RBI doing 'quantitative easing' by buying corporate paper may not quite work out.
There is a call for greater RBI intervention in the market. This is over and above the TLTROs invoked in the past. Such intervention is from the point of view of funding the government deficit as well as private sector requirement. Let us see how these arguments work. At present, the government borrows in the market because direct monetisation of the deficit is not permitted. However, if there is a liquidity crunch in the market, RBI goes in for open market operations where certain securities are bought by the central bank from banks. The securities now get transferred to RBI, and banks get the requisite funds. Therefore, reserve money increases, but it is in an indirect form even though the result is the same given the central bank becomes the holder of government debt.
This is explained as being part of the monetary policy mechanism through which the central bank manages liquidity. Before this process came into play, there was a system where the government would place paper directly with RBI under what was called private placement and the market was never involved. Once the WMA (ways and means advances) became institutionalised, the private placement route was out of the system.
The call today is for the government to go in for higher spending to provide a fiscal push. The argument is that the extra money required to pump prime the economy—at 1% of the GDP, this could be Rs 2 lakh crore—is not funded by the market but by RBI. Laws have to be changed for this, but the advantage of doing so is that the market is not affected by such a transaction as it is a kind of loan given by RBI, which, if in the form of securities, can be released at a later date into the system. In times of surplus liquidity (as seen today), RBI can sell these securities through OMOs. If the same borrowings were made through the traditional channel, the tendency would be for yields to increase as there is a surfeit of paper in the market which pushes down prices and increases yields. The direct RBI route eschews this transmission. Hence, there is merit, from the market perspective, in getting RBI to finance the deficit directly.
Alternatively, if given as a loan and not as securities, the issue is bilateral one, where the government services the debt over a time period (can be 10-20 years) and there is no market effect. In fact, the money can be lent at the bank rate as it is to the government, and the cost can be kept down. This does not look proper for the traditionalist as it may sound to be a violation of prudence. It will be a case of RBI printing money to finance the deficit which happens in some of the more slippery nations of Africa and Latin America, which, in turn, has been responsible for hyperinflation. But it is an option which can be justified as being a response to a ‘once in a lifetime’ pandemic.
The other is to get RBI to buy non-government paper, and provide liquidity like the QE packages in the West. Under QE, the central bank purchased commercial bonds in the form of MBS, ABS etc, and provided liquidity to banks. The argument hence is that, instead of only government paper being taken for an LTRO, this can be done for corporate bonds for a long period of time. The problem is not of liquidity, but one of risk-aversion. The TLTROs were for a specific purpose, and, hence, there was liquidity to be had. However, the fact that the last auction did not receive adequate bids indicates that while funding was not an issue for banks, lending was. Therefore, even if RBI decides to buy, say, AAA-rated corporate bonds of PSUs from banks that are completely safe, banks may not be willing to on-lend these funds to lower-rated companies, and would still opt to cherrypick their customers. Therefore, RBI doing a QE by buying corporate paper may not quite work out.
Conceptually, there is also the unknown of how RBI would have to account for bonds which default in the market. At present, bond-holders must pay the price for such defaults. RBI, as a non-commercial entity, must work out these possibilities when buying such paper. Also, the MTM issues would have to be addressed as prices of such paper can change in either direction, affecting RBI’s portfolio.
The crux is to solve the problem of how sectors like aviation, automobiles, real estate, hospitality, etc, could be assisted by RBI. The TLTRO was a good concept, but if the funds were to be invested in bonds of the targeted sector, the experience shows that they move to the better-rated companies that had no challenges in finding investors to begin with.
The solution here can be using a ‘one-time’ approach. We had a one-time transfer of RBI reserves to the government in the past. We are also talking of a one-time financing of the fiscal deficit of the government with RBI lending directly to the state. The same can be done where the bank advances credit to the banks as the TLTROs are used specifically for lending to the targeted sectors. Here, it is not the bond market being used, but direct loans in the normal course of banking business. The advantage for banks is that such loans would be funded by cheaper funds. The same can be packaged as refinance at repo rate for banks within specified limits. Here, the commercial risk is still borne by the bank, but the higher spread will encourage such lending. Therefore, just like how there is export refinance, there can be auto, hospitality, aviation, etc, refinance. SIDBI and NABARD have been provided with loans for refinancing MFIs and SMEs. The same can be done directly by RBI through a new window.
The present situation is clearly extraordinary, and there is a requirement for some kind of engineering that has to be done. The crux is to ensure that it is restricted to just this year and not extended, whether it is for funding the government or for resuscitating the vulnerable sectors. Prolonging any such measures runs the risk of making it progressively difficult to withdraw, as is the case with QE where any talk of rollback can affect sentiment. And maintaining the posture of QE makes the measure ineffective. Hence, the irony is that while QE has ceased to work to revive economies that went for it in a sustained manner, but any withdrawal becomes fraught with the risk of generating market nervousness.