With the recent Covid 19 situation leading to economic fallout, experts have already warned of profit stagnation, lagging GDP growth, and global recession. In these times of distress, the government and central bank of various nations have resorted to ambitious measures to strengthen the hope ensuring that the pandemic does not cause a prolonged crisis.

This article illustrates the measures like interest rates, quantitative easing, bank reserve requirements and other changes in credit policies taken up and how these work to improve the market confidence. Also, how various economies are implementing these measures amid the trouble caused by the global spread of the coronavirus.

  • Quantitative easing

As per Professor Willem Buiter, Quantitative easing is an increase in the size of the balance sheet of the central bank through an increase in its monetary liabilities (base money), holding constant the composition of its assets.

Quantitative easing (QE) is a monetary policy whereby a central bank stimulates the economy through buying predetermined amounts of government bonds or other financial assets assets without reference to interest rates, and by buying riskier or longer maturity assets (other than short-term government bonds), thereby lowering interest rates further out on the yield curve in order to add money directly into the economy.

In a liquidity trap situation where central bank has lowered interest rates to nearly zero, and it can no longer lower interest rates , the central bank may then implement quantitative easing by buying financial assets without reference to interest rates. QE is sometimes described as a last resort to stimulate the economy.

How it works:

By enacting QE, the central bank withdraws an important part of the safe assets from the market onto its own balance sheet, which may result in private investors turning to other financial securities. Because of the relative lack of government bonds, investors are forced to “rebalance their portfolios” into other assets.

By providing liquidity in the banking sector, QE makes it easier and cheaper for banks to extend loans to companies and households, thus stimulating credit growth.

Because it increases the money supply and lowers the yield of financial assets, QE tends to depreciate a country’s exchange rates relative to other currencies, through the interest rate mechanism. Lower interest rates lead to a capital outflow from a country, thereby reducing foreign demand for a country’s money, leading to a weaker currency. This increases demand for exports, and directly benefits exporters and export industries in the country.

Quantitative easing can be viewed as a debt refinancing operation of the “consolidated government” (the government including the central bank), whereby the consolidated government, via the central bank, retires government debt securities and refinances them into central bank reserves.

Examples of nations implementing it:

CANADA: The Bank of Canada began it’s first-ever foray into quantitative easing in response to COVID 19 with the purchase of C$1.0 billion ($703 million) in government bonds.

The central bank bought various amounts of five different bond series in the five-year range, with maturity dates ranging from Sept. 2023 to June 2025.

US: The US Federal Reserve said it will buy Treasury bonds and mortgage-backed securities in “in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions and the economy”. It will also add purchases of corporate debt, municipal bonds and other assets. The Fed had earlier announced purchase of $700 billion worth of securities on March ‘20.

New Zealand: The Central Bank said it will buy up to NZ$30 billion ($17 billion) of government bonds in the secondary market over the next 12 months. . It will seek to buy NZ$750 million bonds a week across a range of maturities, via an auction process.

  • Helicopter Money:

The original definition of helicopter money describes a situation where central bank prints large sums of money for distribution it to the public directly to expand the money supply. The term was first coined by Milton Friedman in 1969 in the paper “The Optimum Quantity of Money, when he wrote the following parable:

Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated.

How it works:

Ina situation of liquidity trap, the bank may consider ‘permanent’ monetization of budget deficits or making direct transfers to the private sector financed with base money, without the direct involvement of fiscal authorities, similar to the concept of helicopter money. With helicopter money, central banks give away the money created, without increasing assets on their balance sheet. The money created is perceived as permanent, in contrast to Quantitative easing where the ‘asset swap’ is reversible.

 Examples of nations implementing it:

Although no nation has implemented it yet in response to the virus, it was in the news that the US Congress pushed through a $2 trillion stimulus bill, and some Americans can expect checks from the government to help them cope with the economic devastation. The payments are expected to be $1,200 for individuals or $2,400 for those who are married and file income taxes jointly. It also includes $500 per child.

  • Interest rate

Rate adjustment is the most popular tool available to expand or contract the monetary base, which consists of currency in circulation and banks’ reserves as deposits at the central bank.

The central bank influences the below market interest rates:

Lending Rate:  The rate that banks use to lend money to each other and to customers.

Deposit Rate: the rates parties receive for deposits at the banks or the interest on reserves.

How it works:

From a consumer perspective, lower interest rates stimulate economic growth, as the financing costs get lower thereby encouraging more borrowing. It reduces the equated monthly installments (EMIs) of borrowers, and also makes it cheaper to take new loans.

 From an investor perspective, it creates an influence on the stock prices due to inverse relationship between bond prices and interest rates mean that as interest rates fall, bond prices rise, leading to increase in investment power. A lot of companies facing cash-flow issues find it easier to manage when interest rates are lower.

Such easing aids demand stresses more than supply issues. It also helps to offset a drop in imports stemming from a depreciated foreign exchange rate.

Examples of nations implementing it:

USA: Amid the Covid-19 crises, the new fed funds rate, used as a benchmark both for short-term lending for financial institutions and as a peg to many consumer rates, will now be targeted at 0% to 0.25% down from a previous target range of 1% to 1.25%. Facing highly disrupted financial markets, the Fed also slashed the rate of emergency lending at the discount window for banks by 125 basis points to 0.25%.

European Union: The European Central Bank cut the interest rate on its Targeted Long-Term Refinancing Operations (TLTROs) – cheap loans to banks – by 25 basis points to -0.75% on March 12. It provided additional LTROs to bridge bank funding through to June and relaxed capital rules.

China: The People’s Bank of China (PBOC) on March 30 lowered the seven-day reverse repo rate to 2.20% from 2.40%, the largest cut in nearly five years.

  • Reserve Requirements

The reserve requirement (or cash reserve ratio) is a central bank regulation that sets the minimum amount of reserves that must be held by a commercial bank to ensure that it is able to meet liabilities in case of sudden withdrawals. RR must be held in the form of a reliable asset: gold, domestic currency plus commercial bank balances held at the central bank. If the bank doesn’t have enough on hand to meet its reserve, it borrows from other banks on a stated interest rate.

Reserve Ratio=Deposits x Reserve Requirement

This is different from the capital requirement which is the amount of capital a bank or financial institution must hold as required by its financial regulator.

How it works:

The lower the reserve requirement is set, the more funds banks will have available to lend out leading to higher money creation and perhaps to higher purchasing power of the money previously in use. This helps in controlling the liquidity in the financial system. On the contrary, reserve requirement has an impact on the interest rates as well. Raising the reserve requirement leads to lower supply of money, therefore, banks can charge more to lend it. That sends the interest rates up.

Examples of nations implementing it:

DUBAI: The United Arab Emirates’ central bank reduced banks’ reserve requirements for demand deposits by 50 per cent to support the country’s economy during the COVID-19 pandemic. The aggregate value of all capital and liquidity measures adopted by the central bank since March 14 is 256 billion dirhams ($69.70 billion), the central bank said in a statement.

Indonesia’s central bank left its key interest rate unchanged, while lowering banks’ reserve requirements amid a severe growth slowdown triggered by the coronavirus outbreak. The bank cut the rupiah reserve requirement ratio by 200 basis points for commercial banks.

Colombia’s central bank said it has reduced reserve requirements for banks by some $2.3 billion in a bid to “permanently” increase liquidity.

  • Other policies:

The relief packages by the International Monetary Fund (IMF) acts as a stimulus for economies to act swiftly. Recently, IMF announced a $50 billion aid package for countries’ efforts to fight the epidemic. The funding is targeted at low income and emerging-market nations, and $10 billion of the total sum will be available at a zero percent interest rate.

Forward guidance is a tool used by a central bank to influence market expectations of future levels of interest rates and likely future course of monetary policy through communication of forecasts and future intentions. Individuals and businesses use this information in making decisions about spending and investments.

Measures taken by Reserve Bank of India:

  • The Reserve Bank of India (RBI) gives temporary loan facilities to the central and state governments. This loan facility is called Ways and Means Advances (WMA). Interest is charged at the existing repo rate. The central bank had on April 1 announced raising the Ways and Means Advances (WMA) limit of states by 30%. It has now been decided to increase the WMA limit of states by 60% over and above the level as on March 31, 2020.
  • The RBI introduced the Targeted Long Term Repo Operations (TLTROs) as a tool to enhance liquidity in the system. LTRO lets banks borrow one to three-year funds from the central bank at the repo rate, by providing government securities as collateral. When the funds are required to be in particular securities like in this case, investment-grade corporate debt, it is known as ‘Targeted’ LTRO. This helps banks get funds for a longer duration as compared to the short-term (up to 28 days) through tools such as liquidity adjustment facility (LAF) and marginal standing facility (MSF)

The central bank first decided to conduct auctions of targeted term repos of up to three years tenor of appropriate sizes for a total amount of up to Rs 100,000 crore at a floating rate linked to the policy repo rate in four tranches. Later, RBI announced it would also conduct a second round TLTRO or TLTRO 2.0 for an initial amount of Rs 50,000 crore to help NBFCs and MFIs to refinance SMEs.

  • RBI noted that the 90-day NPA norm will now not apply to the moratorium granted on existing loans by banks. There will be an asset classification standstill on all loans covered under the moratorium from 1 March to 31 May 2020. However, banks will have to maintain additional 10% provisioning on these standstill accounts over two quarters of March 2020 and June 2020. RBI also said the Liquidity Coverage Ratio (LCR) requirement for scheduled commercial banks (SCB) will be brought down from 100 per cent to 80 per cent.
  • RBI Governor Shaktikanta Das said it has been decided to reduce the fixed reverse repo rate under liquidity adjustment facility (LAF) by 25 basis points from 4 % to 3.75 %. The central bank had last cut reverse repo rate by 90 basis point to 4% on 27 March. This will help discourage banks from parking excess liquidity under the liquidity adjustment facility (LAF) window and instead lend more.
  • RBI also waived any further dividend payouts by banks and cooperative banks from profits pertaining to the fiscal year 2019-2020 in view of the financial difficulties due to Covid-19.
  • The central bank allowed extension of date for commencement of commercial operations in respect of loans given by banks and NBFCs to commercial real estate projects delayed for reasons beyond the control of promoters by one year. However, Das clarified that this extension would not be treated as restructuring.

Additional measures by government of India:

  • Changes in FDI requirement: To curb, opportunistic takeovers/acquisitions centre may impose approval or percentage of investment restrictions from foreign countries to protect vulnerable domestic companies, with possibly low valuations, from unwelcome takeovers. The Centre has made prior government approval mandatory for foreign direct investments from countries which share a land border with India. Previously, only investments from Pakistan and Bangladesh faced such restrictions.
  • Tax relief: Government has extended the due date for various compliance requirements under the Income Tax Act .  There has been extention of tax filing/returns and accordingly all tax due arising between March 20, 2020 and June 29, 2020 now stand extended to June 30, 2020. For delayed payments, interest rates have been reduced to 9% under both income tax and GST.
  • Employees Provident Fund Organisation (EPFO) has allowed employees to obtain a non-refundable advance from their existing PF balances while in service which would not be taxable. The amount of advance shall be lower of 3 months’ Basic and Dearness Allowances or 75 percent of the balance in PF account.

Conclusion:

The shutdown imposed across the world has triggered breakdown of the demand and supply chain having major consequences on the financial markets. The stocks are eroding in value as a response to the threat of falling revenues and losses. Global stock indices have slid by over 30 percent from their peak. It thus, becomes critical to mitigate the burden and ensure stability for economic sustainability. However, it is also to be kept in mind that the aggressive moves taken my central banks do put a pressure on the economy which indeed could result in inflation, increase in debts and NPAs. The way governments of all the countries are coming together to help each other and their people by proactively monitoring the situation is what instills hope for better tomorrow. It is speculated that it might take two to three years for the global markets to recover.

By:

CA Mehak Bathla

For any feedback/suggestions please reach out at  mehak.48@gmail.com

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2 Comments

  1. Subramanian Natarajan says:

    Most research ed article
    Congratulations. Exhaustive by all means. Thanks for pain taking efforts.
    Please do publish more. Overall an excited feeling about aCA touching economics with finesse.

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