During a pandemic lockdown, it is important for people to stay at home and not go out and interact with others, spreading the disease around.
This means that economic output will reduce because people aren’t spending on going out to eat at restaurants, factories aren’t producing goods because workers are sitting at home, and power companies are making losses because no one is using the electricity to run the shop display lighting or the heavy machinery for manufacturing.
The usual prescription that economic theorists provide when people aren’t buying enough is monetary stimulus. Drop interest rates, and people who would otherwise not buy a house can suddenly afford the EMI. The builder can pay back his loan. And the bank can in turn lend more to a credit card customer, who in turn can buy an Air Conditioner, and so on.
The problem is that this is not a standard ‘people aren’t buying enough because of money’ problem. Instead it’s a ‘I don’t want to die, so I will stay home problem!”. That cant be solved by the bank giving you a cheaper EMI.
So what should be done. The first thing is to accept that there is going to be some bad economic outcomes. Once that is accepted, the focus shifts from getting people to spend towards getting people through the bad times successfully so that when things get back to normal, they can go into factories and work. Or go to the restaurant that they went to 6 months ago and get the same wonderful food.
That won’t really be possible if the restaurant has fired its chef and waitstaff. Or if the factory had all its assets auctioned off by a bank for not paying its regular interest payments. So economically, the help that is needed is to fund the expenses that these businesses have to incur during the time of pandemics, so that they can get back on their feet quickly after the pandemic. This funding is usually called working capital financing by banks during more normal times.
The problem is that if I am a bank, there is no way for me to fund a business that doesn’t make money. And for the next few months, very few businesses will make money. So this is where the regulator comes in. First, it can announce a gush of liquidity into the financial system. This is what the RBI has done with its Long Term Repo Operations (LTRO). This allows the central bank to provide credit to commercial banks for periods longer than the usual 1-90 days that repo is generally done for. How much longer? 1-3 years. When banks have guaranteed liquidity for such long periods of time, they can fund the working capital needs of companies for a corresponding similar length of time without concerns of liquidity pressures.
But this is not enough. Banks will only lend if they feel confident of making a profit. And during tough times, it may be impossible to identify what is a good credit risk. This will mean banks will lend less than what the industry needs because they are risk averse.
To make sure that banks are incentivized to lend more rather than less, the United States of America via the Federal reserve has moved to directly buy corporate bonds. This establishes a floor on the borrowing costs of companies and ensures that they have a lender of last resort.
However, can this be repeated by India and the RBI? First, we need to understand what RBI can do. RBI in India manages money for the government of India. It used to lend money directly to the government. But these days its less banker to the government and more ‘investment banker’ to the government. Governments borrow from the banks and financial institutions, and RBI buys the government securities from them and gives them cash that they can use to lend (Simplifying wildly here). Why go through banks and not directly lend to the government? Because it is supposed to be a market driven mechanism and the government will be forced to be prudential with borrowing. Too much borrowing and the banks that lend will ask for more interest income. This disciplines governments.
Now the RBI act is a pretty long piece of work. The relevant sections are basically Sections 17-19 which broadly explain what the central bank can and cannot do. Acting as a banker to the government is a definite yes. But Section 19 explicitly prevents the RBI from building up real assets or industries that a bank would accumulate as part of its lending business. This should therefore mean that the central bank cannot lend directly to corporates like the US Fed can.
But there is a catch all in Section 18 of the RBI which says that the central bank can discount bills or make advances to entities of all types. Specifically, it says make “loans and advances” to “any other person” not exceeding 90 days.
So this can be used by the RBI to lend directly to any person (a company, asset management company, or individual even). The only thing that I see as a limitation is the 90 day period, but even that could possibly be rolled over.
We can argue about whether RBI can therefore lend directly with securities or without (on a closer reading I think it can be either).
The problem is how? RBI cant really be seen as entering the same business as the banks it regulates. By entering the loan market directly, it will lead to significant conflicts of interest. Additionally, it can also be seen as deciding which companies can live and which will be left to fend for themselves.
One possible solution that I like is for the government to formally step in. This can be done by setting up an SPV which is funded directly by the government. The government in turn can receive the funds from RBI via its normal borrowing program or under Section 18 or even via direct funding of the deficit (common before 1992).
This makes it clear that it is a government program. It also leaves the government as the final owner of assets, which neatly avoids the RBI prohibition to own assets. All in all, a fairly straightforward solution given the constrains in India.
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