RBI MPC: No rate cuts but several steps to keep a lid on risk-free rates and incentivising bank lending

October 10, 2020 6:33 AM

While RBI did not cut rates, it took several steps aimed at keeping a lid on risk-free rates and incentivising bank lending

RBI enhanced its dovish stance by providing an extended timeframe to its accommodative stance.

Pranjul Bhandari & Aayushi Chaudhary

We think RBI was as accommodative as it can possibly be without cutting rates. While the repo rate was kept unchanged, as expected, at 4%, the commentary was more dovish than before, accompanied by a slew of market and regulatory steps. We believe RBI had three objectives in mind—(1) putting the growth objective right on the top, (2) keeping a lid on risk-free rates, and (3) incentivising banks to go out and lend more. We discuss each of these below.

Elevated inflation had taken up most of the mind space in the last policy meeting. MPC was upfront in saying that as supply chains are restored, inflation will likely come down towards target over Q3 and Q4. The statement spoke about “look(ing) through the current inflation hump as transient and address(ing) the more urgent need to revive growth and mitigate the impact of COVID-19”. RBI expects a 9.5% contraction in FY21, with downside risks. We interpret the latter to mean that the contraction can be in double-digits. Our own forecast is for an 11% y-o-y contraction for the year. Having said that, RBI did acknowledge that a slew of data has been improving recently, and GDP growth could turn positive in Q4FY21.

RBI enhanced its dovish stance by providing an extended timeframe to its accommodative stance. It said that the MPC has “decided to continue with the accommodative stance as long as necessary—at least during the current financial year and into the next financial year”. RBI announced a slew of measures to help the central and state governments borrow from the market. Steps include:

1 Conducting outright and special OMO operations with the size of each auction at Rs 200 bn (double the size announced earlier). However, RBI did not announce a full OMO calendar for the rest of the year.
2 For the first time, conducting OMOs in SDLs (state government bonds), as a special case for the current financial year.
3 Extending enhanced HTM limit of 22% up to March 2022, in order to incentivise banks to invest in government bonds.

These are amongst the steps the market had hoped for given that public sector borrowing is likely to cross 16% of GDP in FY21. Furthermore, RBI announced measures to incentivise banks to go out and lend to the private sector:

1 On-tap LTROs with tenor of up to three years for up to Rs 1 tn at the floating policy repo rate. Liquidity availed can be deployed not just in corporate bonds, CPs, and non-convertible debentures, but also in extending bank loans to specific sectors.
2 Increasing aggregate retail exposure of banks to one counterparty from Rs 50 mn to Rs 75 mn. The objective is to raise the flow of credit to small businesses.
3 Linking risk weights of individual new housing loans to the LTV ratio alone, rather than linking to both LTV ratio and the size of loan. The objective is to provide a fillip to the real estate sector.
4 Extending the co-origination of priority sector loans framework to all NBFCs (including HFCs), versus select NBFCs previously.

As headline inflation falls towards target by December, RBI could cut the policy repo rate by 25bps in February 2021, taking it to 3.75%. However, there are a few risks that need monitoring along the way, in  our view:

Some upside risks to inflation could be long lasting, particularly those arising from India’s large informal sector. The prolonged pandemic is likely to have disrupted many smaller companies that produce and sell essential items for which demand is typically steady.

True, such businesses have a high rate of opening and closing, but the pandemic-led prolonged lockdowns and labour and financial constraints could elongate the time before they reappear, putting upward pressure on prices in the interim. High inflation expectations could become entrenched over this period. It is, thus, important to ensure that RBI’s hard-won inflation-fighting credibility is not lost.

We believe the biggest challenge will perhaps come later, when the pandemic fears recede, activity picks back up, and central banks begin to withdraw liquidity globally. RBI will have to move quickly then, withdrawing excess domestic liquidity so it does not become inflationary.

(Edited excerpts from HSBC Global Research’s India’s RBI policy meeting (dated October 9)

(Bhandari is chief India economist and Chaudhary is economist, HSBC Global Research. Views are personal)

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