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(Co-authored with Harikrishnan S.)
 
IMF projections indicate the drag of the Covid 19 pandemic on global growth could be to the extent of -4.9 per cent. This is a major revision in the global growth rate over a very short period of time, from 3 per cent in April 2020. The IMF believes “the Great Lockdown is the worst economic disruption since Great Depression, and far worse than the global financial crisis”. It estimates “the cumulative loss to global GDP over 2020 and 2021 from the effects of the COVID19 pandemic would be around $ 12 trillion ( June 2020 estimates), greater than the economies of Japan and Germany combined”.
 
How have central banks responded to this crisis? This is uncharted territory for the central banks—how to deal with “lives vs livelihood”. The pandemic economics of central banks has to be two-pronged. One, the focus must be on economic “firefighting”—for instance, how to ensure liquidity infusion into the system to stabilise market reactions. The second is long-term policy imperatives. In the US, the Federal Reserve responded to the crisis by lowering the policy rates to effectively zero, floated unlimited asset purchase and facilitated “emergency lending” to keep credit flowing to households and firms. These initiatives are relevant at a time when unemployment rates have reached the Great Depression levels.
 
In the EU, the political context is different. The countries came together to form the Union based on economic integration. What holds the EU together? The individual countries do not have a central bank. The monetary policy is exogenous, with one European Central Bank (ECB) for the region. What is specific to each country is the fiscal policy domain. However, through the Maastricht Treaty, individual countries are supposed to follow the fiscal rules where they have to maintain a fiscal deficit– GDP ratio of 3%. Against the backdrop of the pandemic, ECB president Christine Lagarde announced that “the European Central Bank is determined to use the full potential of their tools, within their mandate.” In March 2020, ECB floated the Pandemic Emergency Purchase Programme (PEPP) as a temporary asset purchase programme of private and public sector securities, to the tune of 750 billion euros.
 
In India, the lockdown came into effect on March 25. Subsequently, an economic package was announced in a phased manner. An agreement on a “new monetary framework” had been signed between the Government of India and RBI in February 2016, under which the single objective of monetary policy is “price stability”, based on inflation-targeting. This policy transition, from the discretion of the RBI Governor to a rule-based monetary policy, has constrained the central bank in reacting with ease to the economic growth slowdown and other economic uncertainties. Yet another point to be considered is the central bank’s independence—“operational independence”—after the constitution of the Monetary Policy Committee (MPC). The role of RBI Governor in taking crucial monetary policy decisions was taken over by the MPC. As per the Section 45ZL of the Reserve Bank of India Act, RBI shall publish, on the fourteenth day after every meeting of the Monetary Policy Committee, the minutes of the proceedings of the meeting which shall include the resolution adopted in the meeting, the vote of each MPC member, and the decisions regarding the policy rates, whether to increase, decrease, or maintain the status quo.
 
Let us unpack RBI’s policy response to Covid 19. On the basis of an urgent meeting of the Monetary Policy Committee (MPC) on May 22—before their regular meeting—RBI responded with a reduction of the repo rate under the liquidity adjustment facility (LAF) by 40 basis points, to 4.0%, with immediate effect. In March, it had already been cut to 4.40%.
 
The reverse repo rate under the LAF stands reduced to 3.35% from 3.75%. Since June 2000, the repo rate has remained the reference rate for signaling the monetary policy stance. The Cash Reserve Ratio (CRR) has been cut by 100 bps. The Marginal Standing Facility (MSF) rate (overnight borrowing facility from the central bank for further liquidity) and the bank rate stand reduced to 4.25%, from 4.65%. The MPC also decided to continue with the “accommodative stance”, and its decisions were taken with the objective of achieving the medium-term target for consumer price index (CPI) inflation, of 4% within a band of +/- 2%.
 
RBI has responded to the Covid crisis by infusing liquidity into the system, to the tune of `5.66 lakh crore in May 2020 (up to May 20), up from Rs 4.75 lakh crore in April 2020. Within the liquidity package, `1.2 lakh crore was injected through Open Market Operation (OMO) purchases and Rs 87,891 crore through three Targeted Long-Term Repo Operation (TLTRO) auctions and one TLTRO 2.0 auction. In order to distribute liquidity more evenly across the yield curve, RBI conducted one ‘operation twist’ auction involving the simultaneous sale and purchase of government securities for Rs 10,000 crore each on April 27.
 
In addition to infusing liquidity, “regulatory easing” measures were announced to (i) promote credit flows to the retail sector, MSMEs and real estate developers, (ii) extend the regulatory benefits under the special liquidity facility for mutual funds (SLF-MF) scheme to all banks, (iii) extend the loan moratorium and support for working capital financing till the end of August, (iv) give credit support to the exporters and importers, (v) extend the tenor of the small business refinancing facilities, and (vi) increase the state’s Ways and Means Advance (WMA) by 60% (compared to the 30% earlier) to monetise the deficit.
 
How effective these measures will prove is anybody’s guess. Even after bringing the rates (for borrowing) down to unprecedented levels, there was a huge increase in the funds parked by commercial banks in RBI’s reverse repo account—this went up from Rs 3 lakh crore on March 27 to Rs 8.4 lakh crore by end-April. With unemployment rates going through the roof, there has been a phenomenal crash in demand. In such a scenario, focusing almost solely on liquidity measures can be only as good as applying some plaster!
 
To conclude, how this crisis will shift economic structures depends on how the virus behaves in the long run, and the nature and severity of the economic shocks. In this uncertain environment, how countries emerge from the effects of the pandemic would depend largely on the effectiveness of the policies they design now. Monetary policy needs to play a proactive, stabilising role in this scenario. However, the announcements so far were mainly targeted at reducing the policy rates and infusion of liquidity. Pumping money into banks and NBFCs without adequate fiscal measures to boost demand runs the risk of increasing bad loans. In fact, CRISIL has already predicted a rise of banking sector NPAs to 11.5% by March next year. As Joseph Stiglitz points out (in an article in project-syndicate.org), “today’s excess liquidity may carry a high social cost. Beyond the usual fears about debt and inflation, there is also good reason to worry that the excess cash in banks will be funneled toward financial speculation”, and he warns that this could lead to a “climate of increased (economic) uncertainty” and end up “discouraging both consumption and the investment needed to drive the recovery.” This could lead us into a “liquidity trap”, with a huge increase in the supply of money and not much to show for use of it by businesses and households. Are we headed in this direction? Only time will tell, but it does make one wonder whether, without demand being stimulated, these policies will ever be enough.
 
The authors are, respectively, a Professor, NIPFP and an Independent  Analyst.
 
The views expressed in the post are those of the author only. No responsibility for them should be attributed to NIPFP.
 
(A Special thanks to Michael Stephens for his comments. The earlier version of this article was  published in the Multiplier Effect Blog of the Levy Economics Institute of Bard College New York. This version was published as editorial in the Financial Express, June 23, 2020).
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