As the COVID-19 pandemic and the resultant business shutdown roil economies around the world, governments and central banks are stepping in to stabilize financial markets and allay fears of the public at large. While some steps taken can be termed relief measures, the more serious intervention from these entities is in the form a stimulus. Tax breaks, cash transfers, loan waivers, postponement of repayments, interest rate reductions and making credit easily available for businesses are a few such stimulus measures. In March, the government of India and the Reserve Bank of India (RBI) took a series of measures to put more money in your hands by allowing you to withdraw from your retirement funds and to defer your loan re-payments.
The RBI’s stimulus took the form of a large cut in interest rates (75 basis points). So, when governments and central banks take measures to stimulate the economy, how is your investment impacted?
What is a stimulus?
When economic conditions are weak, people generally refrain from spending. This hurts businesses because they don’t make enough revenues then. That leads to financial losses and potential layoffs. Money becomes dearer. At the same time, banks don’t like to lend because they fear that companies might default on loans. That’s a double whammy for businesses.
A stimulus is a confidence boosting measure where the government puts more money in our pockets and makes credit easily available to those who need it. The aim is to bring back economic activity. “In tough times, policymakers ensure that the financial system has abundant liquidity to avoid panic,” says Rahul Pal, head-fixed income, Mahindra Asset Management Company.
Monetary stimulus includes a cut in interest rates. A fiscal stimulus means, among other steps, a cut in taxation, incentives for companies to invest and more amounts in the hands of investors.
Do monetary and fiscal measures work?
During the 2008 global financial crisis, India didn’t suffer as much as some of the western nations did. Towards the end of 2008, the RBI reduced the cash reserve ratio, the fraction of deposits kept by commercial banks with RBI, to 5 per cent, down from 9 per cent. The repo rate – the rate at which the RBI lends to commercial banks – was cut to 5.5 per cent from 9 per cent, along with a few other moves.
In simple words, RBI discouraged banks from parking more funds with it and instead encouraged them to lend more readily to borrowers. Stock markets recovered sharply. The Nifty nearly doubled from its October 2008 lows, by the end of 2009.
Does a stimulus have side effects?
A stimulus is a double-edged weapon and can have unintended consequences if not handled carefully. “Stimulus needs to be given quickly in response to a crisis, in the right quantity. More importantly, it must be withdrawn as soon as economic activity ramps up,” says Shyam Sekhar, founder and chief ideator of iThought. Stimulus may lead to higher inflation. “In India, we failed to withdraw the stimulus given at the time of global financial crisis. We have seen inflation in 2012,” says Sekhar.
Too much money may lead to inflation and eventually interest rates go up. If there are no supplementary policy measures to revive the economy after a financial stimulus is given, the situation may worsen. Lot of money in the hands of individuals lead to an increased demand of goods and a possible rise in imports. This could weaken our currency if not handled well. More demand for domestic goods can also lead to rise in prices, making our exports expensive and imports cheaper. This weakens the rupee against foreign currencies.
Will we see a recovery soon?
Sekhar expects the increased liquidity to bring down interest rates in the near term, but lead to inflation over the next 12 to 18 months. Though historically higher liquidity has led to inflation, this time, it could be bit different. The coronavirus pandemic has led to destruction of economic activity worldwide. “The COVID-19 induced slowdown in the economy may lead to income shrinkage. It may make people consume less. That may reduce the impact of demand induced inflation,” says Pal.
The coronavirus’ economic impact, will be measured over the next three months. But, the financial markets are likely to discount it earlier. Says Sekhar, “Real estate prices should fall further because there are no buyers. Personal balance sheets are leveraged and there is a possibility of job losses. For financial stability, many would sell properties.” He foresees gold prices going up and real interest rates hovering around two percentage points.
What should you do as an investor?
If you invest in fixed income securities such as fixed deposits, small saving schemes and debt mutual funds, you should choose your instruments based on your horizon and return expectations.
The government may soon resort to large-scale borrowing to fund the costs for fighting the COVID-19 pandemic. Such large-scale borrowing may push the yields on government securities upwards. Since yields and security prices move in opposite direction, the net asset values of bond funds (more so long-term debt schemes) may fall. A recent CARE Ratings report points out that the market expects the gross borrowing programme to be much larger than usual.
Rahul Pal says, “Given the lack of clarity on the macro economic situation, despite interest rate cuts, investors should refrain initially from investments in longer tenured debt funds.”
Stick to short-term bond funds. Don’t forget the tax-free bonds issued by public sector companies or the 7.75 per cent RBI (Taxable) bonds. Also, continue with your long-term investments, in line with your asset allocation. Ensure that you have 10 to 15 per cent of your financial portfolio in gold to ride out market volatility.
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