Unlike 2008, when a crisis in the financial system threatened the economy and society, Covid-19 is a devastating shock to people’s health that threatens their livelihoods, the businesses in which they work and invest, the wider economy, and therefore the financial system.
The shock comes at a time when the Indian economy is poorly prepared to deal with it. Our economy was slowing due to weak demand, caused by a combination of a banking system burdened by non-performing assets with limited room to extend credit, and over-leveraged companies with limited room to invest. The government took up some of the slack, leaving it with weakened fiscal capacity to deal with this crisis.
This is not the time for introspection, however. As the Indian government implements its Rs.1.7 trillion relief package, it’s worth asking how this, and other measures fit in the overall playbook for dealing with the economic aspects of this crisis.
The playbook, including the measures that commercial banks, central banks, and governments need to consider, was laid out in a letter published recently by the CFA Institute backed Systemic Risk Council, a non-partisan body of former government officials, financial, and legal experts. The measures are summarized below.
Commercial Banks:
The need for credit is expected to increase, as businesses and households suffer from loss of incomes and demand, and banks need to be prepared to meet the demand by conserving capital. It may mean halting dividends and buybacks, and suspension of bonuses to senior staff. It may also mean stepping back from trading, derivatives, and securities-lending activities that do not support the real economy.
Regulators could help banks expand credit, by exercising forbearance as banks utilize their capital buffers to increase lending to fundamentally sound borrowers, in some cases going below the capital ratios in the short term. The average capital to risk weighted assets ratio (CRAR) of Indian banks was 15.1%, and the public sector banks’ CRAR stood at 13.6% post government recapitalization, according to RBI’s financial stability report released last December, indicating a reasonable cushion to lend. (the figures do not account for the impact of capital infusion into troubled lender Yes Bank).
Measures For Central Bank
Central banks can take various steps during this crisis, starting with the use of discount-window facility not just by banks, but potentially expand to other financial intermediaries whose stress might materially damage the economy.
Central banks must be prepared to expand the collateral, subject to prudent haircuts. If the situation warrants, central banks must be prepared to use creative measures, such as outright purchases of private securities, or acting as the market-maker-of-the-last-resort for segments that are fundamentally sound, and any malfunction would be socially costly. Lastly, central banks must ensure government programs to protect its citizens and the economy can be funded under any circumstances.
RBI’s actions in recent days addresses most of these measures. RBI prohibited commercial banks from issuing dividends, although it stopped short of recommending other capital conservation measures. In addition to the 75-bps cut in repo and 25 bps cut in reverse repo rates, it has made efforts to inject liquidity in the system, starting from the Long-Term Repo Operation (LTRO) announced as early as 16th of March, the 16-day variable rate repo auctions, and open market operations in government securities over the past few weeks.
Spreads on corporate bonds with even AAA ratings have widened since March, while the overnight lending rates have fallen, as investors increasingly prefer cash and short-term instruments. While RBI has stopped short of accepting corporate bonds as collateral, it has indicated that banks could use the liquidity injections to purchase corporate bonds, Non-Convertible Debentures, and Commercial Papers, and more recently those issued by NBFCs and Micro-Finance Institutions (MFIs).
Measures For Governments
As the scale of the crisis becomes clearer in the coming weeks, the Indian government’s relief package may turn out to be a starting point of a range of measures needed to support households, businesses, and states, described below.
Governments need to make clear that they will guarantee new loans by banks to businesses or households in distress, which should be eligible as collateral in central bank facilities. This approach has been followed by western governments to varying degrees, with UK, France, Spain, and US announcing loans and guarantees worth £330 billion (15% of GDP), €300 billion (12%), €100 billion (8%), and $849 billion (4%) respectively. Governments also need to provide direct aid to business sectors that are vital to address the crisis, as the Indian government’s allocation of Rs.15,000 crore for healthcare attests.
Governments need to provide direct aid to households that lost work due to the crisis, but are otherwise healthy, and ensure no one is prevented from getting the health care they need, whatever the financial situation. While the Indian government’s Rs.1.7 trillion (0.8% of GDP) package, aimed at households, was a robust initial response at the time, it falls short of emerging markets with comparable fiscal capacity, and more relief is expected over the coming days. As of April 16th, the cumulative fiscal measures announced by Indian central and state governments amounted to 1.1% of GDP, compared to Thailand (8.9%), Brazil (6.5%), Russia (3%), Malaysia and Indonesia (2.8% each), according to IMF calculations. In particular, our fiscal and monetary measures taken till date have not addressed the stress faced by micro, small, and medium enterprises (MSME) effectively, considering the large contribution to economic activity and employment from the informal sector.
Lastly, central governments need to support the debt management strategies of states, as they borrow a lot more to tackle the crisis. Kerala was the first Indian state to unveil a relief package of Rs.20,000 crores by frontloading its annual budget. It won’t be the last state to require central government support.
There is a strong need for co-ordination among countries to share experience and resources; the government’s leadership among SAARC countries is a positive step. It’s also important for international financial institutions to support emerging economies; an IMF currency swap arrangement to support EM currencies may be needed, if dollar appreciation proceeds apace.
Covid-19 is a once-in-a-lifetime tragedy. It forces governments worldwide to impose economic misery to alleviate human misery, but the trade-offs are far more complex for developing countries like ours. The economic measures must match the magnitude and speed of the crisis.