A friend asked me recently how the economy is running when most people have not been working due to the lockdown across several countries to tackle the COVID-19 pandemic. Except for the production of a few essential items, the production, sale, and consumption of other goods and services have come to a standstill. Virtually, the entire economy has been stalled. What does this imply for a society?
Traditionally, women have been working at home, cooking, cleaning, and taking care of children, and doing other household chores. But, in our modern society, most of the things used in our homes come from outside, produced by others. There is so much division of labour, based on specialisation, that we produce little of what we consume. The farmer may produce the wheat they consume but they have to get manure from outside. So, the earlier self-sufficiency of village life is gone.
This outside represents the market, where we exchange what we produce with what others produce. In a primitive society, this exchange happened in the form of the barter system, and now in the modern society, we use money we earn from producing what we individually produce to exchange for what we need. Money is only a medium of exchange, and it should not be confused with the income that someone earns. Income is earned from work that is done outside our home. A spouse whoworks at home does not get paid, but a maid who comes from outside to do exactly the same work in our houses gets paid and that is counted as income. So, when we pay the maid, we are exchanging our labour for their labour.
Consider Robinson Crusoe, marooned alone on an island, where he would have to produce everything: food, fetching water, shelter, clothing, energy, and so on. Life would be rudimentary. He would not be able to produce a spoon if he does not have a knife to carve a piece of wood, or produce a cooking vessel if he does not have the skill of a potter and energy to bake mud or clay.
But, we are not Robinson Crusoe cast away on an uninhabited island. We live in a society that has a lot of capital of all kinds with which one can potentially produce what all of us need. For this, human labour is required to run machines, as society is not completely robotised.
Against this backdrop, when a lockdown is announced, people cannot go to their places of work, and production halts. Only essentials are allowed to be produced. For instance, those working in the milk processing units, drinking water supply, electricity, among others can go to work. However, other workers are required to isolate themselves at home to meet the objective of lockdowns, like containing the spread of virus in the current scenario. The modern-day production of goods and services is concentrated in some pockets that are widely dispersed geographically. So, the produced goods have to be moved to the consuming centres all over the globe. This requires finance, trade, and transportation. Consequently, no country or a region in a country is self-sufficient. There are global supply chains, so even nations are not self-sufficient. Only a few large economies have relative self-sufficiency. Even large economies, such the United States (US) and the European Union, import a lot of common consumables from the developing world. While some of those imports are consumed (like, clothing and electronics), others (like, machines) are put to use in production units.The smaller economies are even more dependent on imports.
Given such a scenario, when China, the hub of the global manufacturing sector, announced lockdown in late January, supply chains have been affected across the globe. Progressively, as more and more countries came under lockdown, global production has been increasingly affected. These global supply chains can only be revisited once the world recovers from the ongoing pandemic.
Generally, manufacturers hold some raw material in stock so that even if supplies are affected for any reason, they can continue their production. But, maintaining inventories come at a financial cost, since working capital is borrowed from banks, and an interest is paid to banks in return. So, companies try to minimise their inventories. Many businesses now work on the concept of just in time; get inputs every day and produce every day to cut down costs on inventories. Such a business is considered efficient. Due to such business structures, a supply disruption, due to the lockdown, immediately stalls production in the entire supply chain.
For instance, if cotton is unavailable, thread cannot be produced, and because of that cloth production stops. The processing units do not get work. In turn, garment manufacturers and cloth merchants are affected. The transportation industry carrying finished products, the accountants and shopkeepers, and a whole host of workers throughout the chain lose work in a single stroke.
A lockdown does two things. First, workers cannot go to work, and second, the supply of inputs are disrupted, so that production largely stops. So, even though workers and capital both exist, production stops.
Generally, world over, production is carried out in large- and small-scale industrial units. In India, there is also the medium and cottage industry, or the unorganised sector. The large and medium industrial sectors by definition have a lot of capital and machines while the rest have minimal resources. A working capital is needed to buy raw materials and inputs, and to pay workers their salaries. At the start of a business, to buy machinery and to construct factory buildings, among others, loans are taken from banks. The smaller unitsget loans from private lenders, or have to invest their own savings. In a nutshell, businesses work with a lot of debt on which they pay interest.
An interest is paid outof revenue generated from sales. So, if sales stop, repayment of loan or payment of interest becomes difficult, and businesses begin to fail. Such loans from the banks turn into non-performing assets (NPAs). However, if production continues when sales have stopped, more inputs are needed and more unsold products accumulate, so more working capital is required and more interest has to be paid. As a result, losses increase, and companies stop production in a lockdown.
Healthy companies maintain reserves (savings) which they can use for a while, but that is not the case with weak companies or smaller industrial units. Generally, in the cottage industry, savings are used to carry out the production, but when production stops, there is no income flow.So, savings are used for consumption.
A working capital is required to carry out production, or to restart. This comes from banks, which, in turn, get it from their depositors in theform of savings. It is the working capitala form of investmentthat keeps the economy running. Since production is not possible without it, investments are crucial than consumption to keep the economy going.It is known that if investments decline then income declinesand so do consumption and savings.
As workers earn their wages and businessmen their profits from production, both are negatively affected in a situation of economic lockdown. The demand in the economy falls, and even if factories are in a position to produce, they do not carry out production lest inventory builds up. As production capacity becomes idle, more investment does not make sense. As investments decline, there would be another round of reduction in incomes and consumption levels, becoming something like a vicious cycle. This is the story of a near-complete lockdown, only when essentials are allowed to be produced.
Savings are the amount of the income left after consumption. So, if incomes collapse, so do savings. But, in any case, consumption has to continue, so people withdraw their savings and past deposits from the banks and financial institutions. Small businesses use their savings for current consumption. As a result, deposits in the banks decline, and simultaneously, credit demand falls as production and investments are affected. That is why an interest rate reduction by the central banks does not give a boost to the economy, because businesses which are shut do not need credit. Banks park any excess funds with the Reserve Bank of India (RBI), as is the case currently.
A vast majority of Indians who are working in the unorganised sector and the poor have low incomes and hardly any savings. So, when incomes stop, their consumption drastically falls. They are the ones who are now migrating from the cities to villages where they feel that their families will at least get food. This model of uneven development, which has been forcing people to migrate, has to be re-examined after the pandemic. Similarly, those running small and cottage industrial sectors are bound to exhaust their savings within a short while, and would not be able to restart their businesses when the situation limps back to normal.
On the other hand, organised sector employees, having fixed incomes, will continue to get at least a part of their salaries for some time and would be able to continue their consumption of essentials. But, this would also mean loss of savings for the companies, and they too cannot sustain it for long. The self-employed, elderly, and retired people have no option but to use their savings.
Businesses, which had already been stressed in a slowing Indian economy prior to March 2020, will now face a failure. Among them, those which have been depending a lot on borrowing (highly leveraged) will be the first ones to fail. Many firms in the financial sector are in this category, and can fail. As these firms are all interlinked via credit, so when one fails to return a loan, the next fails too, and the domino effect takes over, as it happened when Lehman Brother Holdings had failed in 2008 in the US. Though the three-month moratorium announced by the government for the payment of interest to banks could help check business failure to an extent for some time, it may not, however, be enough because production and income generation have stopped during the lockdown, and their revival is uncertain. Despite the fact that businesses that have large reserves (savings) could face less trouble, they too will come under strain due to the prolonged lockdown.
Although agriculture, mining, forestry and logging, and fishing could continue, but as incomes fall, demand for their produce would also decline. In such a situation, either they have to reduce production, or their prices would collapse. For agriculture and fishing, the looming danger is that the price of produce could fall at the source, but in consuming centres in urban areas, due to shortages and profiteering, their prices would rise. Therefore, regulation of trade would become crucial in the coming days.
As the lockdown is likely to be recovered in stages, production could recover gradually. However, the demand for non-essential items would remain low as consumer sentiment and capacity utilisation are down. As it would take some time for investments to pick up, employment and incomes could only revive gradually.
Businesses, which have exhausted their working capital, or have failed during the lockdown, would not be able to restart operations immediately. Even if they want to, banks would be wary of lending to such businesses because of the fear of loans turning into NPAs. In fact, the financial health of banks and other financial institutions would also be precarious, owing to the adverse impact of the lockdown.
As the economy is currently running at 25% of its capacity, compared to what it was in February and before, and assuming that this period of economic inactivity lasts for two months and then it recovers slowly to pre-crisis level in a year,India could see 35% and more drop in its gross domestic product (GDP) levels in this financial year. The economy would lose more than Rs 70 lakh crore of production and GDP would come down to Rs 130 lakh crore from Rs 204 lakh crore in 201920. Most of this loss will be that of the small and unorganised sectors of the economy and that is why many of these units would collapse. So, support would be required both for workers and the small businesses and that can only come from the government, the collective. It would have to provide essentials to the people, so that they do not face hunger, and societal disruption is prevented. It is a medical emergency, so massive investment is required in health infrastructure to tackle the disease. All this would require tightening governance which has been notoriously weak in India.
How does the government finance the massive increase in expenditures that would be required to tackle the pandemic? Taxes are collected from the incomes of people and also from production and consumption. But if the economy produces much less and incomes collapse, then tax collections would also fall. Other revenues would also fall as they too depend on economic performance.
Since GDP would be down by 35%, tax collection would fall by much more than this amount, as essentials would come with alow tax rate of zero rate. Currently, whatever production is taking place, it is mostly essentials. As per my calculations, revenues of centre and states could fall by 50% to 8% of the reduced GDP of 202021. So, from Rs 32 lakh crore, it would be down to about Rs 10.4 lakh crore. It may be noted that last year, the tax/GDP ratio was around 16%. This cannot even meet the current levels of expenditures much less the burden of new expenditures due to COVID-19. No wonder the state governments are complaining of shortage of resources and they have to carry much of the burden of taking care of the people.On the other hand, government expenditures have a committed part, like, interest payment which cannot be reduced.More measures such as a curtailment of salaries, defence expenditure, travel, meetings, and so on would be required. Investments could be postponed, and new projects could be shelved to reduce expenditure. But, it would also mean bringing down employment levels further in the economy. If expenditures are not slashedas the fiscal deficit was already at 10% of the old GDPitcould touch 15.5% of the already reduced GDP levels. In fact, even before this crisis emerged, the fiscal deficit was already at 10% of the GDP pointing out at the poor health of the economy. The possible rise in fiscal deficit levels could be attributed to a drastic fall in the revenue (around 17% of the already reduced GDP projections), increased expenditure to sustain at least half of the population (amounting to 14% of the GDP) and increased medical expenditures to deal with the pandemic.
Against such a backdrop, the government has to go in for a survival package by massively bringing down expenditure and providing a basic minimum for the population to survive, and to contain the spread of infection through lockdown.
Thus, even though machines, factories, and offices exist, the economy has stalled, and restarting production would be difficult if the lockdown lasts for a few months. The poor and the unorganised sector producers who have little savings would be the worst sufferers. As the governments resource position is badly stretched, it could only cater to survival. Most of the economic challenges that have come to the fore due to the COVID-19 crisis are a result of an uneven development. Once the pandemic is tackled, there has to be a serious rethink about our development paradigm and how our society should be run.
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