The Central bank of a nation is tasked with multiple responsibilities to maintain the dynamic, complex and entangled macroeconomic variables with the sole objective of economic development of the country. The Reserve Bank of India (RBI) follows the same pursuit of growth by working out the price and financial stability of the state. The gigantic wave of virus that swept the world in late 2019 and hit India in early 2020 has inevitably accelerated the socio-economic division, the footprint of which will be felt for years to come. With the advent of such unprecedented times, all eyes are turned to the Central bank and to the government for rescue from the ramifications of this situation.

On the late evening of March 24, 2020, Indian Prime Minister Narendra Modi announced a 21-day complete lockdown which got extended for months due to the rising number of COVID-19 cases in the country. This declaration meant an absolute halt for businesses leading to complete disruption of market forces of demand and supply, money creation, etc. In short, it was a difficult affair for the economy. Nonetheless, the RBI sailed through it almost effortlessly, supporting the economy through the various tools:

a) Rate cuts: To incentivise investments and loans.

b) Liquidity Infusion: Increasing the availability of funds in banks via various policy rates like CRR, Repo rate, Reverse Repo Rate, OMOs, and special windows for financial institutions to borrow.

c) Regulatory Easing: Via mechanisms like a moratorium, etc to support the borrowers.

These steps resulted in a liquidity spree in the banking system, drawing concerns of inflationary pressure in an already high inflation economy (CPI inflation rate in July was 6.93%). In addition to this, the influx of dollars in the country through Foreign Direct Investments (FDIs) and Foreign Portfolio Investments (FPIs) fuelled the additional circulation of Indian currency in the economy. This, supported by collapsing net imports, led to the pile-up of RBIs forex kitty to an all-time high of $541billion.

In layman’s language, it looks like a rosy picture. However from an economist’s point of view, this means appreciation of the Indian rupee with respect to the mighty US dollar. Thus, putting exports at a disadvantage. It adds to the already concerning topic of inflation as now excess money will be spent on the imported items, increasing our dependence on imported goods. At the same time, we will be letting go of the opportunity of utilising the liquidity available in the system which could have been used to build productive capacities like infrastructure that will lead to the creation of employment, income and welfare of the nation.

On the flip side, inflation will only occur when the monetary surplus in the banking system actually reaches the hands of the consumers via businesses and loans, but banks are averse in lending out due to skyrocketing Non-Performing Assets (NPAs). Hence the overflowing liquidity is limited within these financial intermediaries.

According to an article published in Business Today, despite the Central bank reducing the Reverse Repo Rate (RRR) from 4.9% to 3.35%, the number of deposits increased during the period of the pandemic. Unused funds in the financial system have further been increasing as businesses and firms are reluctant in taking loans for investments due to low production and capacity utilisation. Moreover, rising COVID-19 cases engulf the future with a blanket of uncertainty for businesses.

The jump in the deposits with the RBI is a cause of worry as the excess money sitting idle with banks now requires the Central bank to pay interest on these deposits. Additionally, the money is never actually entering the productive sector for money creation, which was the prime motive of slashing the RRR.

Nevertheless, governments too have a vital role in reviving the economy through its targeted expenditures. But the Union government’s fiscal deficit has soared to 109% of the budgeted target in just 5 months of the current financial year. State governments have been facing a shortage of funds owing to the shortfall of revenues due to sluggish economic activities and failure on part of the Union government to settle the compensation for Goods and Services Tax (GST). Hence, the governments’ bank stepped in to facilitate the reduction of that deficit by borrowing from the bond market. The Center has stuck to its borrowing plan of ₹12 trillion in 2020-21. The superfluity of funds in the financial system is managing to keep the yields in the bond market low, benefitting the borrowers in borrowing funds at low-interest rates. The Central government borrowed ₹7.66 trillion at a weighted rate of 5.82%, the lowest in 15 years, in the first half of the ongoing fiscal year.

Getting the rate of economic expansion back on track is a daunting task and RBI has managed the situation quite decently, but the major chunk of work now lies on the government to use their borrowing for capital expenditure and revival of demand. Better demand sentiments would enable restoration of the market disruptions and lead to an expansion in the trade deficit which would perhaps reduce the balance of payment surplus and minimise the intervention by the Central bank to some extent.

The latest projection by the US Federal Reserve to keep its interest rate near zero till 2023 would result in a sustained flow of foreign funds into countries like India. Therefore, the bankers’ bank needs to be watchful and avoid unnecessary currency appreciation which will not only affect exports but also other macroeconomic variables, thus risking the financial stability of the nation. The biggest challenge will perhaps come when pandemic recedes and activity picks back up but for now, the Reserve Bank needs to maintain a fine balance between the intertwined variables of inflation, bond yields, and currency market for the economic interest of India.