With economic revival likely to take a hit due to the latest Covid surge, RBI will continue to keep policy accommodative
The liquidity surplus in the banking system ranged between Rs 2.13-6.72 lakh crore in FY21.
Two months is not a long time, but no one could have predicted April would see India in such trouble. The ferocious second wave of Covid-19 infections threatens to slow a promising recovery, and inflation remains stubbornly elevated even though growth is losing momentum. Amid this uncertainty Reserve Bank of India (RBI) Governor Shaktikanta Das has the unenviable task of keeping liquidity just sufficient to rein in yields, prevent the currency from appreciating and inflation from going up. Very challenging at a time when the developed markets are unleashing large fiscal stimuli, US treasury yields are rising and commodity prices are running away. And when the government wants to borrow a mammoth Rs 12.05 lakh crore over the next 12 months.
Headline consumer inflation for February eased to 5%, but core inflation was a shocking 6% y-o-y, up from 5.5% in January. Now, some economists say there is a chance it could remain sticky at 5.5%- 6% as producers pass on the cost of rising raw materials to consumers. Input prices, they point out, are at multi-year highs while output prices have not risen proportionately, but could do so as firms gain the confidence to assert pricing power.
Fortunately, some helpful base effects are expected to hold down food prices. Mercifully, therefore, retail inflation is not estimated to cross 5.5% just yet, and will respect the central bank’s projections of 5-5.2% for the April-September period. Beyond that, one is not so sure. Even RBI had cautioned us in February that there was a chance of a broad-based escalation in cost-push pressures in services and manufacturing prices, following from increases in industrial raw material prices.
For the moment, it is not looking so bad, especially because the revival in the demand for services is likely to be pushed back due to the fresh round lockdowns. So, it is more or less a given that RBI will hold the repo rate where it is at 4% on April 7. Yields may move up at the shorter end of the curve, closer to the 4% repo rate, so that real rates do not remain too negative for too long. However, RBI would be careful not to drive up yields at the longer end so that government can borrow at affordable rates. Despite inflationary pressures building up in the region, it appears there will be no repo rate hikes before October—by which time the government would have mopped up 60% of the target. However, the reverse repo may be moved up in October. To be sure, it is a bit of a tug-of-war with the bond markets, but, so far, yields have been held within 6.2%.
With liquidity assuming tremendous importance over the past year or so, the bond markets would look for some guidance on this score. In February, Governor Das had reassured the markets saying the accommodative stance would continue for as long as necessary—at least during the current financial year and into the next financial year. The objective, Das said, was to “revive growth on a durable basis and mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target going forward”. The commentary later this week is likely to sound similar with Governor Das re-asserting there will be ample liquidity for as long as it is needed.
The liquidity surplus in the banking system ranged between Rs 2.13-6.72 lakh crore in FY21. With loan growth likely to stay anaemic and hit multi-year lows, and deposits growing at a brisk pace, liquidity should remain in a surplus even as foreign inflows continue to be reasonably strong. It will take all of RBI’s skills to soak up some of this while reining in yields, keeping the rupee from gaining value and subduing inflationary pressures. One can expect it to work with more Operation Twists and term reverse repos to play both in the bond and currency markets even as the CRR retraces its way to 4%. Also, the sizeable $580 billion of forex reserves gives RBI the option to buy fewer dollars, in the event of smaller BoP surplus, leaving it room to buy bonds.
With the second wave of infections threatening to hit the economy, it is unlikely Das would dwell on the timing of the exit from the accommodative stance. Growth is clearly losing momentum; factory output has increased at just about 0.6% y-o-y in the past five months and the manufacturing PMI fell to 55.4 in March, from 57.5 in February. The fresh round of mobility restrictions across several key states could make it worse for the services space, which is already lagging the manufacturing sector. Manufacturing too isn’t exactly on a roll. Wholesale despatches of two-wheelers in March, for instance, were smaller than in March 2019 while despatches of commercial vehicles were significantly smaller. With consumer confidence still low and private sector investments nowhere in sight, there are bigger priorities than a negative real interest rate. Governor Das must do all it takes to try and make sure business does not lose momentum. The hard work of the past year must not come undone.