The Reserve Bank of India's monetary policy committee (MPC) has lowered its repo rate by an unconventional 35 basis points to 5.4%. This is the fourth reduction in a row of its key policy rate since Shaktikanta Das took over as the governor of the central bank in December last year. The GDP growth forecast for 2019-20 has been revised downwards to 6.9%. Two key measures have been announced to help the struggling non-bank financial companies.
What are the highlights of the Monetary Policy Review?
For the fourth straight time in a row, the Reserve Bank of India (RBI) has cut its benchmark repo rate, this time by a an unconventional figure of 35 basis points. The announcement was made after the third bi-monthly policy review by the Monetary Policy Committee (MPC), led by RBI Governor Shaktikanta Das, for 2019-20. The benchmark rate is now at the lowest since April 2010.
With a 35 basis points (0.35%) cut (the highest this year) the repo rate, at which RBI lends to commercial banks, stood at a 9-year low of 5.4 per cent, since July 2010 when it was 5.25 per cent. The previous three cuts this year were 25 basis points each. Alongside a cut in the repo rate, the central bank also lowered its GDP growth projection from 7 per cent in the June policy announcement to 6.9 per cent now.
All the six members of the MPC unanimously voted to reduce the policy repo rate and to maintain the accommodative stance of monetary policy. Four members — Ravindra H. Dholakia, Michael Debabrata Patra, Bibhu Prasad Kanungo and Shaktikanta Das — voted to reduce the policy repo rate by 35 basis points, while two members — Chetan Ghate and Pami Dua — voted to reduce the policy repo rate by 25 basis points.
The path of retail (CPI) inflation is now projected at 3.1% for the second quarter of FY20 and 3.5-3.7% for second half of FY20, with risks evenly balanced. Consumer price index (CPI) inflation for the first quarter of FY21 is projected at 3.6%. The MPC said that inflation is currently projected to remain within the target over a 12-month ahead horizon. “Since the last policy, domestic economic activity continues to be weak, with the global slowdown and escalating trade tensions posing downside risks. Private consumption, the mainstay of aggregate demand, and investment activity remain sluggish," it said.
The central bank also said that liquidity in the system was in large surplus in June-July 2019 due to return of currency to the banking system; drawdown of excess cash reserve ratio (CRR) balances by banks; open market operation (OMO) purchase auctions; and RBI’s foreign exchange market operations.
Why is the rate cut not surprising?
While inflation is a key consideration for a rate cut and the currently prevailing low level provided RBI the comfort to go for a cut, the decision was also taken to boost aggregate demand especially private investment.
As of last count, retail inflation was still below 4%, a medium-term aspiration for decades that turned into a formal target in 2016. With that out of the way, the focus point of policymakers obviously is the floundering economic growth.
The RBI statement said that domestic economic activity continues to be weak, with the global slowdown and escalating trade tensions posing downside risks. The MPC added that even as past rate cuts are being gradually transmitted to the real economy, the benign inflation outlook provides headroom for policy action to close the negative output gap. Addressing growth concerns by boosting aggregate demand, especially private investment, assumes the highest priority at this juncture while remaining consistent with the inflation mandate, it said.
But why 35 basis points? Governor Shaktikanta Das termed the steeper 0.35 percentage point reduction in the repo rate as a "balanced" call, given the domestic and global developments. He explained that a 0.25 percentage point reduction, as it had done thrice this year since February, would have been "inadequate", while a 0.50 percentage points cut would have been "excessive".
Das said the RBI has been pre-emptive in its actions on rates and the policy stance through the year, and has always provided adequate liquidity to the system. Addressing the media at the customary post-policy presser, Das said there was nothing sacred about multiples of 0.25 percentage point cuts, and also made it clear that the decision has not been taken on "gut feel" but on hard data.
"Too much should not be read into it, it is a judgment call which the MPC has taken," he said, adding, it was "prudent" to be accommodative. The RBI will ensure that there is sufficient liquidity available for the economy.
When does the liquidity logic seem flawed?
Before this cut, its monetary policy committee had voted for a cumulative 75 basis point cut in just six months’ time. The RBI has also flushed the banking system with enough liquidity. But the money isn’t flowing freely or even pushing banks to lend. That is because money doesn’t move unless it has trust with it.
That is why a liquidity surplus of over ₹2 trillion (lakh crore) and rate cuts haven’t brought down bank lending rates. The weighted average lending rate on outstanding loans increased between January and May, while that of fresh loans fell by just 11 basis points (0.11%). Add the crisis surrounding non-bank lenders (NBFCs), the impact on growth cannot be ignored.
The lack of transmission has two parts to it. The trust part is where the central bank can do little beyond what it has done already. Of course, it has to detail the liquidity framework that RBI promised at its previous meeting. “Markets would also wait for signalling from the central bank on whether it intends to keep liquidity in surplus for an extended period of time. This could also infuse confidence and in turn assist in better transmission of monetary policy," analysts at ICICI Bank Ltd said in a note.
What RBI can do is create conditions where trust can be cultivated. But there is only so much it can do. The rest is up to the government, which should be more honest about fiscal deficit in the first place. Cumulative public sector borrowing is crowding out private sector borrowers, which is the second part of the transmission problem. Basically, the government is borrowing so much the private sector getting enough.
The rise of off-balance sheet (which is not shown in the budget) borrowing even as the headline fiscal deficit remains at 3.3% of gross domestic product is skewing the pitch for transmission. This is coinciding with a steady decline in household savings, the backbone of funding in the country. With most of the savings cornered by the government, there is little left for private sector companies.
As banker to the exchequer, the RBI needs to sensitize the government on the effect off-balance sheet borrowing has had on private sector borrowers. As of now, the biggest beneficiary of the rate cuts is the biggest borrower of India – the government.
Where will the new announcements help NBFCs?
The central bank announced two key measures to help non-bank financial companies, a sector that is facing a liquidity squeeze.
The first is harmonisation of single counterparty exposure limit for banks’ exposure to single NBFCs with the general single counterparty exposure limit. Under the revised guidelines on large exposure framework (LEF) that came into effect from April 1, 2019, a bank’s exposure to a single NBFC is restricted to 15% of its Tier I capital, while for entities in the other sectors the exposure limit is 20% of Tier I capital of the bank, which can be extended to 25% by banks’ boards under exceptional circumstances. The central bank has decided to raise a bank’s exposure limit to a single NBFC to 20% of Tier-I capital of the bank.
The second initiative deals with credit to the priority sector. The RBI has decided to allow, subject to certain conditions, bank lending to registered NBFCs (other than MFIs) for on-lending to agriculture (investment credit) up to ₹10 lakh; micro and small enterprises up to ₹20 lakh and housing up to ₹20 lakh per borrower (up from ₹10 lakh at present) to be classified as priority sector lending. Detailed guidelines on the above measures will be issued by the end of August 2019. Priority Sector Lending Certificates (PSLCs) are a mechanism to enable banks to achieve the priority sector lending target and sub-targets by purchase of these instruments in the event of shortfall.
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| Shishir Baijal, Chairman & Managing Director, Knight Frank India |
Welcoming the RBI’s measures Shishir Baijal, Chairman & Managing Director, Knight Frank India said, “The NBFC liquidity crisis has severely choked credit availability for the industry, especially developers, as they struggle to raise even construction finance. While the limit for priority sector lending for housing has been enhanced from Rs 10 lakh to Rs 20 lakh, the scope of this move is limited to the affordable housing segment.”He, however, added that more needs to be done to provide a liquidity stimulus to the broader real estate spectrum. “As the threat of a slowdown looms large on the Indian economy, strong measures such as substantial rate cuts and meaningful sector-specific policies need to be taken,” he said.
The government is doing its part too
Last week, the Finance Ministry had said it would put in place an oversight mechanism for the one-time partial credit guarantee scheme for Public Sector Banks (PSBs) to purchase high-rated pooled assets of financially sound NBFCs as announced in the Budget 2019-20.
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| Finance Minister Nirmala Sitharaman |
Presenting her maiden Union Budget in July, Finance Minister Nirmala Sitharaman had announced that the government would provide a one-time partial credit guarantee of six months to PSBs for the first loss of up to 10 per cent to enable them to purchase pooled assets of financially sound NBFCs amounting to ₹1 lakh crore.
This was aimed at ensuring financial support to the stressed housing finance companies (HFCs) and NBFCs which were facing a severe liquidity crunch following the series of payment defaults by IL&FS. This caused the drying up of bank funds to the NBFCs and HFCs from lenders fearing further addition to their massive non-performing assets (NPAs or bad loans), creating, thereby, a spiral effect on the economy.
Note: Priority Sector Lending is an important role given by the (RBI) to the banks for providing a specified portion of the bank lending to few specific sectors like agriculture and allied activities, micro and small enterprises, poor people for housing, students for education and other low income groups and weaker sections. A target of 40 percent of Adjusted Net Bank Credit (ANBC) or Credit Equivalent amount of Off-Balance Sheet Exposures (OBE), whichever is higher, as of preceding March 31st, has been mandated for lending to the priority sector by domestic scheduled commercial banks and foreign banks with 20 branches and above.
Who said what about the announcements?
Devendra Pant, Chief Economist, India Ratings: “The rate cut can’t be called unconventional. The slightly higher-than-expected rate cut shows that there is a need for rate cuts, but the decision gives the impression that expectations of a 50 bp cut maybe too high.” “Ultimately, it will depend on how the transmission takes place. The policy even talks about the combined impact of 75 bp before this; it says overall banks reduced their weighted average lending rate by 29 bp on fresh rupee during the current easing phase so far.” “Banks are cutting on deposit rates and from whatever they are borrowing from the markets too. There will be some impact on cost of borrowing. The impact of this 35 bp cut maybe felt with a lag, it will take sometime to see its impact.”
Sakshi Gupta, Economist, HDFC Bank: “The cut of 35 bp is a deviation from the convention of changing rates in multiples of 25 bp. The central bank recognises the risks to growth and consequently lowered their growth forecast.” “Their projections for H2 still seem a bit optimistic. We expect the GDP growth at 6.7%-6.8% for FY20. Given that growth could continue to slow and inflation readings remain contained, there is room for more rate cuts this year.” “It was disappointing to see little clarity on whether the current liquidity situation will continue under the new liquidity management framework. The recent improvement in the liquidity situation is likely to improve transmission in the coming months.”
Aditi Nayar, Principal Economist, ICRA: “The unconventional 35 bp rate cut is a clear signal that increasing evidence of a pervasive slowdown in economic growth has emerged as the MPC’s chief concern, given that it expects inflation to remain under its medium-term target.” “While the stance was maintained as accommodative and the tone of the outlook was dovish, we expect that incremental data will crucially guide the MPC’s decisions on additional rate cuts. The focus will now shift to improving transmission to bank lending rates...”
Shubhada Rao, Chief Economist, YES Bank: “Welcome the 35 bp rate cut. Growth is likely to be revised down further from 6.9%. Given the well-anchored inflation, we believe that the RBI is set to cut rates in the next policy review in October. It could be 15/20 bps also. It is clear that reviving growth has received most attention.”
Sujan Hajra, Chief Economist, Anand Rathi Securities: “The 35 bp rate cut is higher than the consensus and our expectation of a 25 bp rate cut. This clearly shows the RBI’s concern about growth performance and outlook, and the urgency to take measures to revive growth.” “The real issues, however, are improving monetary policy transmission and reviving the NBFC sector; the policy does not provide any new measures or even perspectives on these areas.” “With 110 bps cumulative rate cuts, banks would be under moral pressure to cut lending rates, which can depress Net Interest Margins (NIM). This is negative for the sector and positive for interest-sensitive sectors.”
How is the economy expected to fare this year?
The RBI has again revised its growth forecast downward, but we didn’t really need to wait for the review to let us know the economy is not looking good.
The economic data coming out now are stark. There is negative growth in the core industrial sector as passenger vehicle sales, tractor sales, two-wheeler sales and domestic air traffic growth have all been declining for around six months. Other consumer durables, like white goods, also show a hit in sales. Sales of fast-moving consumer goods, normally the last to react, are slowing down.
Capacity utilisation in all manufacturing segments is apparently below 70% on average, even as inventories pile up, rail freight traffic is now below the past five years’ average and the real estate sector is stuck with over seven years’ stock of unsold buildings. All this comes even as the credibility of India’s official GDP data is being questioned, as it does not appear to capture the material realities faced by millions of producers, employers and workers.
Interestingly, low inflation rates, the only bright spot on the horizon, seem to be yet another symptom of the slowdown. Core inflation (retail inflation minus prices of fuel and food products) is at its lowest in two years, reflecting weak demand for both consumption and investment goods.
The obvious immediate task for the government is to revive demand, which at the moment is only possible through an injection of public spending, ideally in necessary infrastructure and in social sectors that have high employment multipliers. That will need a lot of money, but the government has already exhausted more than two-third of the fiscal deficit limit, meaning there is very less room for more public expenditure.
There is no easy way out of this slowdown.
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