In its December policy, the Reserve Bank of India suddenly paused on cutting rates, putting the ball in the government’s court to support growth. With last week’s Union Budget belying expectations of short-term growth boosters, the ball was back in the RBI’s court. The Budget opted for fiscal conservativism over activism, consolidating the fiscal deficit to 3.5 per cent of GDP in 2020-21 from 3.8 per cent in 2019-20 — bypassing any ambitious expenditure boost or significant tax cuts.
Meanwhile, the policy arithmetic turned more complicated for the MPC. At the time of the December policy meeting, CPI inflation was trending close to 5 per cent (the October reading was 4.6 per cent). Since then a combination of supply-side shocks, which led for example to unseasonally high vegetable and protein prices, buoyed inflation to over 7 per cent, nearly 140 basis points above the RBI’s upper bound comfort zone of 6 per cent.
As a primarily inflation-targeting central bank, this effectively stopped the MPC from easing further. To complicate matters, on the growth side, high-frequency indicators such as the manufacturing and services purchasing managers indices, auto sales, aviation passenger traffic, and output growth of some industrial inputs, have shown signs of a nascent recovery. These raised concerns in the market that the RBI may choose to interpret these as adequate green shoots and conclude that its work on growth is done.
The February policy meeting removed two key uncertainties in the current policy scenario. First, the RBI is still very concerned about growth and the burgeoning negative gap between the current growth trajectory and potential growth. Despite official forecasts pencilling in a recovery in growth to over 5 per cent by Q1 2020, the RBI warned that “the few indicators that have moved up recently are yet to gain traction in a more broad-based manner”.
The RBI sees space for more policy easing with governor Shaktikanta Das candidly admitting in the policy press conference that the next move is likely to be a cut, with timing being the key uncertainty. Second, monetary policy is no longer strictly limited to the MPC’s decision-making. Because of the risk of supply-side shocks hitting inflation, it is understandable that the RBI has summarised its outlook on inflation as “highly uncertain”. Hence, of the policy measures that the RBI has at its disposal, the MPC’s “conventional” arrow of rate cuts was left unused. Instead, the RBI has opted for macroprudential intervention, unveiling two other “unconventional” policy arrows.
The first arrow is aimed at policy transmission. The primary macro challenge has been transmission via the credit channel — banks are not lowering their deposit rates (due to competition from the small savings rate and to protect savers), and in turn are keeping lending rates high. Sectors considered higher risk (real estate, MSMEs) find themselves credit-starved. In a move that seems inspired by the European Central Bank’s quantitative easing in 2011, the RBI’s announcement on long term repo operations (LTROs) has been aimed at promising banks longer-duration liquidity at the repo rate, which is cheaper relative to their current deposit rates. The aim is to nudge them to kick-start the credit cycle. The exemption of cash reserve ratio for incremental loans to MSMEs and the retail sector is also aimed at lowering costs for banks, which ideally should be passed onto these sectors.
The second macroprudential arrow is aimed at managing the looming stress in the financial system from bad loans, especially as deleveraging becomes more difficult during an economic slowdown. The extension of the restructuring scheme on MSME loans and projects in the commercial real estate sector is aimed at releasing capital for banks in the short term, though banks will ultimately need to recognise loans that are non-performing. Similarly, easing guidelines on the classification of loans for projects in the commercial real estate sector that have been delayed is essentially designed to provide some breathing space to banks and shadow banks that remain exposed to such stress.
What do all of these mean for the macro outlook? The RBI’s new macroprudential measures, its “unconventional” policy arrows, while well-meaning, are ultimately supply-side measures. For the RBI to attain its goals, be it on asset quality or transmission, there eventually needs to be a recovery in demand conditions. To be fair, even the ECB’s LTRO programme has had mixed success — a central bank can flood the market with liquidity, but the ultimate onus on releasing it to the real economy rests with banks. So far, excess liquidity has not benefitted segments considered high risk (real estate developers, MSMEs). This, combined with asset quality deterioration makes for a pessimistic outlook on growth, in our view.
We see GDP growth moderating to 4.3 per cent in the third quarter of the current financial year (as against 4.5 per cent in Q2) and expect a sub-par recovery next financial year with growth rising to 5.7 per cent as against 4.6 per cent this year — lower than the RBI’s projections. On inflation, we broadly concur with the RBI. We expect CPI inflation to remain uncomfortably high at 6.4 per cent in the fourth quarter of 2019-20, but moderating to 4.7 per cent in Q1 2020-21, and then sliding to 4.6 per cent in the second quarter, and 2.3 per cent in the third. We continue to believe that the next policy move is still a rate cut; we expect a 25 basis points cut in the repo rate in Q1 2020-21, which could be delivered as early as April.
A niggling concern remains. The ECB introduced the LTRO programme when growth was weak and the euro area was struggling with a severe sovereign debt crisis. With the RBI embarking on something similar, albeit on a smaller scale, the niggling concern is if there is more financial instability lurking around the corner but not yet evident in the current data.
This article first appeared in the print edition on February 8, 2020 under the title “RBI’s growth push.” The writer is India economist and vice president Nomura. Views are personal.
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