What induces inclusive growth?

In an article in VoxEU, Jalles and de Mello argue (related paper in Review of Development Economics) that episodes of inclusive growth are more likely to occur where human capital is high, tax-benefit systems are more redistributive, productivity grows more rapidly, and labor force participation is high. Trade openness and a range of institutional factors, including political system durability and electoral regimes, also matter. They define inclusive growth as increases in GDP per capita without a concomitant deterioration in the distribution of household disposable income.

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In fact, data from the World Bank World Development Indicators show that inclusive growth is not a rare event: between 1980 and 2013, there are 268 episodes of increases in GDP per capita without an associated deterioration in the distribution of household disposable income in the sample of up to 78 countries for which information is available. These episodes include, for instance, France between 1985 and 1989, Germany between 1995 and 1997, Brazil between 2004 and 2006, and India between 1998 and 2000. 

[…] In an average episode, real GDP per capita grows at about 3.3% per year, and the Gini coefficient of household disposable income falls by about 0.8 over the same period. While duration does not seem to have much influence on the magnitude of changes in real GDP per capita during inclusive growth episodes, the reduction in the Gini coefficient tends to be more pronounced in episodes that last four years or less.

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They argue that inclusive growth episodes are more likely to occur where:

• Population is better educated
• Tax-benefit systems are more redistributive
• Labor force participation and multifactor productivity growth are higher
• Economies are more open to trade 
• Share of population working in industry is higher
• Durable political systems exist with regular parliamentary elections and electoral regimes based on proportional representation (not exactly durability of governments per se though)
• Some degree of fiscal decentralization exists

But then, inclusive growth episodes are less likely where:

• Inflation is high
• Output growth is more volatile
• Unemployment is widespread
• Financial deepening is more (higher probability of banking and financial crises occurring)

So, redistribution through tax-benefit systems, human capital accumulation, and a sound macroeconomic framework seem to be important for inclusive growth. However, note that results may change slightly depending on the definition of inclusive economic growth. For instance, some define inclusive economic growth (prosperity) as the annualized growth in average real per capita consumption or income of the bottom 40 per cent. Others define it as rapid and sustained economic growth, access to education and health opportunities, and social protection. 

Fiscal policies to address COVID-19 pandemic

In its latest Fiscal Monitor (October 2020), the IMF argues for flexible fiscal measures to respond to lockdowns and tentative reopenings, and facilitation of structural transformation to a new post-pandemic economy. The report outlines a roadmap for the overall fiscal strategy to promote a strong recovery. The idea is to facilitate the transformation to a more resilient, inclusive and greener economies. The IMF recommends full transparency, good governance, and proper costing of all fiscal measures, especially given their size, exceptional nature, and speed of deployment.

Going forward, interest rates will remain low for a long time in advanced and some emerging market economies due to high levels of precautionary savings by households and limited private investment amidst the uncertainties. It means there is scope and motivation for fiscal policy (thanks to negative interest-growth differential) to remain a crucial and powerful tool for recovery. For instance, scaling up of quality public investment will boost employment and economic activities, crowd-in private investment, and absorb excess private savings without increasing borrowing costs. Some emerging market economies and low-income developing countries that face tight financing constraints may need to reprioritize expenditures, enhance efficiency of spending, and seek further official financial support and debt relief.  

On the nature of fiscal policy during and after the pandemic, the IMF recommends:

• No premature withdrawal of crucial household and business support measures
• Ensure social protection systems are targeted and able to deliver benefits to vulnerable people
• During the recovery phase, help workers find new jobs and facilitate vulnerable firms to reopen
• Support structural transformation toward the post-pandemic recovery including building resilience against future epidemics and other shocks. Policies to ensure that all people have access to basic goods (food) and services (health and education) are useful. Similarly, increasing carbon pricing and catalyzing investment in low-carbon technologies would help reduce emissions.
• When the pandemic is under control, focus on addressing the legacies of the crisis such as elevated private and public debt levels, high unemployment, and rising inequality and poverty.
• Countries with limited fiscal space should consider increasing progressive taxation and ensuring that highly profitable firms are appropriately taxed. This should be a growth-friendly and equitable adjustment.
• Develop well-resourced and better-prepared healthcare systems, expand digital transformation, and address climate change and environmental protection. 

Recovery strategy

To boost immediate-term growth, the IMF recommends transfers and public investment, which when faced with uncertainty combined with very low interest rates, weak private investment, and a gradual erosion of public capital stock over time yield a high fiscal multiplier. The fiscal response strategy depends on at what stage of the recovery a particular country is in, i.e. lockdown, partial reopening or post-pandemic phases. These generally include the following

• Lockdown phase: The objective is to save lives and livelihoods by continuing projects where safe (especially maintenance/repair).
• Start planning or reviewing portfolio of planned and active projects
• Partial reopening phase: The objective is to ensure safe reopening and to provide lifelines and targeted support. 
• Public investment could focus on job-rich projects, reassess priorities and prepare pipeline
• Maintenance works and ready for implementation projects should be the priority
• Review, reprioritize and restart feasible projects put on hold, plan for new projects or prepare pipeline of appraised projects that can be implemented in the next two years
• Post-pandemic phase: The object is to transform to a more inclusive, smart and sustainable economy. 
• Depending on fiscal space, countries could implement large, transformational projects with large long-term multiplier in healthcare, climate change adaptation and mitigation and digitization sectors.
• Strengthen project planning, budgeting, and implementation practices to improve public investment efficiency

Fiscal multiplier

The pandemic focused fiscal strategy calls for strengthened public investment management practices and governance to avoid delays, cost overruns, and disappointing project execution. Countries facing tight fiscal conditions could borrow at a low interest rates, which are expected to remain low through the medium-term. 

In advanced and emerging market economies, fiscal multiplier can be as high as 2 in two years. The IMF finds that increasing public investment by 1% of GDP in these economies would create 7 million direct jobs, and between 20 million and 33 million jobs indirectly. Similarly, GDP could grow by 2.7%, and private investment by 10%. The estimate is based on an empirical exercise covering 72 AEs and EMs with data on economic uncertainty regarding GDP forecasts (proxied by disagreements among forecasters). 

Public investment has larger short-term multipliers than public consumption, taxes or transfers. Macroeconomic conditions, institutional quality, and the quality of investment undertaken affect the size of multiplier. 

• First, higher levels of public debt could yield lower fiscal multipliers if deficit-financed investment leads to greater sovereign spreads thus higher private financing costs (essentially, crowding-out the private sector). 
• Second, if an economy faces supply constraints, then fiscal multipliers tend to be smaller (social distancing measures limit output capacity). 
• Third, uncertainty over the trajectory of the virus and the economy could affect multiplier if private spending does not react to a fiscal stimulus (due to uncertainty and precautionary savings). Alternatively, multiplier could be higher if private spending reacts positively to higher public investment amidst mounting uncertainties. 
• Fourth, weak balance sheet of firms (as they are unable to repay debt) and default risks limit their investment and hence the size of fiscal multiplier. 

Generally, multipliers tend to be larger in countries less open to trade because low propensity to import reduces leakage of the demand gains to other countries. Similarly, multipliers tend to be large in countries with fixed exchange rate regimes or where central banks are facing an effective lower bound. Also, when resources are underutilized (like in recessions), fiscal multipliers tend to be high – could be through direct public investment or through a combination of direct public investment and crowding-in of private spending through confidence boosting measures. 

Crowding-in private investment is possible in communications and transport (to respond to healthcare crisis), and construction and manufacturing (during recovery). Investment in health and education, and digital and green infrastructure can improve connectivity, economy-wide productivity, and resilience to climate change and future pandemics. Right government policies and initial investment can crowd-in private investment when faced with uncertainties.

 

Sizable fiscal support

The IMF notes that fiscal actions in response to COVID-19 amounted to $11.7 trillion (12% of global GDP) as of 11 September 2020. Half of this was additional spending or foregone revenue (such as temporary tax cuts and liquidity support including loans). In 2020, government deficits will likely surge by an average 9% and global public debt will approach 100% of GDP. Sizable discretionary support, a sharp contraction in output and an ensuing fall in revenues along with a rise in expenditure (beyond preexisitng automatic stabilizers) have increased government debt and deficits. 

Fiscal space

The ability of countries to respond to the pandemic is determined in part by their fiscal space, and by public and private debt levels. In advanced economies, massive liquidity provision and asset purchases by central banks have facilitated fiscal expansions. In some low-income countries, financing constraints have been high due to debt distress. 

Countries with limited fiscal space need to weigh in the benefits, costs and risks of additional fiscal support measures in the face of limited fiscal space. Evidence so far suggest that public health policies that quickly contain the spread of the disease also allowed for an earlier and safer reopening, restoration of confidence, and economic recovery. 

Popular fiscal support measures included the following:

• Household income support (targeted cash transfers or/and in-kind transfers, unemployment benefits/stimulus checks)
• Employment support (wage subsidies, hiring or retention subsidies)
• Tax support measures (temporary tax deferrals, social security payments, income tax cuts, progressive tax, increase in excise duty, VAT refunds, utility subsidies)
• Liquidity support (loans, guarantees, equity injections/solvency support, debt restructuring) 
• Support for innovation, green growth and digitization

Financing public spending

Some EMDEs have met increasing financing needs from borrowing internationally, drawing down buffers or extrabudgetary funds (India) or sovereign wealth funds (Chile, Russia), purchasing of government debt by central banks through quantitative easing (many AEs and some EMs), and increasing taxes (especially fuel excise tax in India and VAT rate in Saudi Arabia). Low income countries are relying on external assistance (grants or concessional loans).

Fiscal risks: Fiscal risks are high. They stem from

• A protracted economic downturn (private sector demand may remain subdued, bank balance sheets may deteriorate, high fiscal resources needed to support and retain unemployed workforce) 
• Tightening global financial conditions (rapid growth of sovereign debt and nonfinancial corporations debt expose countries to sudden change in financing conditions, especially borrowing costs, and subsequently issues with sustainability of corporate credit and sovereign debt)  
• Commodity market volatility (price fluctuations impact commodity exporters and importers differently)
• Contingent liabilities (new guarantees increase liabilities and debt vulnerabilities)

Post pandemic recovery strategy

It was published in The Kathmandu Post, 19 October 2020.

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Everything is not okay

A series of impractical and confusing recovery policies have heightened business, investment and employment uncertainties.

Owing to a prolonged combination of health, supply and demand shocks, and a botched response to containing the spread of the novel coronavirus, the pandemic is severely affecting the economy. These shocks, along with preexisting economic and governance weaknesses, have increased the likelihood of subdued economic activities well into the medium-term; that is, the ongoing economic pain may not be a temporary phenomenon. The poorest households, informal sector workers, and those working in contact-intensive services have been disproportionately affected. Consequently, both poverty and inequality are expected to increase. Furthermore, many micro, small and medium enterprises are expected to face bankruptcy, as consumer demand remains muted and supplies continue to be disrupted.

Against this backdrop, a sustained and inclusive economic recovery hinges on pragmatic stabilisation policies over the short to medium term, followed by coherent structural reforms across sectors over the medium to long term. The economic strategy should focus on propping up aggregate demand over the medium term through public spending on quality, shovel-ready projects; or through the repair and maintenance of public assets. In order to bridge the short-term financing gap amidst high fiscal stress, the government may need to rely more on policy-based external borrowing, which comes as budget support conditional on fulfilling certain committed reforms.

Not so rosy

Economic output growth in the fiscal year 2020-21 will most likely be only slightly better than in 2019-20, thanks to a base effect, which refers to a tendency of achieving an arithmetically high rate of growth when starting from a very low base. Gross domestic product (GDP) growth might actually contract in 2019-20 as labour and capital mobility were curtailed in the last quarter of 2019-20 as well. Third quarter estimates released by the Central Bureau of Statistics in September show that GDP growth plunged to 0.8 percent even though lockdowns started in the middle of the quarter. This is the slowest pace of quarterly GDP growth since the second quarter of 2015-16, when the Indian economic blockade contracted the economy. The fourth quarter GDP data for 2019-20 will probably show a contraction. Cumulative full year GDP will also likely contract due to the severe disruptions in industry and services owing to lockdowns, a shortage of inputs in the agricultural sector and a lack of effective fiscal response to prop up consumer demand. The Bureau’s 2.3 percent growth projection for 2019-20 has no relevance now. The International Monetary Fund projects the economy to grow by 0.02 percent in 2019-20 and 2.5 percent in 2020-21.

The other statistics are also not that rosy. Despite subdued demand for consumer goods, continued supplies disruptions, as well as higher logistics costs, will likely keep inflation above 6 percent. The surge in banking sector liquidity is temporary, as credit growth has slowed down significantly due to a drop in new loan applications. This is benefitting the government as it is able to borrow at a record level with lower interest rate. The current account deficit is narrowing down as imports decelerate more than exports and remittances’ deceleration is below expectation. These indicators will quickly deteriorate as businesses and household activities pick-up pace. Overall, the outlook is not at all rosy.

Effective recovery

What went wrong since the first confirmed Covid-19 positive case on January 23 and the lockdown that started on March 24 but was relaxed in September? The uncontrolled outbreak and the lack of healthcare infrastructure are now considered a basket case of bad pandemic mismanagement. The lockdowns were an opportunity to prepare necessary healthcare infrastructure—which includes the availability of personal protective equipment, hospital beds, Covid-19 care centres for those unable to stay in home isolation, an active network of contract tracers, and widespread testing, among others—to respond to the eventual rise in infections. Not only was healthcare response mismanaged, the economic response too was patchy and demoralising. A series of impractical and confusing recovery policies heightened business, investment and employment uncertainties. These need to be rectified for sustained and inclusive recovery.

The priority should be the healthcare sector. Without controlling the spread of the novel coronavirus and providing necessary medical care to the infected, a full recovery to pre-crisis output growth is a foregone conclusion.

The government should then implement effective short-term measures to support struggling households (through cash transfers and in-kind food subsidies) and businesses (with subsidised low interest loans, credit guarantee schemes, tax deferrals, moratoria on debt services, and equity injections in promising firms). This calls for both a growth-enhancing revenue policy and an expenditure policy designed to stabilise the economy in the short term, followed by structural reforms to boost long term growth potential.

However, since this entails additional fiscal burden amidst limited resources, the third priority should be a smarter fiscal strategy. For instance, expenditure should be reprioritised to address the healthcare crisis. It means investing in temporary Covid-19 care centres, increasing hospital beds and ventilators, increasing availability of affordable and hassle-free testing, and tracing potentially exposed people effectively, among others.

Similarly, to boost short-term aggregate demand, the government could prioritise shovel-ready projects that can be completed within the next two to three years, or simply focus on the maintenance of existing assets (especially water supply, irrigation canals, bridges, rural roads and highways, transmission and distribution lines, etc) and the completion of ongoing projects. It will not only give an immediate-term boost to public sector-led demand at a time when private sector demand is subdued, but will also create badly needed manual and low skilled jobs for returning migrant workers. Initiating new projects that are short of project readiness should not be the priority for the short-term. To save scarce resources, the government could think of ending subsidies on fuel and all discretionary handouts.

To generate more resources to finance short-term needs, the government could also focus on securing policy-based loans from development partners. A well-planned set of sectoral reforms with clear policy, regulatory, institutional and legal framework would serve as a basis for securing policy-based loans. The post-Covid-19 era is a defining moment to initiate consequential structural reforms similar to the ones rolled out in 1992. Public financial management reforms, such as in robust medium-term expenditure and revenue frameworks, streamlined processes across the three tiers of government, and legal cap on central and provincial fiscal deficit, are important. The digitisation of government services, integrated social protection platform for better identification and to control leakages, and core sectoral reforms in energy, water supply, roads, education and health sectors are other key areas. Another key avenue for development is an overhaul of the vocational training curriculum to provide reskilling to shrinking sectors such as travel and tourism. In business, the promotion of economic corridors to boost enterprise on the one hand, and a facility to resolve bankruptcies sooner for struggling organisations on the other would both go a long way to boost growth and recovery.

Remittances and external sector stability in Nepal

It was published in The Kathmandu Post, 02 September 2020. Related Twitter thread with charts here. 

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The cash cow is drying up

Don’t be fooled by the better-than-expected results from the external sector, the effects are only temporary.

The latest provisional data for the fiscal year 2019-20 released by the Nepal Rastra Bank provide interesting insights on the impact of Covid-19 and the subsequent lockdowns on the economy. Almost all areas, except for the external sector, have been hit hard since the first lockdown began in late March. Specifically, unlike projections of a sharp drop, the data shows just a small deceleration in remittances.

This has led some to argue that Nepal’s external sector is sound as well as resilient and that vulnerabilities are on the downside. However, the reality is that it only appears sound owing to a larger import contraction than export contraction, and slower than expected deceleration of remittances. Remittances are an important household coping strategy when faced with an adverse income or consumption shock. Migrant workers tend to use precautionary savings to remit more after such shocks. This should not be construed as a sign of resilience.

Still unstable

A sudden supplies disruption was expected to hit imports and remittances, resulting in an improvement in the current account balance, which is a record of Nepal’s transactions with the rest of the world. Exports pretty much stalled after the pandemic spread globally. Imports, except for medical equipment and supplies, were also severely curtailed due to disruptions and logistical hurdles. Further, oil imports, which normally account for 15 percent of the total import bill, decreased on account of a drop in internal demand, particularly for transportation and development projects.

Declining global oil prices also contributed to a lower oil import bill. Consequently, imports decreased much faster than exports. For instance, in US dollar terms, merchandise exports and imports contracted by 7.9 percent and 18.9 percent, respectively. In a reversal of the previous trend, merchandise trade deficit actually dropped to 28.2 percent of the gross domestic product in 2019-20 from 37.1 percent of GDP in 2018/19.

Similarly, the trade imbalance in services also improved as services import (which includes outbound travel and foreign educational expenses) decreased much more than services export (which includes inbound travel and tourism). A sharp contraction of imports but a small contraction of remittances (by just 3.4 percent) improved the current account balance. This is what the analysts meant when they argued that the external sector remained stable despite the adverse external environment.

Meanwhile, the balance of payments reached a record $2.4 billion as a large contraction of imports but a lower than expected deceleration of remittances and an increase in foreign direct investment and foreign emergency loans all played crucial roles. Similarly, gross foreign exchange reserves have also hit record levels. The Nepali rupee depreciated by 9.2 percent against the US dollar at the end of 2019-20.

The improvement in the current account balance, a large balance of payments surplus and record foreign exchange reserves might have given a misplaced assurance that all is sound and stable. But regardless of the pandemic being contained or the country choosing to simply live with the virus, as the economy opens up after the lockdowns and supply chains are restored, the situation might quickly change.

Most prominently, the import of commodities (oil, food and raw materials) as well as intermediate capital goods will increase. Meanwhile, given the lack of price competitiveness, an unfavourable policy environment, distortionary incentives and generally subdued external demand, exports will likely not recover soon. Travel and tourism activities may not also recover quickly. These will deteriorate the tenuous external sector stability and put a strain on foreign exchange reserves.

A short respite

The problem will be compounded by the expected deceleration of remittance inflows. Apart from its positive effect on reducing poverty and boosting consumer demand, government revenue and financial sector liquidity, large remittance inflows have been a saving grace for external sector stability in the face of a large and growing trade deficit. The number of Nepali migrant workers has been continuously declining since 2014-15. The persistent deceleration of remittances will be coupled with a smaller expatriate workforce, with fewer outbound migrant workers and a reduction in the work hours of those already working abroad.

There are three main reasons why remittances did not decelerate as expected in 2019-20. First, remittances tend to increase immediately after a shock in receiving countries. For instance, remittances increased by 12.2 percent in 2014-15 as migrant workers, drawing from their precautionary savings, remitted more income to their earthquake-affected families. However, the following fiscal it only grew by 0.8 percent. Second, the depreciation of the Nepali rupee against the US dollar also provides an incentive for migrant workers to remit more money. The rupee depreciated by 9.2 percent in mid-July 2020, much higher than 0.02 percent depreciation in mid-July 2019. Third, the use of formal banking channels to remit income has increased along with the rise in the number of money transfer agencies and the crackdown on informal inflows.

The Nepali economy entered the Covid-19 era with pre-existing weaknesses: a weak foundation for meaningful structural transformation, volatile GDP growth and inflation, mounting fiscal stress due to a large fiscal deficit and increasing public debt, persistent asset-liability mismatches and high credit growth by financial institutions, and decelerating remittances. It was exacerbated by weak governance and contract management in public projects, political infighting within the ruling party, over-politicisation of the Millennium Challenge Corporation’s compact programme and geopolitical discord. The potential deceleration of remittances will exacerbate these trends, and heighten external sector stress.

The impact of COVID-19 on Africa

Paul Collier explains how four shocks (drop in commodity prices, remittances, tourism, and international capital) due to the overarching COVID-19 shock are threatening Africa's progress.

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Two in three jobs in sub-Saharan Africa are in the informal sector. There are no economies of scale or specialisation. Small is not beautiful, it is unproductive. Africa needs more companies capable of organising a workforce into specialised, collaborative teams, disciplined by competition. Yet even the firms that Africa has are bleeding from the economic impact of coronavirus.

This shock is not predominantly a result of Africa’s health crisis. The causes are the sharp downturns in advanced economies. Commodity prices have dropped and Africa is a major net exporter.

Senegal and Ethiopia are major recipients of remittances from citizens working abroad. Normally, these rise during a domestic crisis, but in this global emergency Africa’s diaspora are losing their jobs. This also hits the most desperate places such as Yemen.

Finally, the retreat of international capital to safety is hitting hardest the countries that were most promising for investors. Ghana was attracting US pension fund money and major companies such as Volkswagen and Bosch. All four shocks are eroding Africa’s scarce organisational capital and are likely to persist for the medium term.

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Impact of COVID-19 on the external sector

The IMF’s latest external sector report highlights the state current account balance amidst the global trade and supplies disruptions caused by the COVID-19 pandemic. The pandemic has sharply curtailed global trade, lowered commodity prices, and tightened external financing conditions. 

According to the report, the world had a current account surplus of about 2.9% of world GDP in 2019. About 40% of current account surpluses and deficits were excessive in 2019. Euro area had larger-than-warranted current account balances, but the US, the UK and Canada had lower-than-warranted current account balances. China’s external position remained unchanged and they were broadly in line with fundamentals and desirable policies. Currency movements were generally modest, but with preexisting vulnerabilities/fundamentals in EMDEs (large current account deficits, a high share of foreign currency debt, and limited international reserves or reserves adequacy). 

The IMF forecasts current account surplus narrowing by 0.3% of world GDP in 2020, thanks to large fiscal expansion but offsetting increases in private savings and lower investment (precautionary move by household and business sectors). Economies dependent on severely affected sectors such as oil and tourism, and remittances have been hit hard.  There was a sudden capital flow reversal and currency depreciations in EMDEs as financial market sentiment deteriorated during the initial days of the crisis. Unsurprisingly, global reserve currencies appreciated as investors looked for safe haven amidst the financial stress. There is some unwinding now though, reflecting exceptional monetary and fiscal policy support. 

Current account balances in 2020 will be affected by 

• Contraction in economic activity (lower output/export and import demand)
• Tightening in global financial conditions
• Lower commodity prices (oil, metals, food, raw materials)
• Contraction in tourism
• Decline in remittances 

The number of export restrictions in 2020 is higher than during the global financial crisis, but the number of import restrictions is lower. Sectors such as pharmaceutical and medical supplies, made-up textile articles, wearing apparel, rubber products, and ethyl alcohol and spirituous beverages faced the most export restrictions.  

Some EMDEs with preexisting vulnerabilities (large current account deficits, a high share of foreign currency debt, and limited international reserves) might face high risk of an external crisis (with capital flow reversals and currency pressures) if risk sentiment deteriorates. 

A second wave of the pandemic could lead to tightening of global financial conditions, narrow the scope of EMDEs to run current account deficit, further reduce current account balances of commodity exporters, and deepen the decline in global trade. Up to now, swift response of central banks (policy rate cuts, liquidity support, asset purchase programs, and swap lines offered by the US Federal Reserve) and expansionary fiscal policy have contributed to an easing in global financial conditions. EMDEs experienced sudden capital flow reversals in late February and march but then stabilized in most cases with even modest inflows in selected economies. 

Near-term priority

The near-term priority should be to provide relief and promote economic recovery. 

• Flexible exchange rates should be allowed to adjust as needed to absorb external shocks (especially a fall in commodity prices or tourism). 
• Official financing to ensure continued healthcare spending is required for those economies experiencing disruptive balance of payments pressures and without access to private external financing. 
• Tariff and non-tariff barriers to trade, especially on medical equipment and supplies, should be avoided. 
• Countries with adequate forex reserves could engage in exchange rate intervention to avoid disorderly market conditions and limit financial stress. 
• Countries with limited reserves and facing reversals of external financing, capital outflows management measures could be useful (but these should be used to substitute the warranted macroeconomic and structural policy actions).

Medium-term priorities

Preexisting economic and policy distortions may persist or worsen over the medium-term.

• Fiscal consolidation over the medium term would promote debt sustainability, reduce current account gap, and facilitate raising international reserves. Note that excess current account deficits in 2019 partly reflected larger-than-desirable fiscal deficits. 
• Productivity-enhancing reforms would benefit economies with low export competitiveness. 
• For countries with large current account surpluses after the COVID-19 pandemic, prioritizing reforms to encourage investment and discourage excessive private savings are warranted. In some instances, economies with large current account surpluses could discourage excessive precautionary savings by expanding the social safety nets. 
• For economies with some fiscal space, emphasis on greater public sector investment would be helpful to narrow excess surpluses and to stimulate economic activities. 

Outlook for 2021

The outlook for 2021 is highly uncertain. Under a scenario where a second major global outbreak occurs in early 2021 (disruptions to economic activity is assumed to be half the size of the baseline in 2020, financing tightening of about one-half of the increase in sovereign and corporate spreads since the outbreak began in EMDEs, and relatively limited tightening of sovereign premiums for advanced economies),

• Global trade is projected to decline by an addition 6%, global GDP decline by 5%, and oil prices to be higher by 12% compared to the baseline. 
• Recovery in global trade will be underpinned by the need to rebuild the capital stock (investment goes up), and higher import intensity of exports. 
• Emerging market economies will face higher borrowing costs, lower oil prices and subdued domestic demand – it will raise current account balances toward surplus. 
• Net oil exporters will face lower oil prices, which will reduce their current account balances.
• Advanced economies will face relatively limited tightening in external financing conditions and greater fiscal policy space will mean lesser import compression than among EMs, leading to lower current account balances. 
• So, capital will flow from EMs to AEs, highlighting the unequal impact of the crisis and the need for a global policy response. 
• Under a faster recovery scenario, global trade rises by 4% in 2021 compared to the baseline. 

The report notes that the historical relationship between trade and the components of GDP/aggregate demand (or import-intensity-adjusted measure of aggregate demand, which basically is a weighted average of aggregate demand components in which the weights are the import content of each component computed from national accounts input-output tables) fully explains the expected global decline in trade of goods. A part of the impact of lower economic activity on trade is felt through global value chains. After the global finance crisis circa 2009, residual factors such as rising protectionism explained part of the fall in trade in goods and services as they could not be fully explained by the fall in economic activity alone. Services trade contraction in 2020 is more severe than what could be expected based on the historical relationship between services trade and aggregate demand, suggesting the role of special factors such as travel restrictions. 

The IMF determines excessive current account balances by comparing the actual current account (stripped of cyclical and temporary factors) and the current account balance that is consistent with fundamentals and desirable policies. The resultant gap reflects policy distortions (e.g., higher current account balance than implied by fundamentals and desirable policies correspond to a positive current account gap, whose elimination is desirable over the medium-term). The IMF also considers REER that is normally consistent with the assessed current account gap. A positive REER implies an overvalued exchange rate. Other indicators that are considered are financial account balances, international investment position, reserve adequacy, and other competitiveness measures such as the unit-labor-cost-based REER and staff views on the current account gap using country-specific trade elasticities. 

On economic and financial fundamentals, and desired policies, advanced economies with higher incomes, older population, and lower growth prospects have positive current account norms. EMDEs tend to have negative current account norms because they are expected to import capital to invest and exploit their higher growth potential.

Restructuring stressed loans and higher government borrowing to stimulate economy

Restructuring stressed loans in India

Ramal Bandyopadhaya writes in Business Standard that the RBI's decision to allow restructuring of stressed bank loans will help to lower gross NPAs in the banking system. Some 80% of the loans in the banking system qualify for restructuring. 

None could miss the collective sigh of relief from the bankers’ community on the Reserve Bank of India’s (RBI) decision to open a restructuring window for stressed loans. Those accounts, which had been in default for not more than 30 days as on March 1, 2020, can be restructured if the borrowers are unable to service them because of their businesses being affected by the Covid-19 pandemic. The loans can be restructured, among others, by funding interest, converting part of debt into equity and giving the borrowers more time to pay up.

The banks must disclose such recast and set aside 10 per cent of the exposure to make provision for the restructured loans. In June 2019, the RBI had framed norms for loan restructuring, making it mandatory for banks to treat restructured, stressed loans as sub-standard unless there was a change in ownership of the borrowing company. Now, the banks can treat the restructured loans for Covid-19-affected companies as a standard asset even if there is no change in ownership.

[...]Going by one estimate, at least 80 per cent of the loans in the banking system will be eligible for such restructuring. One way of looking at this is that it will delay the inevitable by two years. Also, the 10 per cent provision requirement seems to be low as the banks’ unrealised but booked interest income from stressed borrowers is far higher. By RBI’s estimate, the gross bad loans of the banking system, which dropped to 8.5 per cent in March 2020, could rise to 14.7 per cent by March 2021. The restructuring window may not allow such a spike. The one-time forbearance was the need of the hour, particularly when all banks are not adequately capitalised. The good news is the presence of enough caveats to prevent misuse by the banking industry. In absence of this, many banks would have resorted to the tried and tested method of ever-greening — giving fresh loans to the stressed borrowers to keep the accounts good.

Current economic contraction is different from previous ones

Harish Damodaran argues in The Indian Express that arresting the current demand slowdown requires government investment and that debt concerns should not be overead. Despite fiscal slippages, yields on 10-year government bonds have dropped to 5.9% for the center and about 6.4% for states. This may fall further if banks are not able to lend the money they have collected as deposits.

That makes the current contraction totally different from the previous ones which were “supply-side” induced. There’s no shortage today of food, forex or even savings: Aggregate deposits with commercial banks as of July 31 were Rs 14.17 lakh crore or 11.1 per cent higher than a year ago. The closest parallel one could draw is with the 2000-01 to 2002-03 period of the Atal Bihari Vajpayee-led government. The Food Corporation of India’s (FCI) grain stocks in July 2002 were 2.6 times the buffer norm and the country ran current account surpluses in 2001-02 and 2002-03. But the economy didn’t contract then; growth merely fell from 8 per cent in 1999-2000 to an average of 4.5 cent during the next three years.

What we now have is a classic “western-style” demand slowdown that post COVID-19 has turned into a full-fledged recession bereft of consumption and investment demand. Households have cut spending as they have suffered income, if not job, losses. Even those with jobs are saving more than spending because they aren’t sure when their luck would run out. The same goes with businesses. Many have shut or are operating at a fraction of their capacity and pre-lockdown staff strength. The ones still making profits are conserving cash. If at all they are investing, it is to buy out struggling competitors and not to create new capacities. Just as households are uncertain about jobs and incomes, firms don’t know when demand for their products will really return.

This demand-side uncertainty and the resulting economic contraction is something new to India. And it stands out in a situation where food stocks and forex reserves are at record highs. Meanwhile, banks are also facing a problem of plenty. While their deposits are up 11.1 per cent, the corresponding credit growth has been just Rs 5.37 lakh crore or 5.5 per cent. With very little credit demand, the bulk of their incremental deposits are being invested in government securities, which have increased year-on-year by Rs 7.21 lakh crore or 20.3 per cent.