This government is often criticised for its apparent neglect of the demand side and its excessive focus on the supply side and structural reforms—the Covid package was no exception. Pointing towards tepid credit growth, weak inflation and flat wage growth to make their case, demand-side proponents suggest measures such as cash transfers, income tax cuts and cheap credit to consumers. We examine the demand vs supply debate, drawing on basic economics and vast empirical evidence around the world.
We start with low growth in credit. Basic economics tells us a demand shock typically leads to a rise in both volume and the price whereas a supply shock not only hurts the volume but also leads to price rise. In banking, a good proxy for price of credit is the spread between lending rate and the funding rate (repo rate or deposit rates) for the banks. It reflects the risk premium banks charge to their customers.
The spread has consistently risen from just below 4% at the start of 2018 to around 6% in January 2020—even before Covid hit us. The fact that spreads are rising was highlighted by the 2019 Economic Survey as well. At the same time, the credit growth—especially for public banks and the MSME sector—has been sluggish for the past two-three years. The MSME sector witnessed sub-zero credit growth for the whole of 2017 and even now the growth is very tepid, at around 2% YoY. Rising spreads with lower credit volume provide a telltale sign that credit supply is broken.
An influential paper by Nobel laureates Abhijit Banerjee and Ester Duflo amply highlights the fact that the MSME sector suffers from lack of credit availability to finance the investments rather than lack of demand for credit. They showed that when the government changed the definition of small firms, the firms newly covered by the priority sector lending program used the extra credit to increase their production and investment. If there was no demand for credit, cheaper credit under the program should have been used to repay the older expensive sources of borrowings.
Consistent to this view, we think that the government’s approach of guaranteeing SME credit by resolving the risk-sharing problem for banks will expand the credit to money-starved SMEs at lower credit spreads. Similarly, expansion of the universe of small/medium firms will bring fresh investments from the firms that are newly covered under the priority sector program as they will be able to get cheaper credit.
Next we analyse the measures to boost consumer demand and we provide data and evidence to forcefully reject such measures. First, let’s look at the direct transfer schemes. No doubt that cash transfers are superior to distortive subsidies and the “Garib Kalyan” package was a step in this direction. In fact, the government has already transferred close to Rs 40,000 crore to bank accounts so far, including Rs 10,000 crore to women under PMJDY. But is it the ultimate solution to recovery? In fact, total PMJDY account balance has increased from close to Rs 1,17,000 crore pre-Covid to Rs 1,35,911 crore as of May 13—a massive jump of close to Rs 18,000 crore! Recent research by Prasanna Tantri and others show that PMJDY account holders actively use the accounts—1.12 transactions per quarter compared to the World Bank standard of 1 transaction. In fact, PMJDY accounts see withdrawals when account holders are in distress, according to their study. So the rise in balances is not mechanical.
It’s not that people covered under PMJDY are sitting in a comfortable financial position. So why are they not spending? A number of papers show that tax rebates boost the demand in the short run, but the quantum is limited. For example, Sumit Agarwal and his co-authors show that the 2001 tax rebate program in the US led to an average spending of only $60 on a $500 rebate over nine months. A recent study at Kellogg School of Management by Christian Borda and co-authors shows that tax rebates after the 2008 crisis in the US led to a rise in spending—but again only by 3.5% in the first month of the rebates. The crux is that no rational consumer goes on a consumption spree when he is facing job uncertainty!
Trying to boost demand by providing cheap credit to consumers is not a good idea either as evidenced by the debt-financed housing boom in the US that led to the 2008 crisis. In fact, Atif Mian and Amir Sufi, using a large panel of 30 countries, uncovered a more general pattern—an increase in household debt to GDP ratio leads to a sustained drop in future GDP, investments and unemployment. On the other hand, the economic cycles are much more muted when the initial growth is caused by structural reforms as pointed out by a recent IMF study covering more than 80 countries.
To put the burden of recovery on risk-averse consumers, incentivising them to spend rather than save when there is employment uncertainty, is against any reasonable risk-sharing principle. Instead, supply-side policies rest on the sound economics that risk should be borne by those who have the appetite—the firms and the government.
Apoorva Javadekar and Prasanna Tantri are assistant professors at Indian School of Business
(Email IDs: apoova_javadekar@isb.edu, prasanna_tantri@isb.edu)