Monetary Policy: RBI’s Firefight Redux
Intermittent episodes of inflation seem to be driven by supply problems & do not warrant monetary attention, writes Abheek Barua.
It is possible to argue that monetary policy in the middle of a raging pandemic is now getting somewhat predictable. The usual discussions on the trade-off between growth and inflation that is integral to the so-called process of the monetary policy committee and indeed the very act of setting the policy rate become a sideshow. The central bank has to focus squarely on saving livelihoods and production capacities that have fallen prey to the pandemic. Thus, extraordinary measures aimed at getting credit across to sectors and households that might need it the most have had to be the central remit of monetary policy.
The Reserve Bank of India revealed its emergency playbook in the first Covid-19 wave in 2020. This included a deep cut in the policy rate, a massive infusion of liquidity both through bond purchases, and a cut in the currency reserve ratio to ensure that banks had enough funds to lend and at low rates. Targeted Long Term Repo Operations were geared towards delivering credit to the segments of the economy that were hurt the most. Moratoria were granted across the board to borrowers and were later followed by a comprehensive restructuring plan for company loans. Large credit institutions like Nabard and Sidbi received direct liquidity support. The government also lent a helping hand in unclogging the credit sluices. Credit for MSMEs backed by government guarantees (the Emergency Credit Line Guarantee Scheme) was a measure that was clearly successful.
It is unlikely that the RBI can deviate much from this in handling the current crisis that is riding on the second wave. However, it must recognise the specific features of the second wave that make things different from the first and fine-tune its measures. For one thing, the extent of penetration of the virus into the rural areas has been much higher than the first. The likely damage to rural incomes would mean that small institutions such as microfinance institutions and smaller NBFCs are likely to face major problems.
The ability to handle risk is known to be inversely proportional to the size of these quasi-banks. Thus, they need special support.
Besides, there is a raft of anecdotal evidence that sickness in the workforce has caused much greater disruption in labour supply. The current strain of the virus also seems to be more debilitating for its victims. Large firms might have the buffers and facilities to handle this better. Small and medium firms could be crippled by this and need funds to tide over forced shutdowns.
The emergency measures announced on May 5 recognised these problems. Special three-year long-term repo operations of Rs 10,000 crore at repo rate for small finance banks, were announced for fresh lending of up to Rs 10 lakh per borrower. SFBs have been played a key role in the “last mile supply of credit to individuals and small businesses.” SFBs were also permitted to classify fresh lending to smaller microfinance institutions (with asset size of up to Rs 500 crore) for on-lending to individual borrowers as priority sector lending.
But the slip ‘twixt the cup and lip remains. Of the first tranche of these special LTROs conducted on May 17 for SFBs, only Rs 400 crore was borrowed. This reluctance could perhaps be explained as risk-aversion. SFBs might be able to borrow from the RBI at low rates but might be squeamish about lending fearing a rise in bad loans. The only way to address the problem would be to seek credit guarantees from the government to “absorb” this risk.
A more radical option would be for the RBI would be to provide credit directly to the riskiest borrowers. These loans could be securitised and bundles of these ‘securities’ bought directly. The central bank would wring risk out from the system. There could be legal barriers to this but this can perhaps be circumvented through special purpose vehicles with or without a sovereign guarantee.
In a situation where elevated risk remains the barrier between the availability and supply of funds, it is difficult to fathom why the central bank should balk from absorbing some risk itself.
Of the two policy arms of the government, fiscal and monetary, the former is squarely on the frontline in the war against Covid-19. The RBI has to ensure that the fiscal weapons are in fine fettle and the government – both states and centre – can spend freely on healthcare and vaccination without fretting about the macroeconomic consequences of large budget deficits. It is likely that they will overshoot their fiscal targets this year. The consolidated cost of vaccination, for one thing, is likely to go up from Rs 35,000 crore that the central government budgeted as states procure their own vaccines at significantly higher prices than were initially assumed.
More fiscal support is needed for sectors like hospitality and aviation that are literally on the verge of collapse and also for individuals like daily wage workers who have lost their livelihoods. The RBI should use its liquidity levers to ensure that additional government borrowing is absorbed by the market without a sharp spike in bond yields. If interest rates are allowed to rise, the central bank could compromise post-second-wave economic recovery.
What about the familiar dilemma of whether to live with elevated inflation to support growth or smother it right away? There is a strong argument that monetary policy amidst a major shock like the second coronavirus wave can afford to ‘look through’ some inflationary impulses. While it is true that rising commodity price inflation is a problem and could travel soon from the wholesale to the retail index, there is every reason to believe that with subdued demand the second round or pass-through effects will be muted.
Besides, the past fifteen months have shown us that there are intermittent and unexpected episodes of inflation in some items. These seem to be driven by supply problems induced by the pandemic and do not warrant monetary attention. The most that the RBI can do at this stage is to goad the centre and states to manage the supply of essential items to take the pressure off headline inflation. As far as policy rates and stance go, the status quo with a steady policy rate and accommodation is likely to remain the default mode well into the next year.
Abheek Barua is Chief Economist at HDFC Bank. Views are personal.
The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.