The US Fed in some sense pushed boundaries and stepped directly into the market for lending of all sorts with its most recent announcements. Thus the Fed announced facilities amounting to USD 300 billion to directly support the flow of credit to various agents in the economy. The US Treasury, using the Exchange Stabilization Fund (ESF), will provide USD 30 billion in equity to these facilities.
Under a Primary Market Corporate Credit Facility (PMCCF) the Fed will offer bridge financing for up to 4 years to investment grade companies. Furthermore, borrowers may choose to defer repayment of interest and principal for the first 6 months (or for a greater period at the Fed’s discretion). This facility will be via a special purpose vehicle (SPV) financed by the Fed and capitalized by the US Treasury. Another facility, called the Secondary Market Corporate Credit Facility (SMCCF) has been instituted to purchase corporate bonds issued by investment grade companies from the secondary market. This facility will also buy units of exchange traded funds (ETFs) investing in such bonds. Again the US treasury will capitalize the program. Under a third facility, called the Term Asset-Backed Securities Loan Facility (TALF), the Fed will lend to holders of certain AAA rated asset backed securities (ABS), backed by newly and recently originated consumer and small business loans. This again will be via a SPV capitalized by the US Treasury. Under this the Fed will lend an amount equal to the market value of the ABS less a haircut and will be secured at all times by the ABS. Apart from these, the Fed has also announced the intent to soon establish a Main Street Business Lending Program to support lending to eligible small and medium sized business. Alongside all these measures, the ongoing quantitative easing (QE) program will likely run without any limits and the Fed has also expanded the scope of 2 other programs that are running, the Money Market Mutual Fund Liquidity Facility (MMLF) and the Commercial Paper Funding Facility (CPFF), to include a wider range of securities.
With these programs the Fed is now supporting almost all aspects of the market and financing, from sovereign to corporate bonds, from big businesses to small, via the secondary market as well as through direct lending. The model distinguishes between capital and financing. The former, required in smaller amounts but requiring to absorb losses wherever they arise, will be provided by the US Treasury. The latter, required in much larger amounts, will come via expansion in the Fed’s own balance sheet. These will be further complimented with the direct substantial fiscal stimulus being discussed in the US Houses currently.
The Template Is Set
The Fed has displayed remarkable speed and aggression, especially given the fact that a substantial fiscal stimulus package is in the works and the US economy was still growing at or slightly above trend pre the Coronavirus. This probably reflects a speedy realization of the magnitude of the current problem and is anchored in the Fed’s earlier revealed preference around importance of keeping the growth going with it reaching the economically susceptible parts of the society as well as its fears around inflation not picking up. Indeed, inflation expectations have collapsed in the past few weeks. This is a ready template now for other developed market central banks around the world that have largely reached the limits of interest rate cuts and traditional QE. In all, such measures will likely act crucially to smoothen volatility in markets for financing and facilitate credit flow when normal fund flow chains may be severely compromised. Equally, they will have vocal critics given that the Fed is now acting as a direct lender to major parts of the economy with all the consequent risks of moral hazard.
The template is tempting for our own RBI as well. Thus we are facing a clear market dislocation, the commercial banking system is severely impaired to a large extent, and the fiscal has very visible constraints. Indeed, RBI’s attempts to provide liquidity via banks through its Long Term Repo Operations (LTRO) seem to be making little discernible end impact. The flood of cheap 3 year and 1 year money that banks got is conspicuously absent even in supporting the purchase of near term money market instruments over the past few days. Thus, the case is tempting for the RBI to bypass banks (regulatory enablement may not pose a binding constraint) as well as explore “capital-financing” structures where the constrained fiscal provides the capital and RBI does the financing. The big hurdle of course is that the US Fed prints the reserve currency of the world. Whereas, an emerging market central bank can afford only so much unconventionality before questions about sustainability and independence start abounding. Thus, it is not at all clear that the template set by the Fed can readily be copied by emerging market central bankers as well.
The RBI Still Can Do Much More
Even without venturing into direct lending, there is a lot that the RBI can do within its existing and previously deployed toolkits. In fact it is somewhat surprising that it hasn’t done so yet. Thus while the first response of the central bank was remarkably clear when economic growth slowed dramatically starting last year, it seems from evidence so far that the RBI is struggling to reorient its reaction function to the current crisis like situation that has engulfed the world including India. Financial conditions have tightened rapidly as equity prices and bond spreads have eroded. The RBI’s self-described channel of transmission of influencing corporate bond yields via government bonds stands entirely broken for now as yields across the spectrum (government bonds, corporate bonds, money markets) have spiked. The response has to measure in speed and quantum to the size of the problem and has been decidedly underwhelming so far.
We still think that the RBI (including the monetary policy committee) will act, and sooner rather than later. The 4 key areas that one can readily identify are as follows:
- Cut repo rate drastically (say 100 bps)
- Offer sizeable LTROs for 3 and 5 years at the revised rates
- Open a substantial open market bond purchase program, preferably open ended on quantum but with a large initial target (say INR 2 lakh crores)
- Offer liquidity window to non-bank entities via their holdings of money market and AAA holdings.
As a first step this should help stabilize the market and ease somewhat the very tight financial conditions. More measures can be taken depending upon the efficacy of the first set.
It is to be noted that India’s last year’s growth was already way below its assessed potential growth rate. This underscores the urgency of a meaningful response. Also, the RBI is the only agent in the system currently with the wherewithal to actually provide a sizeable response. Speed matters in these situations as well, a fact that the US Fed well understands, since the delay causes unnecessary destruction of risk capital in the system which is already in thin supply.
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