Monetary policy must keep rates unchanged, cut growth forecast

RBI monetary policy review
The monetary policy amid a major shock like the second wave of Covid-19 can afford to look through some inflationary impulses to support economic growth.

By Abheek Barua

Monetary policy review: The RBI used emergency measures during Covid-19 first wave in 2020. This included a deep cut in the policy rate and a massive infusion of liquidity through bond purchases as well as a cut in cash reserve ratio to ensure that banks had enough funds to lend at low rates. Targeted Long-term Repo Operations were geared towards delivering credit to the segments of the economy that were hurt the most.

Moratoria were granted across the board to borrowers, followed by a comprehensive restructuring plan for company loans. Large credit institutions like NABARD and SIDBI received direct liquidity support. The government also lent a helping hand in unclogging the credit sluices. Credit for MSMEs backed by government guarantees (the ECLGS) was a measure that was clearly successful.

It is unlikely that the RBI’s monetary policy can deviate much from this in handling the current crisis that is riding the second wave. However, it must recognise the specific features of the second wave that make things different from the first and fine-tune its measures. For one thing, the extent of penetration of the virus into the rural areas has been much higher than the first. The likely damage to rural incomes would mean that small institutions such as Micro Finance Institutions and smaller NBFCs are likely to face major problems.

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Besides, there is anecdotal evidence that sickness in the workforce has caused much greater disruption in labour supply. The current strain of the virus also seems to be more debilitating for its victims. Large firms might have the buffers and facilities to handle this better. Small and medium firms could be crippled by this and need funds to tide over forced shutdowns.

Monetary policy measures already taken

Some emergency measures announced on May 5 recognized these problems. Special three-year long-term repo operations (SLTRO) of Rs 10,000 crore at repo rate for Small Finance Banks (SFBs), were announced for fresh lending of up to Rs 10 lakh per borrower. SFBs have played a key role in the last mile supply of credit to individuals and small businesses. SFBs were also permitted to classify fresh lending to smaller MFIs (with asset size of up to Rs 500 crore) for on-lending to individual borrowers as priority sector lending.

However, there are problems. Of the first tranche of these special LTROs conducted on May 17 for SFBs, only Rs 400 crore was borrowed. This reluctance could perhaps be explained risk-aversion. SFBs might be able to borrow from the RBI at low rates, but might be squeamish about lending fearing a rise in bad loans. The only way to address the problem would be to seek credit guarantees from the government to absorb this risk.

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It is likely that both the Centre and states will overshoot their fiscal targets this year. The consolidated cost of vaccination, for one thing, is likely to go up from Rs 35,000 crore that the central government budgeted as states procure vaccines at significantly higher prices. Besides, more fiscal support is needed for sectors like hospitality and aviation as well as for individuals like daily wage earners who have lost their livelihood.

Future policy direction

The RBI should use the monetary policy’s liquidity levers to ensure that additional government borrowing absorbed by the market without a sharp spike in bond yields. If interest rates are allowed to rise, the central bank could compromise post second-wave economic recovery.

Monetary policy amid a major shock like the second wave of Covid-19 can afford to look through some inflationary impulses. While it is true that rising commodity price inflation is a problem and could travel soon from the wholesale to the retail index, there is every reason to believe that with subdued demand the second round or pass-through effects will be muted.

Besides, the past 15 months have shown us that there are intermittent and unexpected episodes of inflation in some items. These seem to be driven by supply problems induced by the pandemic and do not warrant monetary attention. The most that the RBI can do at this stage is to goad the Centre and states to manage the supply of essential items

Monetary policy recommendations for June

  • Moderate downward revision to growth estimates for FY22 in light of the second wave impact to 9-10%.
  • Continue with unchanged repo and reverse repo rates and accommodative stance.
  • Offer higher reverse repo rates for targeted lending to specific sectors.
  • Announce GSAP amount for Q2 FY22 of at least Rs 25,000 crore. Indicate willingness to increase this amount should fresh borrowings arise (such as Rs 1.58 trillion likely to bridge GST compensation cess shortfall).
  • Indicate that credit guarantees from GOI critical for last mile delivery of credit to target sectors

(Abheek Barua is chief economist and executive vice-president, HDFC Bank. This article is a reproduction of Mr Barua’s comments at the shadow monetary policy committee, convened by EGROW Foundation.)

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