RBI needs to do a Fed!
In the wake of a pandemic that has caused unprecedented job losses and demand contraction globally, the role of central banks in playing a balancing act is more important than ever before. The major central banks — US Fed and European Central Bank (ECB) have responded aggressively and proactively to counter the Covid-induced recession that has hit both the developed and emerging nations. The recessionary effects have been so severe that IMF has estimated the global GDP would take at least three years to recover to its pre-Covid levels. As the world races to find a cure to the virus, a pre-emptive cure needs to be provided to the global economy to make it resilient and position it for a V-shaped recovery once the pandemic is behind us.
The US Fed and ECB have responded by taking a break from inflation targeting and slashing their respective policy rates to near zero and have purchased government bonds as a Quantitative Easing (QE) measure to boost liquidity in the economy. The US Fed has gone a step further and started the acquisition of risky mortgage backed securities from the banks and general population to ease banks’ balance sheets and put money in the hands of retail/institutional holders of such securities.
The response of the developed markets’ central banks has been almost clinical, both in terms of agility and execution, as if they were operating from some sort of muscle memory. And they had the 2007–8 global financial crisis to thank for that. Those central banks have used the tried and tested two-pronged formula to spring back languishing economies back to their growth path — reduce policy rates and infuse cash in the economy through QE. The same tools were again deployed to counter this recession. Only this recession has been so deep that most developed and emerging economies have shrunk by negative double digits in the second quarter of 2020. This gravity of this economic crisis caused the US Fed to come out with a surprisingly bold statement yesterday that they would maintain near zero policy rates for at least the next three years and in the process would be letting go of their inflation targeting approach in the medium term.
India was amongst the least affected economies in the 2007–8 financial crisis and a minor slowdown didn’t call for a major fiscal/monetary response. The last major economic crisis faced by the Indian government and the RBI was the 1991 Balance of Payment crisis. To mitigate that crisis, India sought a bailout from the IMF and the IMF set terms and conditions to prop up the economy and the RBI and the government merely implemented their terms set out by the IMF to tide over the crisis. Today, when India is in the midst of a recession after four decades, the government and RBI have to proactively counter it and boost market sentiment. The fiscal and monetary stimulus will have to be timely and effective. Also, the stimuli cannot be at the expense of fiscal discipline since there is not much fiscal room at India’s Debt/GDP ratio of ~82%. And the government’s first tranche of stimulus which was pegged at INR 20 Trillion clearly showed the intention of being fiscally prudent. Merely ~INR 1.5 Trillion was direct burden on the exchequer and the remainder was outsourced to the banks, PSUs and the RBI.
In such times of fiscal conservatism by the government, the RBI needs to assume a pivotal role in providing a fillip to the Indian economy. Since the pandemic began, RBI has cut the policy/repo rate twice from 5.35% to 4%. The RBI has been conservative in cutting the interest rates majorly because of the inflation targeting (RBI’s current target is 4%) that was introduced by the RBI in 2016. The pandemic has resulted in inflationary pressures due to the disruption in supply and demand cycles and in August 2020, the CPI inflation has heated to 6.69%. This heating up of inflation has caused RBI to maintain a hawkish stance on the money supply and hence RBI might maintain status quo in its next MPC on the repo rate, like it did in the last MPC in July.
The Indian economy is in doldrums currently. Demand has slumped and supply side disruptions caused by weak demand and weaker corporate balance sheets have caused rampant job losses and loss of economic output. A splurge from the consumers is the only thing that could revive the demand side and hence supply and production, which would then lead to a multplier effect on the larger economy. The consumers have lost their urge to splurge in the face of uncertainty that has been unleashed by the pandemic. Corporates have also stopped borrowing since the lack of demand has hit them and newer projects have been delayed with the imminent focus on strengthening balance sheets and deleveraging. The result is that banks today are sitting with excess liquidity to the tune of ~INR 15 Trillion and they are parking funds with RBI at reverse repo rates of merely 3.35% p.a., in the absence of better alternatives. This cycle needs to be broken and only the RBI has the policy tools at its disposal to change the current situation.
The RBI should cut its repo rate boldly by 300 bps to 1% and provide a long-term guidance of maintenance of repo rates at those levels for the next 3–4 years. The RBI should also mandate the benchmarking of all loans to repo rate. This would cause a paradigm shift for the industry. The loans for infrastructure projects and fresh capex would suddenly be cheaper and would reduce the effective cost of capital and hence increase the financial viability of many stuck projects. These projects getting on track would be a major boost to mass scale employment. Banks would aggressively lend to customers and that would in turn stoke the consumption appetite in the economy and would spur the supply side of the economy.
This approach would also disincentivize conventional mode of savings like savings accounts and term deposits. These customers would enter the financial markets which would also be a great value unlocking opportunity for many struggling and overleveraged MSMEs to raise capital and de-leverage without falling into the debt trap. The SEBI could look at doing away with the pre-condition of 3 years’ profitability and minimum net worth requirements for MSMEs and startups.
The RBI needs to pull a rabbit out of the hat to revive the economy out of this slump and repo rate is a policy tool that could achieve it. Inflation targeting should take a near term break till the economy and the various struggling sectors are firmly back on the profitability and stability track. The RBI needs to emulate the Fed’s stance on policy rates, but the window of opportunity is small, and the RBI needs to take cognizance of the fact and needs to act decisively and fast. India is poised and at a precipice yet again in its history, and the RBI and government’s response will decide the fate of its “USD 5 Trillion economy” dream.
