Context: Recently, the RBI governor stated in a press conference that the central bank has an armoury of weapons and it will not hesitate to deploy them to mitigate the impact of COVID-19 on the economy.
Two steps that has been suggested by RBI governor to support liquidity in the market:
- Forex swap
- long-term repo operation (LTRO)
Why should the RBI focus on liquidity?
- Rate cut is only a short term booster: A rate cut is a short-term sentiment booster, is not going to help in alleviating the situation.For instance, In the USA Federal Reserve has taken the funds rate to zero, but the markets remain unimpressed.
- The focus should be on finding prudent steps because the worst in terms of virus impact is not yet seen in economic terms.
- This might result in a long term term slowdown in global economy and instability.
- The falling indices are the result of first order impact of the COVID-19 virus.
- Second order impact when major economies either slow down sharply or tip into recession will manifest into longer term instability.
- If the virus spread is not controlled in 2-3 weeks the effect on the economy will multiply.The disruption caused to commerce, trade and travel will be immense.
- In such a situation, it is sensible to hold on to the rate cut option for use at a more challenging time Monetary policy, unlike in a business cycle, is less effective in dealing with a pandemic. The problem is not liquidity alone, but also confidence in the future and disruption in economic activity.
Dollar swap Window
Recently, the Reserve Bank of India (RBI) has opened a six-month dollar sell-buy swap window to pump liquidity in the foreign exchange market.
What is the dollar Sell-Buy window?
- RBI buys dollars from banks instead of bonds but wants to return these dollars at the end of the time period decided for a ‘forward’ premium.
- This premium is determined through an auction.
- RBI is doing two things: buying dollars from banks and selling ‘forward dollars’ for a price or premium.
- The swaps will be conducted through the auction route in multiple tranches. The auctions will be multiple prices based, i.e., successful bids will be accepted at their respective quoted premiums.
- Authorized Dealers (ADs) Category 1 banks will be the eligible entities to participate in the auction.
- It will not have any negative effect on the Forex reserves of the country since the level of forex reserves remains at $487.24 billion as of March 6, 2020. Such a large reserve amount makes a comfortable room to meet any exigency.
Types of Monetary Policy
Broadly, there are two types of monetary policy,
- Expansionary Monetary Policy
- Contractionary Monetary Policy
Expansionary Monetary Policy
Expansionary monetary policy increases the money supply in order to lower unemployment, boost private-sector borrowing and consumer spending, and stimulate economic growth. Often referred to as "easy monetary policy". This description applies to many central banks since the 2008 financial crisis, as interest rates have been low and in many cases near zero.
Contractionary Monetary Policy
Contractionary monetary policy slows the rate of growth in the money supply or outright decreases the money supply in order to control inflation. While sometimes necessary, contractionary monetary policy can slow economic growth, increase unemployment and depress borrowing and spending by consumers and businesses.
Image Source: Indian Express