Behind the recovery

Policymakers should not lose sight of economic distortions

Economic activity continues to recover from the Covid-induced shutdown and, according to the Reserve Bank of India (RBI), the economy is expected to break out of contraction in the current quarter. The latest advance tax collection numbers also indicate a rebound. Although it is encouraging that the economy is recovering at a pace faster than expected, it is important for policymakers not to lose sight of the nature of the recovery. Several areas need greater policy attention.

For instance, despite a decline in revenues, listed companies posted operating profit growth of over 25 per cent in the second quarter of the current financial year. This was made possible by a sharp reduction in costs, including employee cost. Firms have been cutting wage cost since the beginning of the pandemic. The salary bill in mid-size listed companies, for example, came down by over 10 per cent in the first half of the financial year. Wages and employment have suffered more in smaller firms and those in the unorganised sector. At a broader level, higher profits for listed firms at a time when the economy and wages are contracting show that the distribution of income may be shifting in favour of capital. As economist Sajjid Chinoy has argued, apart from the issue of equity, this could affect demand. To be fair, firms have reasons to cut wage costs in the current environment. But if all firms do exactly the same thing, it will affect wage income and future demand. The Covid crisis also seems to have pushed up economic concentration.

Further, the policy response to the crisis may be creating unintended economic dislocations. In India, particularly, most of the heavy lifting has been done by the central bank. The RBI has cut interest rates and infused significant liquidity into the system to ease financial conditions. Excess liquidity has pushed short-term market interest rates below the reserve repo rate. In this context, Monetary Policy Committee (MPC) Member Jayanth Varma noted in the last MPC meeting that only some firms were benefiting from borrowing at rates below the policy corridor. He further argued that lower short-term rates carried significant risks. Demand created by lower short-term rates is not accompanied by a supply boost and has greater inflationary risks. Investment is stimulated by lower long-term rates. Steepening of the yield curve by reducing short-term rates does not help boost investment. As the central bank is focused on reviving growth, higher inflation remains a risk. Inflation has been running above the central bank’s target for many months.

Thus, apart from lower wage income, households are also battling higher prices. This could seriously damage the balance sheet of a large number of households, which will directly affect demand and the sustainability of recovery. It is being argued that the RBI should be willing to tolerate inflation to support growth, but this will only exacerbate the problem. In terms of policy interventions, the government will need to make sure that its expenditure is directed in a way that helps create employment. Meanwhile, the RBI would do well to address the inflation issue before it starts affecting expectations and result in greater economic cost. It is also necessary to ensure that smaller firms are able to get credit. In order to sustain the recovery, it is critical that these disruptions in the economy are adequately addressed in the coming quarters.