On March 27, the Reserve Bank of India announced a clutch of measures to enhance the liquidity of financial markets and thereby improve the flow of credit. This article provides brief description of the key measures with analysis of how effective they would be, and suggests what remains to be done to deal with the economic crisis facing the country.
Reduction in Interest Rates
The Repo Rate was reduced from 5.15% to 4.40%: The reduction would reduce the rate at which banks borrow from RBI against securities. The banks are expected to pass on the reduction in the cost of funds to the borrowers through reduction in the lending rates.
The Reverse Repo Rate was reduced from 4.9% to 4%: The reduction would reduce the interest RBI pays on excess funds parked by banks with RBI. That is expected to create incentives for banks to lend in the market to earn higher return.
Analysis: Rate reductions of such magnitude under normal circumstances would have hugely cheered the markets. They did not. The reason is clear. Rate reductions are blunt instruments in a situation of severe demand destruction in the real economy inflicted by COVID-19. The demand cannot be revived by enhancing the supply of funds through reduction in the cost of borrowing and incentivizing lending institutions to lend. What RBI has achieved is to create the conditions for the government to take appropriate fiscal measures to stimulate demand. Would the government act within a narrowing window of time to save the economy?
Rescheduling of Payments: Term & Working Capital Loans
Term Loans: Lending institutions of all kind can grant a moratorium of 3 months on payment of all installments falling between March 1, 2020 and May 31, 2020 for all types of borrowers. The moratorium would not require the institutions to classify the loans as NPAs. The credit history of the borrowers too will not be negatively impacted by the moratorium. However, the interest shall continue to accrue for the moratorium period that borrowers will be required to pay later.
Working Capital Loans: Lending institutions are permitted to defer recovery of interest on cash credit and overdraft facility, falling between March 1, 2020 and May 31, 2020 by three months. However, the interest shall continue to accrue during the deferment period and is to be recovered at the end of the deferment period. Lending institutions may also recalculate the drawing power in respect of cash credit / overdraft facility either by reducing the margin requirement and/or reassessing the working capital cycle to ease the funding pressure on the borrowers. These adjustments will not result in asset reclassification.
Analysis: Prima facie, the measures appear to be with the intention of helping the borrowers. There is however no financial relief to the borrowers as the interest on the loans continues to accrue during the moratorium period. If normalcy in the economy is not restored well before May 31, 2020, which is likely to be the case, then the financial situation of the borrowers would worsen. So, what does the moratorium achieve? It permits the banks to window dress their books by postponing the day of reckoning when the stress will have to be recognized and accounted for.
Enhancement of Liquidity
Long Term Repo Operation (LTRO): The RBI announced that it will inject Rs. 1 lakh crore of liquidity through an LTRO of 3-years. It offered Rs, 25,000 crore in the first tranche of LTRO, whereby banks were able to borrow for 3-years at the Repo Rate of 4.4% against securities with tenure of at least 3 years.
Reduction of Cash Reserve Ratio (CRR) from 4% to 3%: The reduction would mean that cash the banks are compulsorily required to keep with RBI against their Net Demand and Time Liability (NDTL) will reduce. The banks therefore will have more funds for lending. The reduction is expected to release Rs. 1.37 lakh crore for the banks. The reduction is for the next one year.
Marginal Standing Facility (MSF): Banks are required to maintain a specified percentage of their NDTL in designated (mostly government) securities. This is called Statutory Liquidity Ratio (SLR). To enhance liquidity in times of stress, RBI allows the SLR to dip from the requirement temporarily by a specified percentage. The permitted dip has been increased from 2% to 3%. This has the potential to release up to Rs. 1.37 lakh crore for the banks. This measure is available for the next 3 months.
Analysis: At the aggregate level, the amount of liquidity injected is significant. However, the stipulation that the funds thus released be deployed in investment grade assets does not address the liquidity problem the market is beset with. The investment grade borrowers were already well supplied with funds from the ‘flight to safety’ approach of the lending institutions. Already starved of funds, COVID-19 has made it even more difficult for the non-investment grade borrowers to obtain funds. The easing of liquidity was required for such borrowers, as without funding even those who could have survived the crisis would go under. The RBI measures therefore do not address the problem of liquidity faced by the currently non-investment grade borrowers who are viable but need funds to tide over the temporary cash flow problems.
Would the measures deliver?
As expected, there was a crescendo of congratulatory messages to RBI from the ‘right’ quarters for delivering a ‘bazooka’ of monetary policy measures to fight the war on the economy unleashed by COVID-19. A nuanced analysis however reveals a much somber picture of what the measures would be able to achieve.
The onus of altering the lending policies in view of the measures announced by RBI has been left to the boards of lending institutions. They are required to frame policies for granting of moratorium as well as deployment of additional funds. The boards, however, have become extremely risk-averse after facing harsh regulatory scrutiny and penal action over the last few years. They are unwilling to take any policy action that the regulator may find fault with, in the future. Therefore, liquidity will not ease for the segment that is facing the severest cash crunch and desperately needs funding, as boards would dither to provide succor to them.
In the extra-ordinary situation resulting from COVID-19, much bolder initiatives were required from RBI. Instead of leaving it to each institution to frame its policy, a superior option would have been for RBI to direct that the moratorium being permitted by RBI should be extended to all SMA 1 accounts (repayments overdue by 31-60 days) as well as SMA 2 accounts (repayments overdue by 61-90 days), between March 1, 2020 and May 31, 2020. This would truly have helped ease the liquidity crunch being faced by the segment that needs support at this juncture.
The reason for the absence of such clear direction from RBI is that it did not want to take the risk of being held responsible for the rise in NPAs that is likely to occur due to the economic impact of COVID-19. What RBI measures will achieve is to create a financial chimera whereby the financial statements of the lending institutions for FY 2019-20 will artificially appear much healthier than what they would be. However, by not directing decisively on what the lending institutions must do, RBI has ensured that the full benefits of the measures announced would not flow to the borrowers who need help.
In addition to the announced measures, RBI should have chosen another weapon in its armory that is directed at a sub-set of industries. It is not uncommon for RBI to ask banks, from time to time, to make NPA provisions for a set of identified industries, at higher rates to mitigate risk. The extant situation demands RBI to use the same principle not for risk mitigation but for rescuing the economy. For a set of chosen industries, that perhaps will include the construction, the hospitality and the micro-finance industries, that support employment to millions in the lower economic strata of society, RBI should have directed banks to provide loan packages for an extended period of 18-24 months, at a concessional interest rate, by getting the government on board to provide the requisite interest subvention.
In sum, the economy is likely to pay a heavy price, due to the absence of boldness in the policies announced by the RBI and the government thus far.