Step By Step, RBI Moves Closer To Exit From Covid Policies

As the financial year turned, the Reserve Bank of India let lapse a few special provisions introduced to support the economy and the banking system through the Covid-19 crisis. In doing so, India’s central bank and banking regulator moved closer to an eventual exit from crisis-time policies, even though the toughest parts of that process lie ahead.

Most of the special dispensations that have been allowed to lapse are related to the banking sector, which seems to have come out of the Covid crisis bruised but not battered. With bad loans rising but not spiking and limited demand for one-time restructuring, regulatory forbearance for debt recast has closed.

The one-time restructuring scheme for small businesses, which was open until March 31, ended with no indication of an extension from the RBI. As BloombergQuint’s Vishwanath Nair had reported, the scheme saw limited interest. India’s largest lender State Bank of India, for instance, saw less than 2% of its Rs 2.93 lakh crore MSME loan book go for restructuring, CS Setty, managing director at the bank had said.

Remember that in the case of MSMEs, restructuring without an asset classification downgrade, was first introduced in January 2019. It was later extended after the Covid-19 crisis hit. From here on, unless the RBI announces a new set of rules, restructuring of small business loans will mean a downgrade to ‘non-performing’. To be sure, some support to small businesses continues in the form of the government’s Emergency Credit Line Guarantee Scheme.

The closure of the MSME restructuring window followed the shuttering of a similar provision for large corporates in December. That, too, had seen limited interest.

In both cases, the fact that companies and banks didn’t rush to restructure suggests a welcome change in credit discipline brought about a grueling half-decade long banking clean-up. With memories and balance sheet wounds from the last round of regulatory forbearance still fresh, the RBI must be credited for a quick exit this time around to avoid a repeat of the post financial crisis experience.

As research has shown, regulatory forbearance led to outcomes beyond just lending to zombie firms. A study by Anusha Chari, Lakshita Jain, and Nirupama Kulkarni of University of North Carolina into the restructuring permitted following the global financial crisis found that many unviable so-called zombie firms saw a restructuring of their loans. In addition, weakly-capitalised state owned banks had a perverse incentive to restructure bad loans, which, in turn, helped keep bank capitalisation costs low, the research showed.

Alongside the closure of the Covid restructuring window, other provisions have been permitted to lapse.

For instance, the RBI had allowed banks to convert accumulated interest on working capital facilities during the moratorium period to be converted into a funded term loan. This shall be repayable not later than March 31, 2021, the regulator had said. Working capital limits had also been increased with banks being allowed to recalculate ‘drawing needs’ based on the prevailing economic conditions. This provision too was applicable till the end of FY21.

The RBI has not extended either of these provisions.

One special dispensation given to the banking sector, in the form of higher limits within the large exposure framework, continues until June 30. Excluding that, a number of the Covid relief measures provided to the banking sector have been unwound.

So far, the central has taken tiny tentative steps in normalising monetary policy operations. Each was followed by a bond market tantrum.

The first such announcement was the reinstatement of variable rate reverse repo operations, which was aimed at putting a floor under ultra-low short-term rates in the money market. The result was higher borrowing costs for those looking for shorter-term funds but that was part of the plan given concerns over mispricing of credit due to easy liquidity conditions.

Then came the normalisation of the cash reserve ratio and the reversal of the 100 basis point cut announced last year. The normalisation has been communicated to the market and will be concluded in two steps by the end of May. In restoring the CRR to 4%, the RBI has also stuck to a line-in-the-sand for this reserve which has always doubled up as a safety valve and a liquidity tool.

The next step, according to economists, should be an increase in the reverse repo rate. This would help restore the interest rate corridor — the difference between the repo and the reverse repo rate — to normal levels. Any move in this direction, however, will be seen by the markets as a de facto rate hike. While technically, the RBI now has a single operative policy rate — the repo rate, markets still see the reverse repo rate as the operative rate when liquidity conditions are in surplus. The repo rate is the rate at which the central bank provides overnight funds to banks, while the reverse repo rate is that at which liquidity is absorbed.

Beyond the normalisation of the interest rate corridor, lies the wide open question of how long liquidity and monetary policy will remain accommodative.

Rahul Bajoria, chief India economist at Barclays believes normalisation will be a very gradual process. “Communicating an eventual exit from extraordinary accommodation will be a challenging exercise, with multiple stages. CRR normalisation has already begun, and it will be followed up with removal of enhanced forward guidance, increase in reverse repo rates to a ‘normal’ policy rate corridor of +/-25 basis points, followed by an eventual rate hike in Q2 2022 at the earliest, in our view,” he wrote in a note dated March 30.

Pranjul Bhandari, chief India economist at HSBC, expects the central bank may start raising the reverse repo rate gradually in the second half of FY22, but keep the repo rate unchanged at 4% over the foreseeable future. Bhandari, however, points to the myriad challenges the central bank will face in its path towards normalisation.

“How does [RBI] withdraw excess domestic liquidity so it does not become inflationary, and yet do it without spooking the markets and hurting the recovery, at a time when the pandemic is hard to predict, and a lot of the easing/tightening pressures are being dictated by developed market central banks,” Bhandari asked in a note dated March 30.

All good questions with no easy answers. The path to normalisation is paved with pitfalls.

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.