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Photo: Mint

Opinion | A robust policy response for uncertain times

The RBI’s policy reductions have gone hand-in-hand with liquidity injection

Following up on its previous off-policy meeting, the Reserve Bank of India (RBI) called another unscheduled monetary policy committee (MPC) meeting and announced a 40 basis points reduction in repo and reverse repo rate to 4% and 3.35%, respectively. The reverse repo is only 10 bps higher than the previous low of 3.25% seen in 2009. With this, the MPC has reduced rates by 115 bps since March and 250 bps since last year. The RBI does get the unique distinction of leading the Asian monetary easing cycle since last year and, now, with its policy response to the covid-19 pandemic.

The reduction in rates is in response to economic data since the last policy. Economic indicators point to a deep contraction in domestic and external demand. Industrial output contracted by 16.7% in March. It will see a sharper reduction in April, when the entire country was under a lockdown. Both exports and imports contracted by 60.3% and 58.6% in April, compared with a decline of 34.6% and 28.7% in March. Electricity demand, too, was far lower dropping by 29% and 18%? in April and May, respectively.

With such a massive supply and demand side shock, gross domestic product (GDP) growth is expected to be negative in FY21. Our estimate is (-)4.7%. Thus, lower interest rates are particularly helpful as economic activity revives. It will give legroom to borrowers in the form of lower interest payments, particularly for fresh retail and micro, small and medium enterprise (MSME) loans, which are linked to external benchmarks. Even for earlier loans, consumers can move to the external benchmark regime.

The reduction in policy rates was done despite food inflation increasing from 8.8% in March to 10.5% in April. This is attributable to supply shortages emanating from restriction on movement of traffic in April. As restrictions ease, we expect inflation to come down. While food inflation will ease due to supply availability, core inflation will see a sharp fall due to lower consumption demand emanating from a sharp dip in consumer confidence. Thus, growth and forward-looking projections on inflation guided the current decision.

The RBI also announced a number of measures to ease the financial stress of borrowers. First, the moratorium on term loans and deferment of interest on working capital loans were extended by another three months. The interest on working capital loans can be converted into a term loan and repaid by March 2021. Most sources of funding for corporate sector, apart from banks, have dried up. To ensure bank financing available for corporate borrowers, large exposure norms were increased from 25% to 30%. Additional liquidity has also been made available to states to meet their redemption requirements in FY21.

The RBI also announced measures to extend working capital cycle of all borrowers to March 2021 and increase in the timeline of pre- and post-shipment credit for exporters. The EXIM bank has been given an additional line of credit of 150 billion and the existing facility to SIDBI has been extended by three months.

The central bank’s policy reductions have gone hand-in-hand with liquidity injection. In the current year itself, its has done OMOs of 1.2 trillion, targeted long-term repurchase operations of 87,900 crore and extended refinance to financial institutions of 22,300 crore. Despite FII outflows, RBI continues to add to its forex kitty through forex intervention, which has been pushing domestic liquidity higher. Since February, RBI’s aggregate liquidity operations total 9.42 trillion, or 4.6% of GDP.

Banks have been depositing most of the excess liquidity with the RBI and earning reverse repo rate, which has been far less remunerative than lending. This has to do with lack of demand and elevated risk levels. To ensure credit markets are functioning, the finance minister announced a 100% sovereign guarantee for fresh credit of 3 trillion (20% of outstanding) to MSMEs so that they can start their operations. A similar facility is being made available to NBFCs, though the quantum is lower. This will ensure flow of credit to stressed sectors and enable them to tide over the current cash-flow mismatch. More such measures may have to follow to ensure smooth flow of credit. For instance, low-income housing loan borrowers and microfinance customers also qualify for such an intervention.

As the economy opens up from the lockdown, the need for a calibrated exit and demand stimulus will be felt. Given the growth inflation dynamics, there is not much room for monetary policy easing. Another 25 bps reduction in policy rate will just about keep real rates positive in the year. Extraordinary times call for using that space as well. RBI may also look at restructuring accounts where demand may take a while to return to pre-covid-19 levels. Uncertain times call for unconventional policy. It seems RBI will tick the right boxes.

Sameer Narang is chief economist at Bank of Baroda

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