On a historic weekend in September 2008, the US treasury secretary was able to spook lawmakers into passing the Troubled Asset Relief Program (TARP) with almost no debate. This was in the wake of the crash of Lehman Brothers, and god knows which other giant institutions would have fallen were the emergency relief not provided. Credit markets were frozen, as nobody was willing to lend even to solvent and gilt-edged entities. Unless the government stepped in to unfreeze the market, it would spiral downward and large banks would crash like dominoes. The US Congress approved a plan, which authorized the Federal Reserve to purchase or insure up to $700 billion of “toxic assets", such as mortgages from private institutions, and other illiquid hard-to-value assets from financial institutions. This effectively made the Fed an instrument of fiscal policy. That’s because it had implicitly taken on credit risk, and it had also bought assets above market prices. This was nothing but a fiscal subsidy. This was the onset of an “unconventional" monetary policy to infuse distressed credit markets with liquidity. The term “liquidity" itself became much abused, as it connoted different things to different constituencies, depending on their vested interests. Eleven years later, unconventional monetary policy has become mainstream, not just in the US but in most other advanced economies. Quantitative easing, a euphemism for the central bank buying assets with credit risk, is being used routinely, not just for emergencies. As Satyajit Das wrote recently, instead of being the lender of last resort in times of financial crisis and lending only against sovereign risk, central banks in advanced economies have become lenders of first resort. Indeed, whether it is falling equity prices, widening credit spreads or frozen credit markets in the non-bank finance space, the central bank is supposed to help out in all situations. Central bank chiefs are under tremendous pressure from fiscal authorities across countries. While this pressure may be subtle or indirect in countries like the US and Japan, it can become explicit and ugly in developing countries. For instance, Pakistan sacked its central bank chief in May since he was seen as too rigid in resisting a free float of the currency—which the International Monetary Fund supported in its loan package for the country. Earlier this month, Turkey sacked its central bank governor apparently over differences on cutting interest rates. Mind you, Turkey’s currency is down by half in the last two years, its foreign loans are ballooning, and inflation was 25% quite recently. But the demand for rate cuts from the government and allied interests was enough to lead to the chief’s exit. The successor is bound to be under pressure to balance the opposing forces of maintaining central bank independence and toeing the line of the powers that be. It’s another matter that an accommodative monetary policy, including unconventional methods like buying commercial paper, may not lead to an economic recovery. And this is the heart of the issue—that over-dependence on monetary authorities to fix everything, from so-called illiquid markets in the non-bank space, to sagging equity prices, financial instability or falling housing prices, is ultimately unproductive. The real problem may lie with low aggregate demand, investors’ risk aversion, low productivity growth and business-unfriendly taxes and policies.
India is not immune to this tendency of over-dependence on the central bank for all kinds of rescue. For instance, when the Reserve Bank of India (RBI) wanted to get away from making commercial calls on loan restructuring and haircuts, and asked banks and borrowers to proceed to the insolvency and bankruptcy courts after a time limit, it was stopped short. It lost in the Supreme Court, no less; RBI has had to backtrack a bit on its famous February 2018 circular. Similarly, after the IL&FS episode, there has been pressure on RBI to “do something" to inject liquidity into non-bank finance companies (NBFCs). The NBFC crisis was more about investor nervousness and lack of confidence in the rating of various commercial papers, especially because of fraud in some cases. It wasn’t so much about lack of funds, which the more reputed NBFCs were able to garner anyway. RBI is anyway normally required to provide liquidity to commercial banks (against sovereign paper as collateral). It is not supposed to take on credit risk, for that would be tantamount to a creeping fiscal policy action of providing an implicit subsidy with taxpayer money. Indeed, RBI does provide almost 5% of its revenue to the government through its annual dividend. That’s nothing but direct fiscal support.
India’s central bank has to juggle the apparently conflicting task of raising money for the government while keeping interest rates high enough to signal scarcity of savings (and keep inflation in check). Last year, more than 80% of the Centre’s borrowing was eventually funded by RBI, which is dangerously close to monetization of the deficit. Clearly, this is over-dependence. In the Union budget, it has been asked to provide credit enhancement to ease the liquidity situation for non-banks. We need to shift the dependence back from monetary to fiscal measures and good old reforms to get the economy revving.
Oh, by the way, the TARP was a huge success. The Fed ended up making a profit. But that one-off lucky outcome doesn’t mean we lean on monetary policy for everything.
Ajit Ranade is an economist and a Senior Fellow, The Takshashila Institution