no confirmed cases for the past 21 days and orange are classified as in between the two situations.

Of the nationwide 733 districts, 120 have been classified as red zones. These include key metropolitan cities, with urban areas hit disproportionately harder than rural areas. Populous states of Uttar Pradesh and Maharashtra have the maximum number of red zones at 19 and 14 respectively (as of May 1), followed by Tamil Nadu at 12 and Delhi’s 11.

Using our preferred gauge of cases per million, the top five most affected states are highlighted in the chart below. Top five states (highest cases per million) make 35% of the national output and 27% of the country’s population. Resumption in normal activity in these areas will be staggered and with social distancing measures, especially as a global cure is still to be established and in absence of herd immunity.

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Selective resumption in activity

In the first part of the lockdown, close to 65-70% of the economy was shut (see table). The first extension saw few other sectors open allowing close to 50% of the economy to resume but with strict regulations. The latest extension on May 1 will also certain industrial establishments to resume activity, based on respective zones and at the discretion of the state governments.

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Sectoral implications

Given the stringent regulations that are in place, impact will differ across sectors:

Agriculture, fisheries and forestry (17.5% of Gross Value Added): This sector is the likely bright spot for revival prospects, with the Indian Meteorological Department (IMD) forecasting a normal south west monsoon this year after a delayed start and excessive rainfall hampered output trends in 2019. Some disruption in activity is likely in the short-term due to delay in labour movements and cash flow squeeze. Rabi harvesting is underway, with sowing for the kharif crop to begin shortly. Long-standing need for improvement in food-processing, storage and logistical modes will also help boost net returns.

Industry (27%): Sub-sectors include:

1)      Mining (2.2%): largely out of action in the June quarter and is also likely to be impacted by large-scale labour disruption. Resumption in normal activity is only likely in 2HFY21 (i.e. beyond September)

2)      Manufacturing (16%): food products and beverage supplies were partially ongoing during the lockdown and are thereby likely to be amongst the less impacted. Pharma sector is classified as essential and thereby has been functioning albeit below capacity during the lockdown, as is FMCG. Partial kickstart in construction should spur cement and metals output. Consumer durables, automobiles, gems & jewellery, textiles, machinery were likely amongst the worst hit, and might endure an extended period of hiatus before resuming activity. 2H is the earliest for activity to resume.  

3)      Utilities: Power supply was ongoing but a sharp deceleration in demand (for industrial and consumer use) have likely impacted earnings in 1HFY21. As the broader economy heads back to work, this sector might partially witness a reprieve in 2H, but pre-existing constraints of weak cash flows, indebtedness and delay in payment from states is bound to continue

4)      Construction: activity had come to a standstill in first leg of the lockdown, but restrictions have been partially lifted especially in the rural areas. Yet, with large scale labour disruption, need to observe social distancing and slower project disbursements are likely to impact output even when work fully resumes in 2HFY21

Services (53%): Services were likely the amongst the most affected and given the high weightage in overall growth, we expect the drag on GDP to be significant on this count:

1)      Trade, Hotels, Transport, Communication & Broadcasting (18%): wholesale and retail trade were partially operational for essentials during the lockdown. Commercial transport had largely come to a standstill in early part of the lockdown, with inter-state cargo eased in the subsequent extensions. Rail and road likely slowed sharply in the June quarter and are likely to gradually recover. Yet it will be below trend due to delays and restricted fleet. Airlines will be amongst the worst hit due to widespread disruptions in domestic and international travel and are likely to be amongst the last to recover. Hotels and entertainment venues will also bear high costs due to closures and social distancing requirements

2)      Financial Services, Real Estate and Professional Services (20% of GVA): Banks and financial institutions were open through the lockdown, being classified as an essential service. Market activity was however besieged by lower volumes amid high volatility. Rest of the segment was likely hurt by broader deceleration in demand and closure in related activities (real estate etc.). IT services has resumed, but were operating at below capacity in 1H and will likely be back to normalcy in 2H

3)      Public Administration, Defence and Other Services (15%): The main segment i.e. public services operated through the lockdown, Health was also considered an essential service, but educational institutions remained closed through the period and are likely to resume in 2H

Even as extension is lifted, labour intensive sectors will face hurdles in workforce availability especially contractual labour as the lockdown had created large scale displacement amongst the workforce. A lift in inter-state travel is likely to see urban labour return to their homes initially, before returning. It remains unclear how fast the return would be. Given the larger proportion of self-employed and casual labour in the manufacturing, trade, transport, hospitality sectors, these are likely to be witness broader disruptions even after the lockdown eases. The second derivative is that the high proportion of non-salaried workforce will also negatively impact employment and income prospects.

India: Dissecting Slowdown And Likely Recovery 5

Incoming data reinforces deceleration

We captured incoming indicators in our publications herehere and here. More data releases have reinforced expectations that although the lockdown went into effect only in late March, output and consumption had begun to slow down earlier.

  • Core industries index slumped -6.5% y/y in March, deepest contraction for the new series. Except coal, all sub-sectors registered a fall in the month, reflecting broad-based slowdown in activity
India: Dissecting Slowdown And Likely Recovery 6
  • March GST collections slowed to INR976bn below the targeted INR1.15trn. Release of data for April and May has been deferred. FY20 GST rose a tepid 4% y/y to INR12.2trn, missing the revised target. With 60-70% of the economy closed for much part of April, only the exempt sectors likely contributed to the kitty
  • Only 6.7mn e-way bills were reportedly generated in April vs 40.6mn in March, according to GSTN data cited by the press. States have also reported a 60-90% drop in GST collections according to unnamed official sources according to local media.  

This sectoral breakdown highlights that growth this year is likely to be at its weakest in 1QFY21 i.e. the June quarter and only gradually recover thereafter. Bringing together selected data releases (for which Mar output is available), our momentum indicator points to a notable deceleration (see chart).

India: Dissecting Slowdown And Likely Recovery 7

More support expected from monetary and fiscal policies

The Reserve Bank of India has undertaken swift action, with emphasis on three levers:

  • Lowering the cost of capital;
  • Ensuring surplus liquidity and financing facility to channelize funds from banks to credit-starved sections;
  • Regulatory forbearance, asset classification freeze and moratorium on loans

Many of these moves have had the intended benefit for businesses, much of which has been through domestic banks. With commercial banks still in midst of cleaning their own books, and the additional burden of provisioning against potential increase in stressed assets, has not surprisingly magnified their already weak credit and duration appetite. This was reflected in the weak uptake of recent cheap financing facilities, meant for banks to borrow and lend to lower rated corporate and non-bank papers.  

To get around this hurdle, expectations are high for the authorities to directly reach out to the stressed sectors, through measures likely – a) creation of a special purpose vehicle (SPV) to directly purchase corporate bonds, in a bid to arrest widening spreads vs GSecs and temper volatility; b) direct institutional (from the RBI or government) to backstop credit facilities to quell contagion and systemic concerns, while supporting banks lower their credit aversion.

Fiscal support: drawing parallels with the GFC 

Beyond the first package announced in wake of the late-Match lockdown, further steps are awaited. This is particularly as India’s lockdown is amongst the most stringent in the region, but also where the fiscal package is amongst the smallest.

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We draw parallels to the fiscal response outlined in wake of the global financial crisis in 2007-2008.

Admittedly the nature, extent of impact, duration and scope of the COVID-19 crisis differs vastly from the GFC. Nonetheless, the government had provided strong fiscal support to arrest downside risks to growth.

In the run-up to the GFC, India’s fiscal situation was on a stronger footing. The fiscal deficit had shrunk by 340bps over the previous six years to -2.6% of GDP by FY08. A strong response to counter GFC-led slowdown saw the fiscal deficit balloon from -2.8% to 6.6% in FY10, entailing ~3% of GDP worth stimulus. The combined fiscal deficit (including oil marketing and fertilizer securities) reached 10.7% of GDP.

Response was rolled out in phases from late 2008 to 1H09. We also recall that demand-boosting measures had also been introduced ahead of the GFC shock, which included implementation of the sixth pay commission’s recommendations (higher salaries for government employees) and farm loan waivers.

Main highlights of the fiscal response to the GFC-shock included;

  • Credit guarantee cover for micro, small and medium enterprises (MSMEs), with a revised lower lock in period to draw in banks’ support. There was sector-specific support (textiles, housing, auto, exports etc.). For instance, to spur demand for commercial vehicles, an extra line of credit was provided to NBFCs. Concurrently, purchase of buses for urban transport system were stepped up as part of the urban renewal scheme.
  • To protect domestic industries from external competition, import and countervailing duties were imposed
  • Funding support for India Infra Finance Company via tax-free bonds worth INR300bn to affirm long-term thrust towards infra spending
  • Capital infusion for banks
  • Indirect tax cuts i.e. lower excise duties by 6% and service tax cut by 2% and selected exemptions from basic customs duty.

Fiscal support: this time is different

The starting point in 2020 differs on a few counts. Firstly, impact of the COVID-19 shock on domestic sectors and consumption will be far more severe than during the GFC. This makes it more imperative for swift fiscal support. Secondly and in contrast, the government’s fiscal position (centre and states) is more precarious than back during the GFC, making it a challenge to ramp up a generous support package. With a smaller headroom, we reckon that measures announced will be incremental, targeted and undertaken in phases.

In consideration might be:

a)      further cash transfers under the Jan Dhan channel or through higher payments under the MNEGRA route; b) fund assistance for companies to cover fixed costs during the lockdown period; c) interest subvention schemes for selected sectors d) further financing support to state coffers; e) bunched up repayments for past arrears of government services, amongst others; f) targeting immediate relief to MSMEs (contributes to a third of GDP), a credit guarantee facility might be in the offing, which will require the centre to partially guarantee loans that banks could offer affected businesses.

India: Dissecting Slowdown And Likely Recovery 9

Speculation is that the total support package might be limited to INR4.5trn (2% of GDP), according to unnamed sources cited by local press. With INR1.7trn already outlined, another INR 1.5-3trn might in the works. A package of this size will fall short of compensating all affected economic agents. But might provide some respite through a well-targeted approach to cushion MSMEs (see chart) along with more vulnerable households.

We note in this piece, that the general government (centre and states) deficit is likely to rise to 10-10.5% of GDP in FY21 vs around 6% of GDP earlier. This would entail the public debt level to rise from 70% of GDP to 75-80%, with the shrinking GDP (denominator effect) also ballooning the debt burden.

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Fiscal financing options

With fiscal deficits bound to rise, financing options will warrant close attention. As written in this piecefew likely to be considered:

1)      The central bank could outline a pre-set calendar for OMOs for bond purchases Private debt placement or/ the central bank’s participation in the primary market is also a way to support domestic issuances.

2)      Higher T-bill issuances or small saving schemes

3)      Earmarked COVID-19 funding i.e. additional (centre and states) borrowings and expenditure towards this purpose can be placed under a COVID-19 fund or contingency arrangement. 

4)      Tax-free COVID-19 bonds issued to residents and domestic investors, carrying attractive returns and longer tenors

5)      Tap offshore savings and non-residents by way of special securities. As already indicated earlier in the year, earmarking a bigger proportion of the FY21 issuance for inclusion by bond indices might also help attract more passive and long-term investors.

Rating action a risk

The need for a strong support package in midst of a sharp slowdown in growth as well capital infusion to recapitalize financial institutions, will weigh on the fiscal math. Higher contingent liabilities might be accompanied by a wider fiscal deficit, while slower growth makes public debt ratios look adverse. 

Moody’s currently pegs India two notches above investment grade and Fitch and S&P are only rung above sub-investment grade. Most recently, Moody’s had lowered India’s rating outlook to negative in November 2019.

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What will normalcy entail?

Questions are now being asked on when normalcy will return. Encouragingly, an extension in the lockdown is accompanied by gradual opening of the economy. We expect 2Q20 (1Q FY21) to mark a trough for activity, with a negative headline print, before inching higher in rest of the year.

As restrictions are lifted, worries over a resurgence in infections will see social distancing remain a norm as experiences of other countries show (including China).

There might be an early burst in consumption due to pent-up demand and inventory restocking needs by manufacturers. Services undelivered during the lockdown are, however, permanently lost.

Domestic fragilities will need to be addressed with a heightened sense of urgency. Primary amongst is ensuring financial sector stability, as the strain of weak private sector performance, higher stress in corporates’ balance sheets, questions over business viability and spike in working capital requests will put pressure on the capital base. Around the GFC, the domestic financial sector was in a much healthier shape and yet required capital support coming out of the crisis. Given the deeper economic shock this time around and material hit to corporate profitability on the cards, a capital backstop would become necessary to absorb higher stressed assets as well as provisioning needs.

Rest of the domestic agenda will be focused on smoothening the large scale labour migration during the lockdown and facilitate a return of the workforce to the urban areas with better health and infrastructure facilities.

A bigger presence in the global supply chain as well as building on the manufacturing base, just as regional competitors face tougher operating conditions, will be a priority. In this regard, pursuing earlier efforts to simplify labour regulations, easing land acquisition, strengthening the contractual framework etc. will be key.

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Radhika Rao
Economist, DBS Group Research

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