The pressure on the RBI to conduct a larger quantum of OMOs is likely to rise given the huge borrowing calendar ahead.
Deepak Jasani
On August 6, the RBI unanimously voted to keep the policy repo rate unchanged at 4 percent and reverse repo rate at 3.35 percent respectively. The marginal standing facility (MSF) rate and the Bank Rate stood to 4.25 percent. Policy stance was retained as 'Accommodative'.
The Monetary Policy Committee (MPC) maintained the status quo by keeping the repo rate at 4 percent after delivering 115bps policy rate cut (155bps reverse repo rate cut) since the pandemic hit the economy. Additionally, the cash reserve ratio has been reduced by 1 percent since March. MPC's medium-term target for CPI inflation of 4 percent within a band of +/- 2 percent perhaps weighed on its decision for policy interest rates. Various initiatives had been announced to ensure more than adequate banking system and funding liquidity.
The average CPI-based inflation was over 6 percent for two consecutive quarters — January-March and April-June. It was 5.83 percent in the October-December quarter of 2019-20. The present inflation trajectory, albeit based on an incomplete set of data trended upwards mainly impacted by supply chain disruptions rather than emanating from demand side factors. Although we have seen a broad based rise in core inflation in the recent data print; given the moderation in domestic demand, core inflation should soften from the current levels over the medium term. RBI also expects the headline inflation to moderate in H2:2020-21 aided by favourable base effects.
The MPC noted that the economy is experiencing unprecedented stress and is committed to support the recovery of the economy. While the RBI once again refrained from sharing its FY21 GDP growth forecast, it expects real GDP to be in negative for the whole of 2020-21. A pause in interest rates when lending by banks is subdued is justified. In this current environment, the ability of monetary policy in stimulating credit demand is limited. Rate cuts should be saved for when the economy starts reviving, and not when we are in a partial lockdown mode.
Economic activity has weakened further and the output gap remained largely negative. The COVID-19 outbreak has led to scares regarding public health and the economy. Delayed return to normalcy has been our key worry in the recent past. While supply lines are likely to be restored as lockdown is relaxed, demand would take far longer to revive to pre-COVID levels. External demand will continue to remain weak, shrinking our exports. Even as some support will be provided by government expenditure, overall consumption is likely to slow down due to a slump in private consumption. More than private consumption, however, it is investment demand which is expected to be hit hard in this uncertain environment and may be a huge drag on economic activity in the near future.
Transmission of interest rates has been inadequate, although it has improved significantly recently as reflected by fall of 91bps in weighted average lending rate (WALR) on fresh rupee loans sanctioned by banks during March to June 2020. Banks are yet to cut their lending rates to the extent of policy rate reduction by RBI (cumulative reduction in policy rate since Feb 2019 – 250bps, while the WALR on fresh rupee loans declined by 162bps). Risk aversion among lending institutions has resulted in low credit growth. Rate cuts work more effectively when bank lending picks up and the economy normalcy is restored. By maintaining the status quo, MPC has kept some gunpowder dry.
RBI has ensured that there is ample liquidity in the system. Massive liquidity infusion (around 4.7 percent of GDP – Rs 9.54 lakh crore) after pandemic outbreak via CRR rate cut of 100bps, MSF, Targeted LTROs, re-financing financial institutions tried to ensure that the stress with yields hardening across maturity spectrum do not intensify into macroeconomic risks by impairing monetary transmission and giving rise to financial stability risks.
Credit spreads for better rated corporates have shrunk and there is room for better transmission once uncertainty fades. Steepness in the yield curve still remains as RBI did not announce any measure on increase in HTM limits. The pressure on the RBI to conduct a larger quantum of OMOs is likely to rise given the huge borrowing calendar ahead.
RBI has announced restructuring for COVID-19 stressed accounts in line with expectations from the markets and has addressed regional disparities in the flow of priority sector credit. The framework for restructuring of loans prima facie seems positive, much of its impact will be known when an expert committee headed by KV Kamath along with RBI issues the guidelines. Additional liquidity facilities provided to NABARD and NHB will further support credit push in the economy. Revision in the priority sector lending guidelines will ensure credit pickup in the areas where it is yet to see any traction. Raising LTV on gold loans to 90 percent from 75 percent may have some delayed impact as lenders may be wary of lending upto 90 percent after Gold prices have already run up too much over the past few months.
RBI is aware of the enormity of the crisis and risks ahead. The overall guidance remains dovish as the recovery of the economy assumed primacy in MPC's further actions. Status quo in this meeting seems justified given the weak credit growth and uncertain inflation outlook. Recessionary fears will dominate over the inflation concerns and one can expect further rate cuts based on the evolving situation. RBI Governor has reiterated that the timing of rate cut is as important as the cut; and if the inflation trajectory turns out as expected and eases in H2:FY21 one could see further rate cut. However, much would depend on the evolving situation. We don’t expect the terminal policy rate to go under 3.5 percent-3.75 percent.
For strengthening domestic demand, it is important to revive consumer and business confidence. The Government has already announced a variety of measures to provide economic support to various sectors of the economy and protect the interests of vulnerable sections of society. RBI has also been proactively managing liquidity to ensure that funds flows to all productive sectors of the economy. While all these measures should help support demand as and when the nationwide lockdown is fully lifted, but given the collapse in demand, the need is further ease financing conditions so as to revive consumption and revitalize investment. While restructuring of loans was a positive move, RBI needs to address the credit growth which will give a fillip to leveraged private consumption. Since, banks are the key players in financing consumption and investment, it is also imperative that they remain adequately capitalized.
Overall, the outcome of MPC meet this time around was prudent, to the point and meets the current requirements of the lending community though the borrowers may want something more. What will be crucial to watch are the challenges faced by the KV Kamath committee in making its recommendations considering the viewpoints of the parties involved and ensuring the success of the plan.
The author is Head of Retail Research at HDFC Securities.
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