Grace under fire: RBI represents a crisis manager's balancing acts

Since 1991, RBI has played key role in averting crises that posed a threat to India's economy

The Indian economy has weathered several storms over the last 40 years, both external and internal.  Dust lifted by such gales didn’t last long as the country’s central bank, the Reserve Bank of India (RBI), acted swiftly and performed a fine balancing act — spurring growth and keeping inflation in check.

 

Established on April 1, 1935, and nationalised in 1949, the RBI is responsible for issuing and regulating currency, formulating and implementing monetary policy, and maintaining price stability in the economy. It also plays a key role in supervising the country’s financial system and serves as the regulator of the payments and settlement infrastructure. The RBI is also the lender of last resort.

 

Since India’s economic liberalisation in the early 1990s, the central bank has played a key role in averting several crises that posed a threat to the country’s financial stability.

 

Business Standard takes a look at five such instances.

 

Balance of payments crisis: 1991

 

In 1991, India was staring at a balance of payments crisis, with the country’s current account deficit swelling to 3 per cent of gross domestic product (GDP) —the highest in the last two decades then — due to a rise in the price of oil following the invasion of Kuwait by Iraq and reduced remittances.

 

There was a fear that India could default on its external payment obligations as its foreign exchange reserves had reduced to only $1 billion — enough for just two weeks of imports.

 

In a firefighting mode, the then RBI Governor S Venkitaramanan pledged 67 tonnes of gold with the Bank of England and Union Bank of Switzerland to raise around $600 million. This helped bolster foreign exchange reserves and prevented India from defaulting on its external obligations.

 

Additionally, RBI, in coordination with the Indian government, undertook a two-step devaluation of the Indian rupee to boost exports, and improved the current account, marking a shift away from a fixed-rate regime to a market-determined exchange-rate regime.

 

The currency was depreciated by as much as 20 per cent.  The RBI also played a key role in facilitating negotiations with the International Monetary Fund (IMF) and the World Bank for emergency financial assistance for India. The country secured a $2.2 billion loan from the IMF, which played a major role in stabilising the economy.

 

Global financial crisis: 2008

 

The global financial crisis (GFC) was triggered by the bursting of the housing bubble in the United States, leading to the collapse of major financial institutions, including Lehman Brothers. It spread globally, resulting in a severe liquidity crunch and demand shock. India, however, was not as impacted as some of the developed economies due to its limited exposure to global trade.

 

However, the impact was felt in terms of capital outflows, currency volatility, a liquidity crunch, and slowing economic growth.

 

The RBI, under the leadership of governor Duvvuri Subbarao, undertook several measures to address these concerns. To inject liquidity into the system, India’s central bank reduced the cash reserve ratio (CRR) from 9 per cent to 5 per cent in phases, and reduced statutory liquidity ratio (SLR) to bolster lending capacity of Indian banks. It also reduced the repo rate from 9 per cent to 5 per cent and the reverse repo rate was brought down from 6 per cent to 3.25 per cent to lower borrowing cost in the economy.

 

Additionally, it provided a special refinance window for banks, non-banking financial companies (NBFCs), and mutual funds to address any liquidity issues. Further, the RBI, in collaboration with the government, created a special-purpose vehicle to provide liquidity support to NBFCs through government guaranteed bonds. The RBI also stepped in to counter excess volatility in the Indian currency by selling dollars from its foreign exchange reserves in the forex market. Further, the RBI also provided regulatory forbearance to banks to restructure loans, especially to sectors impacted by the GFC.

 

Taper tantrum: 2013

 

After the US Federal Reserve hinted that it would reduce bond purchases in 2013, emerging-market economies, including India, faced massive capital outflows, with foreign investors pulling their money out from these markets and moving it to the developed economies, especially the US.

 

This led to massive depreciation in the domestic currency, with the rupee falling by as much as 20 per cent.

 

India’s current account deficit reached a high of 4.8 per cent of GDP during this period. The economy was also facing inflationary pressures for the fuel and food segments. The RBI, then led by governor Raghuram Rajan, stepped in to support the domestic currency by tightening liquidity.

 

The marginal standing facility (MSF) was increased by 200 basis points, making it costlier for banks to borrow short-term money; liquidity adjustment facility (LAF) was also curtailed; daily repo borrowings were limited. The RBI also engaged in open-market operations (OMOs) by selling government securities to suck out rupee-based liquidity.

 

Additionally, the regulator took measures to boost foreign exchange flows to stabilise the rupee by offering a concessional swap rate for banks to swap Foreign Currency Non-Resident Account (B) deposits for a fixed term, attracting $34 billion in inflows. The RBI also allowed a special dollar window for state-owned oil-marketing companies (OMCs) to meet dollar demand outside the spot market, and directly intervened in the forex market to curb excess volatility. Moreover, import duty on gold was raised several times to reduce the current account deficit. Apart from these measures, the central bank gave clear policy signals to the investors.

 

L&FS debacle: 2018

 

The failure of Infrastructure Leasing & Financial Services (IL&FS) in 2018 led to a massive liquidity squeeze for the NBFCs and mutual funds, and eroded confidence in the shadow-bank ecosystem. To ease liquidity conditions, RBI bought government securities aggressively, injecting liquidity into the system. Banks were allowed to lend more to NBFCs, without compromising their liquidity requirements. 

 

The RBI gave targeted liquidity support to the shadow-banking sector, which was by then struggling to raise funds. Bank lending to NBFCs was classified under the priority-sector lending (PSL) for a specific period. It also allowed banks to provide partial guarantees for bonds issued by NBFCs so that they could access the debt capital market to raise funds. Following the IL&FS debacle, the RBI increased scrutiny and oversight over NBFCs and monitored their liquidity mismatches. This crisis resulted in the RBI creating scale-based regulation for NBFCs, placing the NBFCs in four layers depending on their size and systemic importance. NBFCs placed in the upper layer faced regulatory norms that were closer to the banks. As a result, HDFC Ltd, the largest mortgage financier in the country earlier, decided to merge with HDFC Bank, creating a financial behemoth.

 

Covid-19 pandemic: 2020

 

When the Covid-19 pandemic struck the world, the RBI, under Governor Shaktikanta Das, was faced with two tasks: Maintaining financial stability, and economic growth of the country. The RBI put in place business-continuity measures even before the nationwide lockdown was announced, and mandated all regulated entities to take immediate contingency measures to ensure business continuity.

 

During this time, the RBI prioritised growth over inflation. It cut policy rates to infuse liquidity into the system, and looked through inflation spikes, which were assessed to be transitory and driven by supply shocks. While the RBI cut rates, it did not go below the inflation target of 4 per cent to avoid making real rates negative.

 

So, while supporting growth, the RBI was conscious of not being ultra-accommodative. Additionally, the regulator ensured that its measures were not open-ended, and most of them were time-bound, announced with pre-set terminal dates so that their unwinding did not cause market disruption.

 

During this period, the RBI also allowed restructuring of stressed assets by banks and NBFCs, subject to certain financial and operational parameters to be achieved as part of the loan restructuring process. The RBI also engaged in an asset-purchase programme, but it was restricted to government securities and solely through the secondary market. This was unlike some inflation targeting by emerging market economies’ central banks that made emergency provisions to operate in the primary market to finance the government directly.

 

It was considered a prudent decision by the RBI and the Government of India to avoid monetisation of fiscal deficit, a practice which was discontinued by the Reserve Bank in the late 1990s.