The economy is rebounding faster than earlier expected, and year-on-year comparisons, only partly helped by the economic weakness seen in the second half of last year, are turning positive for several (though not all) indicators of economic activity. But the economy still needs policy support: Not only are many indicators still far from normal, the economy has lost two years (even the most optimistic of forecasters expect the fiscal year 2020 output level to be crossed only in late fiscal year 2022), and most importantly, the last six months of extreme economic weakness have created their own victims who need help. Small firms have depleted their capital, millions of households have lost assets or have become more indebted, and risk appetite has fallen sharply.
Given this backdrop, the newly-constituted Monetary Policy Committee’s (MPC) challenge was to continue its support for growth without compromising credibility. Prudently, the RBI and the MPC focused on improving rate transmission, as the rates for borrowers have not fallen as much as the RBI’s cuts to the repo rate this year. In fact, the gap between the repo rate and the average lending rate of banks is at a record high.
This gap can be broken up into two parts to understand it better: The first is the gap between the RBI-set repo rate and the rate at which the government of India borrows (the GSec yield). The second is the gap between the GSec yield and the rate at which individuals or private firms borrow. These two are driven by different factors, but both are at extreme levels currently. While the latter reflects risk aversion in the financial system and a lack of capacity, the former, also called the “term premium” can be influenced by the RBI’s actions.
The RBI has been somewhat hesitant so far in directly influencing the term premium, perhaps to maintain its credibility and independence, staying clear of accusations that it is financing the government’s fiscal deficit. However, unless the rate at which the government borrows comes down (this is the “risk free rate”, as the government cannot default, at least not on local currency borrowings), borrowing costs for the whole economy will stay elevated.
Over the past few months, the RBI has also been faced with another equally important but rare challenge — a substantial balance-of-payments (BoP) surplus. This means that India is getting far more dollars than it needs. The country’s foreign currency reserves have been growing at an unprecedented rapid pace. Some of this is driven by short-term factors, as a weak domestic economy kept imports weak, even as large fiscal stimuli in the developed world and a rapid output revival in China led to a faster normalisation of exports. These short-term changes could be ignored, but there have also been structural shifts in India’s economic policy which point to a persistent BoP surplus. In addition to low energy prices, policies supporting Atmanirbhar Bharat (Self-Reliant India) naturally mean lower imports, and the push towards making India a participant in global value chains mean higher exports. At the same time, India’s capital account is being opened up for reasons that have very little to do with attracting dollars: The special-category government of India bonds, for example, can attract nearly 1 per cent of GDP worth of dollars annually.
This provides a window of opportunity. When the RBI buys the excess dollars coming into India to prevent the rupee from appreciating, it sells rupees. When the excess dollar inflows turn into a deluge, as they have over the past six months, the supply of rupees in the domestic economy also becomes excessive. If the RBI can direct this surplus into government bonds, it can maintain its independence and credibility, and at the same time achieve its target of rate transmission.
Several of the announcements made by the RBI are designed to achieve this. First and foremost, the buyers of these bonds need to feel reassured of not getting hurt by the volatility in bond prices. When bond prices rise, the yields fall, and vice versa. Banks parking trillions of rupees with the RBI at 3.35 per cent overnight would earn nearly 6 per cent if they bought government bonds. That they did not was because they were afraid of the bond prices falling, which would offset the gains from higher rates. By extending the increase in the Hold-To-Maturity limits by one year to March 2022, banks, which have most of the surplus liquidity, have been reassured that they need not fear booking interim losses if bond prices are volatile. The announcement that the RBI would purchase state and central government bonds on the market (even if in small sizes) would provide further comfort.
The most important change, though, was the unambiguous messaging on its assessment of inflation, which should help buyers of government bonds take the risk. The Monetary Policy Report states that 80 per cent of the inflation deviation from target is due to a supply shock in food and the elevated taxes on fuel, and that the MPC intends to look through this period of high inflation. Banks or other bond investors that refrained from purchasing government bonds because they felt the RBI would increase interest rates at some point to comply with its legal mandate, would be reassured by this clear communication.
The RBI also announced some measures to boost credit growth: The targeted refinancing operations (TLTRO) should help bring down borrowing rates in the targeted industries. While other measures like the counter-cyclical changes in risk weights for home loans, higher single-borrower limits for small borrowers and expansion of the co-origination model (where banks and non-banking firms jointly lend to borrowers) in our view may only have minor impact, that these tools have been pulled out is a positive development.
Economic challenges may persist for the foreseeable future. The economic scars of the last six months are likely to take time to heal, the financial system still needs a major overhaul, and the only permanent solution to the large BoP surplus is stronger domestic demand, which will take time, and is best achieved through a well-designed fiscal stimulus. The RBI and the MPC, which have been proactive, creative and accommodative so far, may have to stay so for a while longer.
The writer is co-head of APAC Strategy and India Strategist for Credit Suisse
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