RBI rises to the occasion

In line with what many other major central banks have been doing in the face of the unprecedented economic blow caused by the outbreak of Covid-19, the RBI unveiled an extra-ordinary set of monetary and regulatory easing measures on Friday aimed to ensure financial stability and to put the economy on a steadier footing. These measures for which RBI used all the relevant tools at its disposal, are also intended to complement the fiscal package of Rs.1,70,000 crore announced by the government earlier in the week and possibly to support its borrowing programme for the next fiscal year. That the MPC of the RBI, whose first bi-monthly meeting for 2020-21 was advanced by a week, would announce a steep cut in the policy repo rate was widely anticipated by the financial markets. But to what extent the 75 basis points easing and the fresh liquidity injection to the tune of Rs. 3.74 lakh crore will help reverse or even control their strong pessimistic and bearish undertone is still uncertain.

The moot question now is whether the rate cut will stimulate credit growth, which was lacklustre even before the Covid-19 outbreak.

The prospects and outlook for the Indian economy, as is the case globally, is, in the words of the MPC “heavily contingent upon the intensity, spread and duration of the pandemic.”  It is too early now to foresee how things will shape up even six months down the road, even though it is apparent that the odds indicate a significant downside. Such an uncertain phase for the world economy, for which a recession in 2020 is now a distinct possibility, has not been witnessed in the living memory. The financial markets are only reflecting this reality.

Enormous challenges

The enormity of the challenges currently faced by the RBI and the heft of its response thereto can be gauged from the fact that the repo rate cut comes on the top of a cumulative rate slashing by 135 basis points in 2019, taking the real interest rate into the negative territory. The planned liquidity infusion together with the Rs. 1.60 lakh crore of liquidity already created in the month of March, 2020 by way of long-term repo and open market operations will amount to about 2% of India’s GDP. Already the RBI’s push for higher liquidity is manifest in the rate of expansion of Reserve Money (RM) in the recent weeks: during March 1-20, 2020, RM rose by 3.56% as against its growth by 7.4% in the 10 months of the current fiscal year till end-February.

The moot question now is whether the rate cut will stimulate credit growth, which was lacklustre even before the Covid-19 outbreak. Unlike in many other countries, the India economy has been on a downturn for over a year due to weak consumption demand and private investment growth. The constraints of credit expansion in the present situation will mainly arise out of labour, logistics and order constraints. The MSME business units that are facing difficulties due to severe dislocation of labour will be slow to resume activities significantly.  Further distress in the MSME sector not only forebodes ill for the banking system, but will have serious macroeconomic and social implications.

Similarly, it is uncertain if the formidable amount of fresh liquidity infused will eventually reach the financial sector entities that need it most – NBFCs. Earlier attempts to ease the liquidity difficulties faced by even the well-functioning NBFCs in the wake of the IL&FS default and DHFL collapse didn’t bear fruit in any meaningful way. One measure announced in this policy has, among other useful impacts, a higher chance of success in this regard as well.             

Targeted Long-Term Repo Operation (TLTRO)

A new mechanism for liquidity infusion through 3-year term repo announced by the RBI is an innovative way of quantitative easing that can serve three purposes: One, ameliorate the selling pressure and give confidence to the market in respect of credit-sensitive fixed income instruments viz. corporate bonds, commercial papers and non-convertible debentures. Two, pave the way for new issuances of these instruments, which will help both non-financial corporates and NBFCs. Three, provide liquidity to NBFCs, MFs etc. which cannot access it directly from the RBI.  The first TLTRO auction for Rs. 25,000 crore, which was held shortly after the policy announcement received a very good response with total bids at Rs. 60,500 crore. It is likely that the RBI will raise the total TLTRO amount vis-à-vis that announced in the policy at Rs.1,00,000 crore. This mechanism is not only in keeping with the Indian legal framework, but is also designed to ensure that banks continue to play a pivotal role in monetary transmission and that the RBI’s balance sheet is not exposed to any undue credit and liquidity risks in its domestic operations.

In that respect, TLTRO is better than what both the Federal Reserve and European Central Bank did in the wake of the Global Financial Crisis, by buying debt instruments directly from banks that held them. Needless to say, banks will be required to put regulatory capital for the additional credit risk that will be assumed as a consequence, the cost of which can be more than compensated by the rich earning potential for the portfolio of bonds purchased under TLTRO.            

NDF market

The RBI will now allow banks in India that operate banking units in IFSC to participate in the offshore market for derivative contracts in the Indian rupee, which exists in locations like Singapore, London etc.  This step, which will integrate the onshore forex market with its offshore counterpart was overdue for quite some time. As with many other important liberalisation measures, this one has also been occasioned by a crisis. The Indian rupee has been under selling pressure of late, and RBI has been intervening to prevent any sharp fall thereof.  Presence of few large Indian banks in the NDF market will provide a channel through which RBI will be able to intervene in the offshore market with ease as it does through them in the onshore market. This will significantly enhance the effectiveness of intervention, since, quite often, both positive and negative impulses for the rupee are transmitted to the onshore market from its offshore counterpart.

The MPC has done a good job in presenting an analysis of the situation arising out of the Covid-19 pandemic in a very clear and candid manner.  It has shown its firm resolve to take further measures to lessen the impact and fall-out of the shock now being felt.  Both the domestic and global economic situations are in a state of flux and, as such, more monetary and regulatory easing measures can be expected in the months to come.

(Himadri Bhattacharya is a former Central banker and a consultant to the IMF)

Published online by Business Line here