The Monetary Policy Committee (MPC) cut the repo rate again, the fifth time since February 2019 by 0.25 percentage points, based on the views of the MPC members on current and projected economic conditions. The MPC action was in line with the series of cuts by almost all major central banks across the globe, as counter-cyclical policy responses to the global slowdown. The MPC voted unanimously on the cut, with one member recommending a deeper cut. The accommodative policy stance was retained, signalling a strong resolve to support the revival of growth, evocative of the ECB President Mario Draghi’s memorable 2012 commitment to do “whatever it takes to preserve the euro”.
The reason for this strong signal showed up in the steep reduction in RBI’s FY20 GDP growth projection, from to 6.9 per cent in August down to 6.1 per cent. High frequency indicators of economic activity remain weak, with a flat core infrastructure index growth, continuing weak automobile sales and a sharply lower services sector purchasing managers index (PMI) showing a deep contraction in September. Rural demand, proxied by sales of two-wheelers and tractors, contracted. Of greater concern is the fact that RBI’s forward looking surveys show an expected drop in capacity utilisation of manufacturing firms in Q2 FY20. The Business Assessment Index also fell in Q2.
The strong signal on accommodation, however, is qualified with “inflation remain[ing] within the [2- 6 per cent] target”. Despite some risks, this is a probable outcome; RBI largely retained its earlier growth forecast of October-March FY20 inflation at 3.5- 3.7 per cent, taking the full FY20 average to approximately 3.5 per cent. This is significantly lower than the 4 per cent mid-point and provides adequate buffers for even unexpected food, oil and other price shocks.
With this kind of growth-inflation tradeoff, why might the MPC have limited the repo rate cut to 0.25 percentage points rather than easing it further? The first, of course, would have been a degree of uncertainty on both the effects of the fiscal stimulus measures already announced — particularly the bold and decisive corporate tax rate cuts, and in various stages of implementation — as well as the additional measures which might be needed. While the budget targets are likely to be met in the base case, there are likely to be compositional changes in expenditures and borrowings, the effects of which need to be better understood. Global financial market volatility, trade-related uncertainty, geo-political disruptions to global supply chains would only add to domestic policy responses. And India’s policy rate cuts, now at a cumulative 1.35 percentage points, are one of the deepest of the major central banks.
Second, current household inflation expectations over a three-month and one-year ahead horizons have risen 0.40 and 0.20 percentage points, likely reflecting an adaptive response to the recent hardening of prices of some vegetables. For central banks, inflation expectations are a key input into monetary policy formulation, since hardening expectations usually translate into wage negotiations, which change inflation dynamics. However, such a risk in India’s current economic conditions is quite low.
The third potential reason might be the path of lending rates over the next couple of months, with the switch of interest rates on new retail and MSME loans from the erstwhile MCLR system to one that is repo-rate linked. This brings us to the immediate concern, a drop in bank credit growth, and more broadly, a sharp contraction in the flow of funds from all financial intermediaries — one of the key reasons for the expected continuing weak growth in FY20. Bank credit growth slowed from an average of 14.2 per cent yoy during Q4 FY19 to 10.3 per cent by mid-September 2019, reflecting “weak demand and risk aversion”. Total funding from domestic and foreign sources has shrunk precipitously to Rs 91,000 crore during April-mid-September 2019 from Rs 7.36 lakh crore in the same period last year. Commercial paper issuance (short-term working capital type borrowings) shrunk to Rs 19,000 crore (from Rs 2.53 lakh crore in the same quarter the year before). Credit from NBFCs dropped during April-June, contracting by Rs 1.25 lakh crore, down from a net disbursal of Rs 41,000 crore in the same quarter of 2018. The only channel of stronger funds flows was via foreign currency borrowings, but this was small relative to the overall shrinkage of credit.
What should be next in the policy response? The government, RBI and other agencies have already announced a coordinated set of counter-cyclical stimulus measures to revive consumption, investment and growth. The government is expediting the implementation of the multiple measures it has announced. Moral suasion will probably induce some project capex, particularly by public sector enterprises. Upfront recapitalisation payments to public sector banks might gradually fill loan pipelines, hopefully to MSMEs, which will be critical for the recovery.
The efficacy of these measures over the near to medium term will be determined by the nature of the slowdown. RBI analytics suggest that the slowdown is largely cyclical, and in macroeconomic terms, this is probably correct. However, many sectors have large structural components contributing to slowing growth, including changing consumer preferences, wage growth and income uncertainty. In the near term, lending institutions have become relatively risk averse, and a degree of appropriate risk re-allocation will need to be initiated by the government and regulators. Various credit enhancement and guarantee funds, which are being institutionalised, will help in mitigating some of this.
In the meantime, a combination of relatively easy systemic liquidity and a shift of some loan products to market benchmarks will begin to lower borrowing costs. To support credit flows to sectors which are particularly constrained for funds, the RBI has relaxed some micro-prudential restrictions to cautiously incentivise credit and fund flows to solvent but liquidity constrained financial intermediaries and sectors.
The economic revival process is likely to be gradual and weak at first. In fact, although volume indicators still show weak activity, GDP growth is likely to be 5.5 – 5.7 per cent in Q2 FY20 (July-September) range — better than the Q1 growth. This is likely to be driven largely by an improved manufacturing GDP, (0.6 per cent in Q1), reinforced by higher government spending. Strong policy communication will be an important instrument in reinforcing investor and consumer confidence.
Going back to the ECB President’s 2012 commitment, “And believe me, it will be enough”.
This article first appeared in the print edition on October 5, 2019 under the title ‘Whatever it takes’. The writer is vice president, business and economic research, Axis Bank. Views are personal.
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