Policy after COVID-19

Globally, economic policy could soon be in uncharted territory

The spread of COVID-19 across the world, apart from being a severe health crisis, can have wider economic consequences. This was reflected last week in the heightened level of volatility in financial markets and the flight to safety, which pushed US government bond yields to record lows. The Indian markets also witnessed significant volatility. While the main focus at present should be on checking the spread of COVID-19, it is also vital that the economic impact of the crisis is contained to the extent possible. The present situation is being compared with the 2008 financial crisis. This isn’t strictly correct. It’s not only the nature of the problem that is fundamentally different, the available policy space to deal with the economic and financial dislocation is also far more limited.

 
Along with a number of other central banks, the US Federal Reserve (Fed) has reduced policy rates, and is expected to do more. But it would soon hit the zero lower bound. Other central banks such as the European Central Bank and Bank of Japan already have their policy rates in negative territory. Given the nature of the crisis, while monetary easing by the Fed and other central banks will not push up economic activity, it would help ease credit conditions and contain the damage. The Fed is also providing short-term liquidity support to the market. However, if the problem persists and results in a deeper global recession, which is a real possibility, the effectiveness of the monetary policy will be tested. It is possible that large fiscal interventions would be required despite higher public debt. According to the International Monetary Fund, public debt in 90 per cent of the advanced economies is higher than the level before 2008. Economic policy could potentially move to an uncharted zone with ineffectual monetary policy, rapidly rising public debt, and uncertain outcomes. Therefore, it is vital that the available policy space is used carefully. Globally, ensuring smooth functioning of financial markets should be the top priority. Risk aversion could tighten credit conditions significantly with wider economic implications. Further, fiscal space should be used in a targeted manner.

 
In India, while the government doesn’t have the fiscal room to support the economy, the central bank has done well to proactively intervene in the currency market. Apart from announcing sell/buy swaps to provide liquidity in the foreign exchange market, it is reported to have intervened in the offshore market as well. Although currency depreciation will help the tradable sectors, it is important to avoid excess volatility. A number of market participants also expect the Reserve Bank of India to cut policy rates. While the inflation rate is projected to come down in the coming months, disruption in supply chains could induce uncertainty on this account. Also, the state of the financial system would limit the benefit. The decision of the rate-setting committee, to an extent, will be influenced by global developments between now and April 3. Meanwhile, the government has done well to increase tax on petrol and diesel. This would help contain the fiscal deficit. A number of precautionary steps to contain the virus have also been prudent. The government should continue to build capacity to treat infected people. This will help limit the economic downside.