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The economy recovers amid inflationary pressures

Looking first at the economy, the signals are still mixed. While this year’s second-quarter wave of the epidemic was admittedly less destructive than the Q2 2020 wave, it nevertheless once again hit industrial production, which slowed sharply. The latest available figures show that the recovery picked up somewhat in July but production over the first seven months of the year is still below 2019 levels.

In the short term, the main economic risk to India comes from soaring energy prices. Given the country’s heavy dependence on oil (25% of total imports), higher prices could not only upset the trade balance – which, while never in surplus, had improved during the crisis – but also fuel inflation, which stabilised at around 5.5% over the last quarter.

This also complicates matters for the Reserve Bank of India (RBI), which has held its base rate unchanged at 4% since May 2020 and whose minutes give no indication of any appetite for monetary consolidation before the second half of 2022. Even if its core component is not immediately affected, quickening inflation driven by rising energy prices could force the RBI to review its calendar, especially if the rest of the emerging world begins to hike interest rates, as seems likely.

Controlling inflation and energy prices is an especially tricky issue because it is often a breeding ground for social discontent. And India is already experiencing profound social unrest linked to the conflict between farmers and the government.

The farmers’ revolt turns political

With the farmers’ revolt rumbling on for over a year and no apparent solution in sight, events took a dramatic turn on 3 October when nine people – four of them farmers – were killed in violent clashes at a protest that coincided with a visit to Uttar Pradesh by the junior home affairs minister.

In this highly nationalist state governed by a Hindu monk, authorities were quick to respond by banning public gatherings, suspending internet services, closing main roads and arresting members of the opposition keen to come out in support for the farmers.

Although farmers continue to demand that laws passed in September 2020 aimed at liberalising agricultural markets by scrapping the system of state-guaranteed prices be withdrawn, the movement has taken a more political turn over the past few weeks.

Opposition parties (particularly the Congress Party) had hitherto failed to politicise the movement, but the tone has changed at the last few protests. In Uttar Pradesh for example, where the daughter of former prime minister Rajiv Gandhi and granddaughter of Indira Gandhi (India’s only woman prime minister) is standing for the Congress Party in the regional elections, protest organisers have clearly shown their support and called for the defeat of the ruling party, Narendra Modi’s BJP. 

This no doubt goes some way towards explaining the edginess of the region’s authorities, who understand the critical importance of rural society in India, where the agricultural sector employs more than one out of every two people but is the main source of income for nearly 70% of the population.

With 200 million people, Uttar Pradesh is India’s most populous state and a politically sensitive region: won comfortably by the BJP in the 2017 elections, the state is also one of the most repressive towards Muslims, another highly charged issue. It is no surprise, then, to see positions on these two socially explosive issues (farmers’ revolts and increasing efforts to hunt down Muslims) becoming more radical, especially at a time of economic crisis. The February 2022 regional elections will be a good test of the popularity of Narendra Modi, who still bears the scars of a crushing defeat in West Bengal in May 2021 despite having spent huge amounts and held numerous political rallies in the middle of an epidemic outbreak. Losing Uttar Pradesh would be an even more symbolic defeat and would bode ill for the 2024 general election.

The escalating crackdown goes hand in hand with the politicisation of the movement, which is not at all what Modi – weakened as he is by a very deep-seated economic crisis that has considerably affected the social fabric, in particular by destroying jobs – needs. And this chapter is not over yet: only 18% of India’s population is fully vaccinated (48% have received a first dose), which leaves the risk that a fresh outbreak of the epidemic could further slow the recovery.

Optical illusion or effective government support?

While the suspension of bankruptcy filings certainly goes some way towards explaining these trends, they are also largely a product of preventive measures designed to mitigate liquidity risk linked to cash flow needs, for want of being able to mitigate the drop in sales. These support measures have enabled non-financial corporations (NFCs) to increase their liquidity reserves and improve their cash positions. Their liquid assets increased 9.6% in the first quarter and 18% in the second quarter.

Furlough schemes and the option to defer tax and social security contributions have helped limit the costs incurred by the temporary decline in activity. Government guarantees on loans have enabled businesses to lengthen their loan maturities, meet interest payments, cover operating expenses and adjust output in line with the new environment. In the second quarter of 2020, government-guaranteed loans accounted for 1.6% of all new loans in Germany, 4.8% in France, 5.6% in Italy and 9.2% in Spain. For large corporates, government-guaranteed loans on average accounted for 3.8% of total new loans in the eurozone; the equivalent figure for SMEs is 14.3%. Moratoria on loans to NFCs have also played a part, applying to 2.6% of total loans in Germany, 7.7% in France, 13.9% in Italy and 0.2% in Spain.

These policies have had a greater impact in Italy and Spain, where liquidity stress seems to have arisen more quickly than in France or Germany. According to the ECB, these measures reduced the probability of NFCs experiencing a liquidity crisis during the first two months of the crisis by three quarters in Spain, two thirds in France and Germany and half in Italy. They thus enabled businesses to extend the period over which they would be able to meet their liabilities before business picked up again.

All these measures are temporary, and have simply deferred financing requirements and encouraged higher borrowing. Consequently, a number of corporate issuers have had their credit ratings or outlooks downgraded. The probability of default on loans to NFCs rose from 2% at end 2019 to 2.6% in September 2020; the increase was four times greater among SMEs than large corporates (source: AnaCredit).

What the ECB is worried about

During the initial phase of the pandemic, businesses borrowed more from banks mainly to cover ongoing operating expenses, taking out loans with terms of less than one year. Bank borrowing remained high in the second quarter, while market-based corporate debt rose to record levels thanks to ECB intervention to stabilise markets. As activity bounced back over the summer, corporate bond issues and bank borrowing slowed, though continuing at a sustained pace. Meanwhile, NFCs lengthened the average maturity of their borrowings (with the average proportion of net new loans with maturities over five years up from 57% in 2019 to 100% in September 2020), thus reducing their immediate refinancing requirements and locking in prevailing highly favourable financing terms for a longer period. The volume of government-backed loans exceeded the net amount of new lending, suggesting that existing loans were converted into government-backed loans, particularly in Italy and Spain.

Despite an increase in underlying risk, credit conditions remain favourable. Government guarantees have lowered the risk of loss and kept a lid on upward pressure on interest rates driven by higher probabilities of default.
However, the ECB is worried that credit conditions could rapidly tighten when these measures are withdrawn. It is less worried about the increase in debt carried by the largest corporates. Indeed, more than half of the increase in the debt-to-GDP ratio is thought to result from the drop in GDP. The gradual resumption of economic activity would thus automatically lower the ratio. And above all, the increase in debt has been accompanied by a similar increase in liquidity, keeping net debt stable. Nevertheless, while this stability can be seen when looking at the average of all NFCs, there is substantial divergence between sectors, with significant vulnerabilities appearing in those hit hardest by the crisis, where net debt has increased and refinancing risk has risen sharply.  

No rerun of 2009

The ECB has published a composite indicator of corporate vulnerabilities based on multiple factors: activity, profitability, indebtedness, refinancing risk and debt service capacity. According to this indicator, the level of vulnerability is the same as it was in the 2012 sovereign debt crisis but lower than in the great financial and economic crisis of 2009. The rise in the indicator in 2020 is mainly down to the decline in activity, the observed and expected deterioration in profitability and the increase in indebtedness; however, refinancing risk and debt service capacity have tended to mitigate vulnerabilities, whereas they significantly fuelled them in 2009. The difference this time around is explained by favourable financing conditions and long maturities. Government-backed loans, repayment holidays and the suspension of bankruptcy filings have thus helped significantly contain vulnerabilities.

These support measures have obviously been very effective in limiting corporate vulnerability. The recent extension of furlough schemes will enable businesses to maintain production capacity at lower cost as long as activity is suspended or restricted. However, government-backed loans and the option to defer tax and social security contributions have not been extended beyond the end of 2020 in some countries. The ECB has highlighted the risk of withdrawing these measures too quickly: not only would this shut off the supply of liquidity to businesses, it would also trigger the payment of amounts for which temporary exemptions had been granted. This applies not only to repayment holidays and deferred tax and social security contributions but also to shorter-term government-backed loans. The simultaneous withdrawal of these political measures could knock the recovery trajectory off course. The risk of a “cliff-edge effect” would be concentrated in the first half of 2021.

The ECB is once again calling on governments to take supportive action to supplement monetary measures like the PEPP and TLTRO programmes. This call not to be too quick to withdraw fiscal support for the economy has been reiterated by European authorities. To boost more sluggish growth in early 2021, it will thus be necessary either to roll out a fresh suite of support measures or to withdraw those measures already implemented later than assumed in draft 2021 budgets [1].

Paola Monperrus-Veroni - paola.monperrus-veroni@credit-agricole-sa.fr

[1] Eurozone – Lowering the deficit while maintaining economic support: the 2021 budget challenge, Perspectives, issue 20/302, 27 November 2021