The great banking liquidity debate

The irony is impossible to miss. The Indian banking sector suddenly finds itself flush with funds, anywhere between ₹4 lakh crore and ₹5 lakh crore, in an economy hobbled by a demand slump whose effects have spared no one: from retail borrowers to micro, small and medium industries to the big corporates.

The high-on-liquidity situation is the result of the Reserve Bank of India’s announcement after its ahead-of-schedule meeting of the Monetary Policy Committee (MPC) on March 29, when it unleashed a series of measures to minimise the impact of Covid-19 by infusing ₹3.74 lakh crore into the system.

These policy tools included a 75-basis-point repo rate cut to 4.4%, a 100 basis point cut in the cash reserve ratio to bring it down to 3%. The liquidity adjustment facility (LAF) corridor—the difference between the repo and reverse repo rate—has widened by 40 basis points by reducing the reverse repo to 4% making it a disincentive for banks to park their excess funds in the central bank.

It has also nudged banks to lend to productive sectors of the economy, encouraged credit flow to specific sectors, given relief to borrowers from debt servicing, made access to working capital easier for businesses and relaxed regulatory environment for banks temporarily.

It also increased the ways and means advance (WMA) limit—the amount that the state government can borrow from the RBI—making it easier for state governments to tide over potential mismatches between their revenues and expenditures arising from the current disruptions, measures that will provide some relief to the crucial segments of the economy.

But the real question is whether the RBI has used up too much of its arsenal, saddling banks with excess liquidity at a time when they have few options for deploying them in productive assets. Anagha Deodhar, economist at ICICI Securities, points out: “Economic outlook is likely to remain weak in the near future, hence I don’t expect the repo rate cut to provide meaningful stimulus to the economy.” However, she adds that liquidity and regulatory measures could provide relatively more meaningful support to growth than rate cuts.

A better way to meet the liquidity challenge, according to Deodhar, is by monetisation of the government’s fiscal deficit or the government’s debt. It essentially means the RBI buying up government bonds from the primary or secondary market at a fixed rate of interest, thereby ensuring that the government does not have to borrow from the market or look for other sources of funds.

Such a move, says Deodhar, “will normalise the risk-free yield curve or government securities (which hasn’t fallen in line with rate cuts since the market is expecting higher supply of bonds in the market due to slippages), transmit past rate cuts and ease financial conditions for all market participants”. Monetisation of the government’s debt by the RBI will flatten the yield curve of the government’s bonds—keeping the bond yields low—which in turn will ensure faster transmission of rate cuts to the public at large.

But other economists and bankers believe that higher liquidity is a must during the crisis as the government needs to spend its way out of the current crisis and ensure a speedy recovery. Sameer Narang, chief economist and head, strategic planning at the Bank of Baroda, says since banks will have no money (read receivables) coming in for the next three months because of the government’s announcement of a moratorium on all payments and interests. Hence, banks will require excess liquidity not just to run their own establishments, but also take care of the immediate funding needs like working capital loans of many stressed companies, especially SMEs, self-employed persons etc.

Most companies from the MSMEs to NBFCs, big corporates to housing finance companies (HFCs), will require an extra dose of funds from banks to finance their fixed costs at a time when their sales and other incomes have virtually dried up because of the shutdown, while inventories have been piling up. “They will need extra financing from the banks to pay for things like rent on their buildings, wages to their workers and other such fixed expenses,’’ says Narang.

Moreover, banks will also have to subscribe to the non-convertible debentures (NCDs) or bonds—fixed-income instruments of high-rated companies—and commercial paper of investment grade companies by NBFCs, HFCs and other corporates under the new directives from the RBI.

For Andrew Holland, CEO of Avendus Capital, the real challenge for many companies will be cash flow issues, because in the absence of earnings, companies will find it extremely difficult to manage its interest payments. “The banks will have to provide necessary finances to the so-called solvent companies,” he says.

But the greater challenge for banks will come when the economy opens after the Covid-19 lockdown. Many companies will require restructuring of their loans, given additional time to make repayment, especially for the worst-hit automobile sector, aviation, construction and retail as also some self-employed individuals and retail borrowers. If companies have become bankrupt, then their loans will have to be written off.

As the clamour for more financing grows, the government will need to provide some kind of an insurance cover to the banks because a spike in non-performing assets (NPAs) is a certainty. Banks will not only have to fund businesses which have been devastated by Covid-19, but are also the most vulnerable even when the lockdown is completely lifted, says Narang.

For R.K. Gurumurthy, head, treasury, Lakshmi Vilas Bank, the end of Covid-19 will only mean the end of the health-crisis, but the economic crisis would still remain, probably in a worse form. “With GDP growth at circa 3.5% and banks may get saddled with more/new bad debts leading to rating downgrades. This could impact the ability of a majority of banks to raise regulatory and growth capital,” says Gurumurthy, adding, therefore, the next set of measures (in the absence of poor tax collections and weakening fiscal landscape) will be growth oriented and lower rates are here to stay for some time.

So what should be the priority of the Central Bank once the crisis ends? The RBI’s immediate focus after the crisis ends should be on controlling inflation, stabilising the rupee and ensuring steady financial conditions and not push very hard to boost growth, says Deodhar of ICICI Securities. She argues that that the crisis is likely to be long and shallow because reopening manufacturing units, getting migrant workers back, starting the economic engine back, and reaching pre-crisis capacity utilisation could take some time.