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Insights into Editorial: RBI’s regulatory changes are crucial in the current economic scenario

COVID_19_Impact

 

Context:

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.

RBI Policy interest rate by 75 basis points:

  • The rate is now lower than it was in April 2009, when the central bank had taken it down to 4.75%, 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.
  • The nature of the current economic challenge is a lot different, though. The shock back then had depressed demand, but the economy had not been brought to standstill as it has now, with resources, including labour and capacities idling.
  • 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.
  • The biggest beneficiary of RBI’s rate cut—which was bigger than market expectations—would be 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.
  • 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.

Impact of cut in rates in coming Economic cycle for the country:

  1. When the repo rate is high, banks find it costly to borrow and in turn raise the price of loans to their borrowers. A low repo rate has the overall effect of reducing interest rates for the system.
  2. Lower rates make it easier for entrepreneurs to take loans for working capital and for households for homes, vehicles and so on.
  3. Cut in Reverse Repo has been done to make it unattractive for banks to passively deposit funds with the RBI and instead lend it to the productive sectors.
  4. Bank lending provides the needed oxygen to businesses for their working capital and longer-term loans.
  5. There is another 18.25% of deposits that is also not used for lending under the Statutory Liquidity Ratio (SLR), further reducing the money banks have to lend.
  6. RBI has reduced the CRR to 3%, freeing up ₹1.37 trillion for banks to lend. CRR has been chosen rather than SLR because this increases ‘primary liquidity’ with the banks a bit better.
  7. Not only is there CRR rate down, banks now needs to maintain 80% of the limit on a daily basis instead of 90% till June 26, 2020.
  8. Reducing volatility in the exchange rate is a measure to reduce the volatility of the price of the rupee in international markets by allowing banks to deal in off-shore non-deliverable rupee derivative markets.
  9. It looks like reform using the crisis to bring about this long-awaited change.

RBI’s regulatory changes are crucial in the current economic scenario:

The measures had a bit of everything that the real economy and the financial markets were crying out for—reduction in rates, provision of liquidity, aiding transmission of lower rates, freeing up the financial markets and easing financial stress by forbearance.

Effective borrowing costs in the G-sec repo market is now likely to fall substantially with the surplus liquidity, and with non-bank participants likely to drive the rate lower than even 4%.

This will help reduce interest rates across the spectrum and make loans cheaper, going forward.

The RBI has provided liquidity on multiple fronts for the banking system:

  1. The first step of cash reserve ratio (CRR) cut will not only help infuse ₹1.37 trillion liquidity, but will also increase profitability.
  2. The reduction in daily CRR maintenance to 80% increases the operating flexibility for banks, just when liquidity is most needed due to the volatile nature of corporate cash flows.
  3. In addition to all of this, was the provision of an additional ₹1 trillion in the form of targeted longer-term refinancing operations (TLTROs) to banks to buy corporate bonds and CPs in both primary and secondary markets, and an additional dispensation to classify them as hold to maturity.
  4. This has the effect of aiding transmission by bringing corporate bond spreads lower.
  5. The move to allow Indian banks to participate in non-deliverable forward (NDF) markets is ground-breaking.
  6. It will potentially enable the RBI to intervene offshore through the banking system to check undue volatility, as well as help Indian banks to quote to clients for their forex requirements round-the-clock.
  7. Sweeping regulatory changes announced in terms of moratoriums and deferments are crucial in the context of the current economic scenario.
  8. We expect Q1 FY21 growth to contract as most businesses, especially small and medium enterprises (SMEs), will see revenue loss while facing a cash crunch.

Way Forward: Two more measures could have been considered:

First, the RBI could consider participating in primary auctions of bonds of the government of India, or to subscribe to a private placement of bonds.

This is much needed to ensure that the borrowing programme goes through smoothly.

It could consider this and communicate it proactively to ensure that long bond yields do not militate against the transmission of lower rates, especially when the borrowing calendar starts.

Second, creation of a SPV (special purpose vehicle) funded by the RBI could be considered, which could directly purchase corporate bonds in primary and secondary markets.

Both these measures are much needed to ensure companies do not find the availability and cost of money an issue.

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.