by Rajeswari Sengupta and Josh Felman
When the first cases of Covid-19 started getting reported in India, the economy was already in a precarious situation and the space for a macroeconomic policy response was limited. Even so, the Reserve Bank of India has come up with a number of initiatives to combat the crisis. In this article, we consider the broad principles that should guide the macro policy response, summarise the RBI announcements of March 27, and assess the announcements against the principles.
The “corona crisis” consists of three interlinked problems: a health shock, an economic shock following from the lockdown, and a global economic downturn. Each one of these shocks on its own is significant. Put together, they have created considerable pressure upon policy makers to act quickly and decisively.
Coming up with an effective policy response is not an easy task. For one thing, the corona crisis poses some exceptional difficulties. It is clear that the human and economic toll will be serious, but it is unclear how long the crisis will last or how deep the damage will be. And without a clear understanding of the size and duration of the problem, it is difficult to know how to calibrate the policy response. For example, monetary easing could take a year to have a significant effect. By then the problem might be over, and inflation might have re-emerged, at which point painful measures would be required to bring it down. This is not just a theoretical possibility, it is precisely what happened in the aftermath of the Global Financial Crisis in 2009-13.
Principles of policy response
Policy making is difficult in the best of times. It is harder in exceptional times, when there is pressure for quick actions, grounded in reduced analysis. It is in exceptional times that the toolkit of good governance becomes even more important:
- The lowest cost actions are those which are grounded in root cause analysis.
- Each action needs to be carefully weighed in terms of the costs and benefits imposed upon society.
- As much as possible, policy responses should be fitted into existing rules and frameworks.
- All state actions should be preceded by public debate and consultation.
This toolkit is a valuable discipline, an institutionalised application of mind. Why is root cause analysis important? Consider the problem of weak banks lending to firms in recent years. From 2018 onwards, RBI has been trying to address this problem by injecting more and more liquidity into the banking system, in the hope that banks would deploy these resources and lend more (link, link, link). But liquidity issues were not at the root of the problem, the twin balance sheet (TBS) stresses at firms and banks were the real issue. Bank lending has also been discouraged by the government’s measures to investigate and prosecute bank officials for their lending decisions. As a result of these factors, banks have remained reluctant to lend to the private corporate sector, curtailing credit to industry to a year-on-year growth rate of just 0.67 percent in February 2020.
As an example of poor cost-benefit analysis, consider the regulatory decisions after the Global Financial Crisis. At the time, it was felt that exceptional times called for exceptional deviation from prudent financial regulation. A series of restructuring schemes followed, allowing banks to postpone NPA recognition and hide bad news. With the benefit of hindsight, we know that this restructuring worked poorly, and helped prepare the ground for the twin balance sheet crisis of 2011-2020.
As for respecting frameworks, there is a temptation during crises to abandon rules and resort to discretion. But recent experience warns us that “temporary measures” are often difficult to reverse (consider the 2010 fiscal stimulus), while inadvertent consequences (such as NPAs) are difficult to resolve. More fundamentally, temporary measures disrupt the stable configuration of expectations of economic agents, which hamper the recovery. It takes many decades of consistent behaviour in a rules-based framework to shape the rhythm of the working of state institutions, to build up policy credibility. This credibility can be rapidly dissipated.
Hence, policy makers need to proceed cautiously.
The March 27 announcements
It is in this context that we need to examine the March 27 announcements. Four bold actions were taken, following an “out of cycle” i.e., unscheduled Monetary Policy Committee (MPC) meeting:
- The repo/reverse repo rates were cut by sizeable amounts, to 4.40/4.00 percent from 5.15/4.90 percent. The 91-day treasury bill rate, which measures the de facto stance of monetary policy, dropped to 4.31 percent from 5.09 percent on 26 March.
- Ordinarily, banks can borrow on a short-term basis from the RBI using the repo window. To supplement this facility, a new `targeted long-term repo operations’ (T-LTRO) mechanism, with a limit of Rs.1 trillion, was announced. Banks may find this attractive because they do not have to mark to market the investments made with these borrowed funds for the next three years. However, there is a condition: the money that is borrowed here must be deployed in investment-grade corporate bonds, commercial paper, and non-convertible debentures, over and above the outstanding level of their investments in these bonds as on March 27, 2020.
- The cash reserve ratio (CRR) was reduced by 1 percentage point, bringing it down to 3% of deposits (“net demand and time liabilities”). This is the first time the CRR has been changed in the last 8 years. RBI’s initiatives appear to be motivated by the desire to increase liquidity, as their statement highlights that these measures will free up Rs 3.74 trillion in banks’ funds.
- Banking regulation requires banks to recognise and provide for a loan when there is a delay in payment. According to the Prudential Framework for Resolution of Stressed Assets, banks are required to classify loan accounts in special mention categories in the event of a default. The account is to be classified as SMA-0, SMA-1 and SMA-2, depending on whether the payment is overdue for 1-30 days, 31-60 days or 61-90 days, respectively. RBI has now modified this regulation, so that banks can offer a moratorium of 90days for term loans and working capital facilities for payments falling due between March 1, 2020 and May 31, 2020. However interest on the term loans will continue to accrue during this period. If a firm applies for and receives a moratorium, the loan account in consideration will continue to be recognised as a standard asset and the SMA classifications will no longer apply. Interest on term loans will continue to accrue during this period.
Analysing the monetary policy announcements
Monetary policy is most effective when economic agents understand and can anticipate the behaviour of the MPC. This process of learning and understanding is still underway, given that India is in the early years of building up the credibility of the inflation targeting framework and the MPC process. So, one would have expected that the MPC statement would go into great details and spell out its macroeconomic forecast, explaining why it believed the 75 basis points rate cut was consistent with its commitment to the 4 percent inflation target.
However, tt did not explain the rate decision in the context of a revised inflation forecast, or any other element of a macroeconomic forecast. It did not offer a justification for the magnitude of rate cut chosen.
Since the rate cut announcement was not couched in the standard IT framework, the public does not have the assurance that the rate cuts will be reversed when inflation begins to rise again. To remedy this problem, monetary policy actions could henceforth be couched in terms of this framework, as a way of assuring the public that the RBI is keeping its eye on this critical objective, and that the mistakes of the past will not be repeated.
Analysing the banking regulation announcements
We know that the corona crisis is a temporary shock. Standard economic theory tells us that the optimal response to a temporary shock is for (viable) firms and households to obtain financing, so that they can tide over the difficult period. Over the next few months, three categories of firms will emerge: a) firms that are able to pay their dues throughout the crisis period, b) firms that are fundamentally viable and can survive provided they are given adequate credit support, and c) firms whose business is faulty and who should become bankrupt as a result of this shock.
It will be important for the banks to distinguish among these firms. Banks should ideally do nothing with firms in category (a), extend credit support to firms in category (b), and take the firms in category (c) to the insolvency and bankruptcy courts as and when that process resumes.
Under the 27 March package, the RBI has given regulatory approval to banks and other lending institutions to decide which of their customers needs a 90-day deferral. This decision, to allow banks but not require them, to grant moratoria is a good one, as it allows banks to distinguish among the three types of firms.
However, the plan is not without drawbacks.
- No mechanism has been created to classify the loans that will be rescheduled, so transparency has been lost. Investors – already nervous because of accounting surprises at Yes Bank and other financial institutions – will consequently provide capital only at a cost marked up to reflect this information risk premium. And this increase in banks’ costs will be passed on to the borrowing corporate sector.
- Moratoria will create problems for pass-through certificates, i.e. loans that have been bundled as bonds and sold to mutual funds, because there are no provisions in these certificates for loan rescheduling.
- Finally, and most importantly, there is no clarity on what happens once the moratorium period is over. How will banks clean up the mess that will be created later, as many of the firms which benefited from the moratorium end up defaulting? There will be a new wave of NPAs, which we know from experience will be difficult to resolve.
There is also a risk: now that a “temporary” moratorium has been introduced, there will be pressure for it to be extended again and again. If the RBI is unable to resist, we will quickly find ourselves back in the ‘extend and pretend’ era of post-2008. Banks, investors, the RBI, will all be navigating in a fog, since no one will know – and hence, be able to deal with — the true size of the bad loan problem.
In other words, under the current design, there are risks that the costs of the moratoria could end up exceeding the benefits. Is there an alternative? In fact, two supplementary actions could reduce potential costs, while preserving the benefits.
First, RBI could announce that firms seeking a moratorium would be marked in a separate category. This would give transparency regarding the true financial situation of the banks. There will also have been a bit of a stigma for borrowers, helping to preserve debtor discipline. If a firm has no choice, it will still postpone repayment. But if a firm can afford to pay, it will do so, in order to escape the stigma.
Second, forward planning could help deal with the consequences of the inevitable surge in defaults. Even before the corona crisis, bankruptcy cases were taking far longer than what the law stipulates. Large cases were taking several years to resolve. If this situation is not addressed, there is a risk that large sections of the economy will be tied up in bankruptcy courts, making it impossible for the economy to return to normal, even after the virus abates. To make sure this does not happen, the Insolvency and Bankruptcy Code (IBC) needs to be reformed urgently in order to ensure faster and effective resolution. Such reforms would also have an immediate benefit: banks would be more confident in lending now if they knew the IBC would not be overwhelmed by cases after the crisis is over.
Reviving credit growth
The need of the hour is to revive credit to the private corporate sector. But the marginal benefit of the RBI adding more liquidity to a system that is already in a surplus mode is not clear. This strategy has already been tried, without success. It is unclear why it would work now, especially now that uncertainty about firms’ prospects has only increased.
For a proper root cause analysis, let’s go back to economic fundamentals. Consider a loan decision. When a bank decides to approve a loan, it is performing two functions simultaneously: it is assuming risk, and it is allocating capital. In the current circumstances, it is still possible for banks to allocate capital. They can assess which firms are more likely to be hit badly by the crisis and which firms are going to be less affected. That is, banks can figure out the relative risk. The problem for the banks is that right now they cannot assess the absolute level of risk, because they do not have any idea about how long the crisis is going to last, or how deep the crisis is going to be. And this shock has come at a time when banks have already become risk-averse given the last few years of balance sheet problems. Hence, it is difficult for them to lend, especially to new customers.
In these circumstances, giving them liquidity, exhorting them, coming up with any number of subsidy schemes, will not work. But there is a possible solution. The government– not the RBI — could relieve the banks of the burden that they cannot manage: the burden of risk.
This can be done through a mechanism as follows. The government can capitalise a fund which will then give loan guarantees. The scheme would have some selection criteria, say MSMEs that have been current on their bank loans. It would also specify the maximum rupee amounts per firm, pegged say to the annual revenues of the company. Once the eligibility criteria are specified by the government, the actual selection of the firms would be done by the banks. They would identify the best firms, originate the loans, and then apply to the fund for guarantee coverage. The banks should be charged a fee for this, to discourage them from using the fund unnecessarily.
In this way, we could use the law of comparative advantage to obtain better economic outcomes: the government would do what it does best in crises, namely bearing risk, while the banks would continue to do what they do best, namely allocating capital.
The RBI’s March 27 announcements were bold and decisive. In particular, the reduction in the repo rate by 75 basis points will provide significant debt service relief to firms and households. This is a welcome measure, at a time when their cash flows are going to be seriously strained. The announcement that banks will be allowed to grant temporary debt moratoria to firms and households could also prove a major help, for exactly the same reasons.
That said, the announcements could have been better grounded in basic principles. The root causes of the banks’ reluctance to lend have not been addressed. At the same time, the way the policy actions were designed and announced run the risks of damaging confidence in the existing frameworks. The public may not be so sure that the authorities remain committed to preserving low inflation or financial stability. Nor is it clear that there is an “exit strategy”, to ensure that the defaults will be resolved expeditiously, allowing the economy to return quickly to normal, once the health crisis is over.
There is still time to clear up these ambiguities, and remove any doubts. Initial actions can be followed by supplementary steps, and initial problems can always be remedied. This will take careful root cause analysis, cost-benefit calculations, and a determination to reinforce existing policy frameworks.
Josh Felman is a researcher specialising on India. Rajeswari Sengupta is a researcher at IGIDR.
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