While the committee's hands were tied due to its primary mandate of maintaining price stability, the RBI has continued to take measures outside the purview of MPC.
Anagha Deodhar
In the run-up to the RBI's monetary policy review on August 6, the street was divided on whether the central bank will hold rates or deliver a 25 bps cut. Those in favour of rate cut argued that there were worrying signs on the growth front. Those against pointed out that inflation was stubbornly high, negative real rates were disincentivising savers and recent measures posed a threat to financial stability.
The monetary policy committee (MPC), on its part, faced a tough choice. Rising COVID-19 cases and the resultant local lockdowns in many states were derailing the already fragile and patchy recovery.
On the other hand, headline inflation had been printing above 6 percent since December 2019. In Q4FY20 and Q1FY21, the headline inflation averaged 6.7 percent and 6.5 percent, respectively, significantly higher than the upper bound of MPC’s target range.
After deliberating on the pros and cons for three days, the committee prudently decided to prioritise price stability over growth concerns. However, it maintained an accommodative stance and added that while space for further action was available, it would be used "judiciously and opportunistically".
Since the onset of the pandemic, the MPC has refrained from giving forward guidance on inflation and growth. In the August review as well, it gave only qualitative commentary on growth and inflation, citing a lack of clarity on inflation prints.
Though the National Statistical Office produced imputed inflation prints for April-May 2020, the MPC regarded inflation prints for the two months as a break in the CPI series. This is in stark contrast with global central banks that have published detailed forward guidance throughout lockdowns in their respective geographies. In fact, on the same day as the RBI's policy review, the Bank of England published detailed GDP growth, inflation and unemployment forecasts.
Commenting on inflation, the MPC said that lockdown-related disruption, a spike in food prices due to floods in eastern India, higher taxes on petroleum products, higher raw material prices and telecom charges made the inflation outlook obscure.
While the food inflation is likely to ease due to bumper rabi harvest and modest MSP increases, overall headline inflation is likely to remain elevated in Q2FY21 and moderate in H2 due to a large favourable base effect.
On the growth front, the MPC added that recovery in the rural economy was expected to be robust while domestic demand was expected to recover gradually through Q2FY21 to Q1FY22. External demand, on the other hand, would remain anaemic. Overall, it expects the real GDP growth in FY21 to be negative.
While the committee's hands were tied due to its primary mandate of maintaining price stability, the RBI continued to take measures outside the purview of MPC.
The central bank noted that domestic financial conditions had eased significantly since February 20 due to conventional and unconventional measures taken by it. Borrowing costs were at their lowest in a decade, interest rates short-term instruments were trading below policy rate and illiquidity premia was dissipating due to Operation Twist and TLTRO 1.0.
Moreover, financing conditions for NBFCs had stabilized and corporate bond spreads compressed sharply. Our proprietary Financial Conditions Index (FCI) corroborates this. FCI in February 2020 was 4.45 but jumped to 9.5 in March and further to 11.2 in April as the central bank unleashed various instruments. Though FCI declined to 10.2 in July, it remains significantly above pre-COVID levels, indicating significantly easier financial conditions.
Provide additional liquidity
The RBI continued to take measures to ease financial conditions. It provided additional lending facilities of Rs 10,000 crore (Rs 5,000 crore each for NHB and NABARD) to protect the housing sector from liquidity disruptions and improve liquidity access to smaller NBFCs and MFIs.
Focus on financial stability
In the July 2020 Financial Stability Report, the RBI said that banks' GNPA (gross non-performing assets) ratio may increase to 12.5 percent by March 2021 under baseline scenario and 14.7 percent under very severe stress. Given this grim outlook, maintaining financial stability is becoming increasingly important.
In the weeks leading to the monetary policy review, prominent voices from the banking sector requested the RBI not to extend the moratorium and instead allow one-time restructuring. In what could be termed as the most important announcement in this policy review, the RBI did just that.
The central bank also leveraged lessons learnt from past restructuring experience and incorporated necessary safeguards in the restructuring process such as limiting eligibility to standard accounts, requiring 10 percent provision coverage on restructured accounts, etc. It also announced setting up of an expert committee under KV Kamath to guide the central bank on the parameters for restructuring.
In the coming months, though restructured loans are likely to primarily flow from the moratorium customer base, borrowers who had not sought moratorium earlier can also avail recast. Hence, the stressed pool from this batch can eventually flow into NPAs in Q2-Q3FY21, impacting banks' earnings.
Capital conservation by banks
The expected hit to banks' earnings brings us to the next provision— capital conservation. Currently, banks have to allocate lower capital for debt instruments held directly compared to debt instruments held through MFs/ETFs.
The RBI announced that it will harmonise this differential treatment that is likely to result in substantial capital savings for banks. This comes on the back of incremental provisions made by the RBI since the onset of COVID-19: in March 20, it deferred the last tranche of capital conservation buffer by six months while in April, it prohibited banks from distributing dividends. These measures are aimed at conserving banking capital, so that banks can support economic activity going forward.
Among other measures, it decided to have safeguards for the opening of current accounts and CC/OD for customers availing credit from multiple banks, increased LTV ratio for gold loans to 90 percent from 75 percent and included start-ups in priority sector lending.
While the battle with COVID-19 on the health and economic front is long from over, the central bank is targeting its ammunition efficiently and judiciously to minimise the damage. Since inflation is expected to remain high in the near future, we believe room for more rate cuts is likely to open up only in the December 20 policy review.
(The author is an economist at ICICI Securities.)
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