Never has it happened before that the entire country is in a lock down, shutting majority of the businesses and factories, stopping trains in an attempt to restrict movement of people, and suspending flights. But again Covid-19 is not a usual virus, it calls for the government to take unprecedented measures. But how does lock down impact the economic growth you may ask, with people only focusing to buy what’s essential for their survival, the circulation of money in the economy reduces which in turn leads to the reduction in the growth rate. As estimated by Acuite Ratings and Research Ltd, the lock down could cost the economy almost 35,000 crores every day.
But hey, the lender of the last resort, a.k.a., the Reserve Bank of India has come to our rescue to unlock all the possible measures in a lock-down. And this time with not just the conventional measure of reduction in interest rates, but also various unconventional measures to curb the economic impact of the virus. So here’s a guide on all the measures taken so far.
Step 1 - Cheaper and more cash to banks.
You need money, you go to the bank, the bank gives you loan. But where does the bank get the money from? One is from the deposits that people make to the bank to earn interest on the money. And apart from that, they also have a provision to borrow money from the Reserve Bank of India. The rate at which the RBI lends money to bank is called the Repo Rate. So the RBI in an attempt to encourage the banks to borrow money at low interest rates reduced the Repo rate by 75 basis points to 4.4%. The commercial banks then pass on the lower rate to consumers, which means that you can now take the loan that you wanted at a much lower rate. Why would RBI do this? Well to try to increase the supply of money in the economy.
Just like the Repo Rate, we have something also called as the Reverse Repo Rate, the interest rate at which RBI can borrow money from commercial banks, or to be precise the rate which commercial banks would earn if they park money with the RBI. But what if RBI decides to cut that as well? The banks now have less incentive to park money with the RBI and instead lend it to customers. Just to ensure this, the RBI reduced this rate to 3.75%.
Well well well, I have just started you can’t be tired already! So what else did the RBI do? The RBI requires the commercial banks to set aside a part of their deposits, just in case there’s a huge redemption request from depositors like you and me. This is known as the Cash Reserve Ratio (CRR). And every fortnight, the commercial banks are required to prove to RBI that they have 4% of their deposits that are set aside. Now what if RBI says, hey you can now just set aside 3% of your deposits. And use the rest to lend to customers. And here you go, there’s more 1.37 lakh crore worth of money floating in the banking ecosystem.
The banks also have a mandate to set aside 90% of the CRR on a daily basis. Now what if the RBI says, instead of 90% just prove to me that you have 80% of the NOW 3% CRR set aside with you. Voila, there’s even more money to lend in the system.
Step 2 – Transmission of lower rates a problem? No more.
Up until February 2020, the RBI was reluctant to reduce interest rates, of course because the inflation in India was soaring and also because the lower interest rate wasn’t doing any help. The banks were borrowing from RBI at low interest rates but not actually passing on the rates to the customers. But there seemed to be a caveat here, banks said that they borrow from RBI on an overnight basis and the loans usually for many years. Basically, Repo operation, the process by which banks borrow money from RBI was for short term.
Well, RBI has a solution for everything. And hence it comes up with Long Term Repo Operations, where the banks can now borrow money (loans worth up to 1 Lakh crore) from RBI with a repayment period of 3 years at the repo rate (which is now 4.4%). And that’s not it, to ensure that the banks indeed use the money to lend it to corporates, the RBI adds a condition that the banks can only lend this money to investment grade corporate debts, meaning this money can only be invested in corporate bonds of companies that have rating ranging from AAA to BBB. And boom, your problem of transmission of interest rate is solved.
Step 3 – A breather to mutual funds.
If you have been following the news lately, you would have read about Franklin Templeton which decided to shut down 6 of its debt mutual fund schemes of over 25,000 Crore after it saw a surge in redemption requests. Now, this step for a fund house which has had a reputation of being one of the best in the Debt mutual fund industry would certainly lead to panic among investors across the country. And what if investors from all the debt mutual funds start withdrawing their money. Well this is something that the RBI or the economy cannot afford.
And hence, the RBI steps in again. This time, it opens a special window of Rs 50,000 crore under which a bank can borrow from RBI at the repo rate especially for mutual funds. So how does it work? Under this measure, the banks can borrow money from RBI in a 90-day repo window and either give loans to mutual funds or can also buy their debt papers. So now if the mutual funds are faced with a surge in redemption, they can use this money to fund the requests. Wonderful, isn’t it?
Step 4 – More cash to fund states and centre.
So here’s the thing, just as the centre, states are required to maintain their fiscal deficit (expenditure exceeding income). Now say if the states have budgeted that they will maintain a fiscal deficit of 3%, they are bound to maintain it. But suppose, the fiscal deficit crosses 3% due to some unforeseen circumstances, (like Covid-19) states have a provision called as Ways and Means Advances wherein, they can borrow money from the RBI to tide over any temporary mismatches in cash flow between their revenue and expenditure. Well they aren’t a source of finance per se, but the states can borrow money from RBI at the repo rate on a condition that they would repay it in 90 days.
But obviously the RBI won’t lend how much ever money that the states or centre would ask for right? So they keep a limit. For the centre that limit has been raised to Rs 1.2 lakh crore for the first half of FY-21, from the limit of Rs 75,000 crore from the same time last year. And for the states this limit has been taken up by 60% to Rs 51560 crore from the limit of Rs 32,225 up until March 2020. So will this move help? Given the likelihood of the total borrowing cost of the government to possibly cross Rs 20 Lakh crore, this limit may prove to be grossly insufficient.
Step 5 – Freeze them EMIs.
Say you have taken a home loan or a personal loan, at most times you are expected to pay in Monthly installments. But here we are, with Covid-19 hitting all of us in various ways, what if you don’t have the money to pay off your EMIs. So RBI steps in again, asking the banks to defer EMI payments of customers by 3 months. Which means, you can now defer your payments by 3 months but you will have to continue paying interest rates. And mind you EMI is not waived off. So do not defer it unless you are actually suffering from cash crunch.
Step 6 – More cheap money to the financial institutions.
India has several financial institutions like the NABARD, SIDBI, NHB, the RBI has now decided that it will provide Rs 50,000 crore to these institutions which in turn will lend money to commercial banks, housing finance banks and other financial institutions. This again at the Repo rate of 4.4%. Why would RBI do this? The surplus capital would help infuse liquidity in the economy which in turn would boost credit growth.
Step 7 – Do not yet pay the dividends.
Well, paying dividends is not an obligation for the companies. But companies including banks still pay them, why? To reward the shareholders for providing them with enough capital to run the business and dividends out of profit reduce cash in hand and the ability to absorb losses. In the fiscal year ending March 2019, private sector banks paid a total dividend of Rs 7087 crore in dividends. But this year it is different, to keep the capital intact amidst tough times the RBI has restricted the banks from paying any dividends until further notice.
So well it is fairly evident that the RBI is 100% committed to do whatever it takes to help revive the economy. But there’s a problem, would the banks be willing to take risks on their books? The amount of uncertainty in the markets currently is keeping the lenders and investors very cautious. The second round of Targeted Long Term Repo Operation which was targeted to smaller NBFCs did not garner much attention from banks as the banks are still risk averse to invest in bonds of smaller NBFCs. The problem here is that a lot of smaller NBFCs are not investment grade and this restricts the banks from lending to them.
So does RBI have more scope for monetary action? So far India has not seen much of a strong fiscal response, i.e. the government has not pumped in money. Going further, it is very important that there is a coordinated fiscal and monetary stimulus from both RBI and the Government of India. RBI could possibly see cut more rates in a period of more 3 months. The government and RBI could also come up with Covid bonds and issue them in domestic or international markets. Covid bonds would mean that the money from these bonds would specifically be used to combat the impact of Covid on the economy. The RBI could also give some loan guarantee to banks, that way banks would be incentivised to actually give loans to the SME segments. Or maybe the government could also take some credit risk on their books and not force the banks to take all the risk, considering they have just come out of a very bad NPA (Non Performing Assets) cycle.
So far, RBI has come out with decent measures without which the situation would probably be much worse, but there's room for more. The most important among them being as iterated above: Coordination with the centre. But well as Mary Kay Ash rightly said it, "Central banks don't have divine wisdom. They try to do the best analysis they can and must be prepared to stand or fall by the quality of that analysis".
This is really helpful. Simplified and explained in layman's terms.