The response of Reserve Bank of India to Covid-19: Do whatever it takes
The study has been authored by Rakesh Mohan, Ex-Dy Governor of RBI; former Chief Economic Adviser, & President, CSEP.
India responded to Covid-19 as soon as it was becoming clear that a pandemic was in the offing. The government imposed a sudden nationwide total lockdown on March 25, 2020. This lasted until end of May 2020 and was then lifted in phases subsequently. The country suffered a severe economic contraction with Gross Domestic Product (GDP) estimated to have fallen by 24% in Q1 FY 2021 and by 7.3% in FY 2020-21 as a whole. The policy response to the economic impact of both the pandemic and the consequent lockdown was the usual mix of fiscal, monetary and financial measures, but relatively light on fiscal measures. At 2-2.5% of GDP, India’s stimulus spending has been at the lower end amongst emerging markets.
This paper discusses the role of Reserve Bank of India (RBI) in India’s fight against the pandemic. It documents the various policies undertaken by the RBI in its capacity as the monetary authority, lead financial system regulator and supervisor of financial intermediaries, banker to and debt manager of the central and state governments, currency issuer and manager, and regulator and operator of the payment and settlement system.
The paper also decodes numerous policy instruments at the disposal of RBI and effectiveness of measures such as the credit enhancement schemes, and loan moratoriums which may not have had the desired effects.
As the monetary authority, the Monetary Policy Committee (MPC) laid a triple objective of mitigating negative effects of the virus, reviving growth and preserving financial stability. To ease economic hardship while keeping inflation in check, the RBI slashed interest rates keeping the policy repo rate at a low of 4%. The cash reserve ratio (CRR) was lowered, which provided additional liquidity to help aid banking system. The goal was to ensure that no part of the financial system faced liquidity concerns or credit constraints.
To tide over the pandemic, it was paramount for government and the central bank policies to work in tandem. To ensure that governments did not have to cut their spending due to shortfalls in revenue, RBI needed to enable both central and state government to borrow adequately in debt markets. As a banker to the central and state governments, the limit on ways and means advances for both central and state government were increased. Aside from this, through open market operations, RBI purchased about 30% of central government’s net market borrowings in FY 2021 and has committed to continue to purchase substantial amounts in FY 2022 through the G-sec Acquisition Programme.
Special OMOs – through Operation Twist (OT) involving the simultaneous purchasing of long-term government securities and selling corresponding short-term securities of similar amounts in a liquidity neutral fashion, have lowered long-term yield and smoothened the curve. The Reserve Bank was successful in managing the large government borrowing in FY 2021 at a weighted average borrowing cost for the central government, at just 5.79%, the lowest in 16 years.
As regulator of the banking system, it is crucial that the interests of both borrowers and lenders are aligned to ensure stability of the financial system. A host of measures were put in place to help in the continued smooth functioning of financial intermediaries including banks and non-banking financial companies (NBFCs).
On the one hand, these policy measures were aimed at protecting and helping borrowers in this time of economic and financial stress brought on by the pandemic and the consequent lockdowns. On the other hand, measures were also put in place to provide regulatory relief to financial intermediaries in terms of their access to liquidity and regulatory forbearance to protect their balance sheets. The overall aim was to keep credit flowing despite all the disruptions being experienced by the economy and financial markets.
Overall, the RBI, in cooperation with the Government of India, has succeeded in achieving its broad objective of keeping financial intermediaries, financial markets and the financial system as a whole sound, liquid, and functioning smoothly. It has maintained financial stability despite initial conditions of the Indian financial intermediaries being stressed as a consequence of legacy problems. But very significant challenges remain as this crisis unfolds further in both India and the rest of the world. It has also protected households as well as small and large businesses from experiencing acute financial stress for the time being, but stresses will emerge once regulatory forbearance is lifted.
Transmission of the highly accommodative monetary policy, and the corresponding liquidity management, has been largely successful. Interest rates have fallen across the board and g-sec yields are at almost record lows, with most real interest rates now being in negative territory. However, the RBI’s liquidity injection has been so large that there was an almost consistent systemic liquidity surplus of about ₹6 trillion (about 3% of GDP) that needed to be absorbed by the RBI on a daily basis.
However, despite all the measures implemented to promote the flow of credit to all segments of the market, credit growth has continued to be sluggish except for a significant increase to the small and medium scale enterprise (SMSE) sector. Hence there is a mismatch between the performance of the real sector and financial markets. This could potentially lead to enhanced stresses experienced by both lenders and borrowers, leading to potential financial instability. Thus, financial stability challenges remain for the Indian financial system and its regulator in the months to come.
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(The study has been authored by Rakesh Mohan, Ex-Dy Governor of RBI; former Chief Economic Adviser, & President, CSEP.)