Context

On Tuesday, the Reserve Bank of India’s (RBI) Monetary Policy Committee (MPC) convened for an emergency meeting, ahead of schedule, to discuss its response to the economic challenges posed by the Covid-19 outbreak.

Bond market reaction to the RBI announcement

• The MPC deliberated for three full days, but its decision would most probably have been sealed right at the onset.
• For that day, the Indian bond market saw no trades in the first twenty minutes.
• Fear and uncertainty in the market: The gap between the asking price and bids was so wide that the first trade for the day took place at 9:33 am. Gripped by uncertainty and fear about the future following the outbreak, the market had frozen.

Measures by the RBI

• Injecting the liquidity of Rs. 3.74 trillion: Responding to the market signal, the RBI rolled out a slew of measures from its armoury that will release liquidity of up to ₹3.74 trillion, or nearly 2% of gross domestic product, in the financial system.
• This will facilitate the market’s orderly functioning.
• Condition on LTRO-created-liquidity: In particular, the condition that the liquidity created through the Long Term Repo Operations (LTRO) tool must only be deployed in corporate debt securities was a direct response to the disruption in the markets seeing heavy sell-offs in the midst of thin trading volumes.
• Comparison with measures by the Fed.: The US Federal Reserve, which has launched an unconventional asset sales programme for $4 trillion, has announced it will also directly buy corporate bonds to ease the tight market.
• RBI has refrained from following suit, instead of passing the buck to banks via the conditional LTRO liquidity.
• Banks are unlikely to step in to ease the tight corporate securities market.
• Repo rate below the level seen in 2008: To combat the economic consequences of the Covid-19 pandemic, the MPC has dropped its policy interest rate by 75 basis points, taking it down to 4.4%, a multi-year low.
• The rate is now lower than it was in April 2009, when the central bank had taken it down to 75%, responding to the global financial crisis.
• In 2008, just four days ahead of a scheduled policy review, RBI had cut the policy repo rate by 1 percentage point, sending an extraordinarily strong signal.

How the challenge this time is different from the 2008 crisis?

• The nature of the current economic challenge is a lot different.
• Economy at standstill: The shock back then had depressed demand, but the economy had not been brought to a standstill as it has now, with resources, including labour and capacities idling.

Why the measures would not kickstart the economy

• Effect of rate cut: When all economic activity has halted, and uncertainty about the future is soaring, there’s no way a rate cut—no matter how steep—can kickstart the economy.
• Businesses cannot plan for the future and will not borrow.
• Banks will hold on too, fearful of the risk of loans going bad.
• As it is, even before Covid-19 struck, credit disbursement was sluggish.
• Now, with a host of companies facing the threat of credit rating downgrades, the probability of lenders turning a little less risk-averse is even lower.
• Who would be the beneficiary of the rate cut? The biggest beneficiary of RBI’s rate cut—which was bigger than market expectations—would be the government.
• Reduced borrowing cost for the government: In one stroke, the MPC has altered the fiscal deficit calculation by reducing the government’s borrowing cost.
• There will be savings on its outgo on interest payments for new and rollover borrowings.

Three-month moratorium and issue with it

• RBI also permitted banks and non-bank financial institutions to grant a three-month moratorium on loan repayments and reclassification of stressed loans as non-performing assets (NPAs).
• This will provide relief by cushioning cash flow pressures for firms and individuals when incomes and revenues have dropped sharply due to the lockdown.
• The forbearance on downgrading these loans will prevent a sharp spike in NPA levels for banks and NBFCs.
• There could be a sharp rise in the bad loans: The risk now is that a few quarters after the end of the moratorium there could be a sharp rise in bad loans.
• It could give rise to the NPA problem: In that sense, it amounts to kicking the problem of a potential spike in NPAs down the road.
• The problem of evergreening: On balance, it is the right call given the extraordinary challenge of the lockdown—provided a new cycle of evergreening of loans by banks is not allowed in a repeat of what happened in the aftermath of the global financial crisis.

Way forward

• What more could RBI have done? Special credit windows for the worst-hit sectors like aviation, hotels and tourism may soon be required.

Conclusion

While prioritising financial stability is fine, the MPC’s inflation projection is puzzling. While refraining from providing estimates on growth and inflation, given that the spread, intensity and duration of Covid-19 remain uncertain, RBI said it expects food price pressures to soften going ahead on account of a blow to demand during the lockdown. The projection seems unreasonable when there are unprecedented supply-side bottlenecks.

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