Extra-dovish RBI makes policy pause palatable

October 10, 2020 5:45 AM

RBI’s latest measures are clearly positive for bond markets and should support commercial bank demand. Expect 50 bps cumulative rate cuts by end of Q1 next year

RBI MPCThe MPC has given unequivocal guidance that it sees the inflation surge as transitory and the growth risks as more durable.

By Sonal Varma & Aurodeep Nandi 

The MPC voted unanimously to leave the policy repo and the reverse repo rate unchanged at 4% and 3.35%, respectively, in line with consensus and our expectations, but it retained it accommodative policy stance. It clearly stated that it expects to look through current inflationary pressures and “continue with the accommodative stance as long as necessary—at least during the current financial year and into the next financial year”, given that “revival of the economy…assumes the highest priority in the conduct of monetary policy”. The guidance also stated that the MPC will “await the easing of inflationary pressures to use the space available for supporting growth further”, thereby leaving the door open to further easing.

RBI released its inflation and GDP growth projections for the first time, and these point to a deep contraction of -9.5% y-o-y with downside risks in FY21 (year ending March 2021) and for inflation to return to close to the 4% target by the end of the fiscal year. Specifically, on growth, RBI expects GDP growth to improve from -23.9% y-o-y in Q1FY21 (April-June) to -9.8% y-o-y in Q2 (July-September), -5.6% in Q3 (October-December), before recovering to 0.5% by Q4 (January-March) and 20.6% by Q1FY22 (April-June), largely due to base effects. For FY22, RBI’s baseline projection is for GDP growth to recover to 10.1%.

Governor Das expects a “three-speed recovery”, with pandemic-resilient sectors recovering faster. They will be followed by recovery in “strike form” sectors, where the activity normalisation is more gradual. However, RBI admits in its Monetary Policy Report published separately that “uncertainty about COVID-19’s spread and trajectory continues to fog the outlook and makes forecasts of real GDP growth extremely challenging.”

Why lower inflation? On inflation, RBI projects CPI inflation to track 6.8% for Q2FY21 (July-September), but ease to 5.4-4.5% for H2FY21 and 4.3% for Q1FY22 (April-June), with risks broadly balanced. For FY22, RBI’s baseline projection has inflation tracking 4.1-4.4%. It maintains that much of the current escalation is due to cost-push factors like labour shortages and high transportation costs. On the other hand, “pricing power of firms remains weak in the face of subdued demand” and robust summer crop sowing should ameliorate inflationary pressures. RBI’s survey shows that households expect inflation to soften over the next three months.RBI stepped up its ‘unconventional’ tool chest by announcing a number of measures to give further confidence to the market on both liquidity and managing the government’s borrowing program. RBI intends to provide liquidity to banks for further deployment in corporate bonds, commercial paper, non-convertible debentures and conventional bank loans. The ‘On Tap TLTRO’ will be worth `1 tn for tenors of up to three years at a floating rate linked to the policy repo rate.

RBI ensured that it will maintain comfortable liquidity and will conduct both outright and special OMOs, also announcing higher OMO auction size (Rs 200 bn). RBI broke new ground and will also conduct OMO in state government bonds (SDL) this financial year, which should lead to spread compression.

In a bid to boost banks’s investment in government bonds, the enhanced HTM limit has been extended by a year to March 31, 2022. Ways and Means Advances (WMA) for the central government—which is a temporary credit facility extended by RBI—has been increased from Rs 350 bn to Rs 1.25 tn in H2FY21. RBI has allowed for banks to increase their retail exposure to a single retail borrower (from Rs 50 mn to Rs 75 mn). Secondly, to encourage banks to extend more home loans, RBI has simplified the risk weighing mechanism for new housing loans. It is also undertaking steps to expand the scope of shadow banks’ partnership with banks to extend credit to priority sectors.

The MPC has given unequivocal guidance that it sees the inflation surge as transitory and the growth risks as more durable. We agree with this view. In our view, its commitment to keep its stance ‘accommodative’ into FY22 is a particularly strong one. Combined with its commitment to provide liquidity and manage bond supply, the policy measures are geared towards ensuring that transmission across markets does not freeze, and that monetary policy remains active.

Over the short term, we believe there is little respite from high inflation. Given the unseasonally high build-up of vegetable prices in September, we expect headline inflation to rise to ~7% y-o-y from 6.7% in August. Early October data for vegetables and pulses point to sustained food price pressures for now. Supply side factors—higher commodity prices, labour market dysfunction, frayed logistics—will are also likely dominate core inflation in the short term. Therefore, we expect inflation to remain above 6% through November.

We agree with the RBI’s assessment that inflationary pressures should retrace over the next 6-12 months. Recent declines in oil and gold prices will feed into lower core inflation in October. Lockdowns have resulted in input shortages (material and labour), but these are reversing with the ongoing easing of restrictions. Domestic final demand remains weak. An exceptionally favourable base effect will start kicking in next year. On the whole, we expect the sequential price build up to moderate, with headline inflation declining to an average of below 5% in H1-2021 and the declining to ~3.5% in H22021. The Nomura India Business Resumption Index also provisionally points to a promising start to October. However, the durability of this sequential improvement after the festive season remains uncertain. Part of the consumption rebound is due to pent up demand. Thus, we are a notch more bearish than RBI in expecting GDP growth to average -10.8% y-o-y in FY21, with growth expected to remain in negative territory over the next three quarters, despite sequential improvements (-10.4% in Q2FY21, -5.4% in Q3, -4.3% in Q4).

We continue to believe the hit to growth amid already-weak balance sheets is likely a more permanent decline in trend growth. As the private corporate sector embarks on this debt deleveraging cycle, the financial sector deals with its bad loans, fiscal policy remains hamstrung, and monetary policy will remain at the forefront of rescuing growth in the case of any hiccups. We to expect a cumulative 50bps of policy rate cuts, distributed across the December and February policy meetings. If food prices remain elevated, there would be a risk that the cuts may be delivered later than in our baseline, but we continue to see the next step as easing.

(Varma is chief economist, India and Asia ex-Japan, and Nandi is India economist, Nomura. Views are personal)

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