RBI monetary policy: Rate cuts unlikely for the rest of 2021

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By Anagha Deodhar

RBI monetary policy review: The Monetary Policy Committee of the Reserve Bank of India has kept the repo rate unchanged at 4% and kept the monetary policy stance accommodative “at least through the current financial year and into the next year”. While a few economists were expecting a cut, the MPC decision is in line with consensus. The MPC upped inflation forecast to 5.0-5.2% for the first half of the next financial (FY2021-22) from 4.6% to 5.2% in the previous monetary policy review. It also raised the real GDP growth forecast to 8.3-26.2% in the first half of FY2021-22 from 6.5%-21.9% in the previous review. For the full financial year 2021-22, it expects a real GDP growth rate of 10.5%. While my own real GDP growth forecast is in line with the committee’s forecast, I believe inflation is likely to undershoot MPC’s expected trajectory.

The MPC decision by itself was largely a non-event as both the decisions (repo rate status quo and continuation of accommodative stance) were along expected lines. However, as in the past few policies, the RBI announced a series of measures outside the purview of the MPC to communicate its liquidity operations and support to growth.

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These measures announced in the Statement on Developmental and Regulatory Policies show that RBI faces a very tricky path ahead. On one hand, it needs to withdraw the ultra-accommodative measures announced at the very beginning of the pandemic crisis. It is important that the central bank does not let these measures continue for long as it needs to protect financial stability and avoid asset bubbles.

Since the economy is showing the signs of a robust recovery, the RBI needs to withdraw these measures immediately. On the other hand, the central bank would want to keep interest rates low, overall financial conditions benign and the demand for government securities high to conduct the government’s borrowing programme in an efficient and non-disruptive manner. Hence, it needs to juggle two hats – protector of financial stability and debt manager to the government – cautiously and skillfully.

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This article analyses various measures announced by the RBI in the February 2021 review to see how it intends to juggle the two roles:

Phased exit from ultra-accommodative monetary policy

The most important announcement in the February 2021 monetary policy review was the gradual hike in Cash Reserve Ratio: from 3% of the Net Demand and Time Liabilities (NDTL) to 3.5% from 27 March 2021 and 4% from 22 May 2021. When the RBI cut CRR by 100bps to 3% on 27 March 2020, it marked the beginning of the ultra-accommodative monetary policy aimed at flooding the system with liquidity and keeping financial conditions benign to support the economy through the worst of the pandemic. Now that there are signs of credible and durable economic recovery, the RBI felt the time was apt for a gradual exit from the ultra-accommodative policy.

A phased CRR hike is the first step to drain liquidity on a durable basis. The cumulative CRR hike of 100 basis points is likely to drain liquidity amounting to Rs 1.5 trillion from the system. In the post-policy media interaction, RBI officials clarified that the liquidity drained through CRR hikes would be replenished through more market-friendly instruments. This could possibly mean that the RBI is open to conducting Open Market Operations (OMOs) or deploy some other market-friendly instrument for a similar amount.

The RBI extended the relaxation on availing funds under the Marginal Standing Facility (MSF) by dipping into SLR by up to an additional 1% of NDTL till 30 September 2021. The move is likely to make available additional liquidity of Rs 1.5 trillion.

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Increasing absorptive capacity for government securities

In the run up to Budget 2021, bond traders expected the government to have cash holdings in the range of Rs 2.5-3 trillion. Hence, the bond market expected it to borrow Rs 10.5 trillion in FY 2021-22. However, the finance minister’s announcement that the government will borrow a little over Rs 12 trillion in FY22 and an additional Rs 800 billion in February-March 2021 period came as a big negative surprise for the market. The fact that revenue collection, nominal GDP growth and funding from other sources (such as multilateral agencies, NSSF etc.) could be significantly higher than budgeted in FY22 did not sooth the market’s nerve. The 10-year bond yield shot up to 6.12% on 2 February from 5.9% on 29 January 2021.

Hence, the RBI took a couple of important measures for ensuring that the government’s borrowing programme goes through smoothly in the next financial year. Firstly, it extended the enhanced the held to maturity (HTM) limit for SLR securities at 22% of NDTL till 31 March 2023. This was originally extended till 31 March 2022. Banks are required to reduce their HTM portfolio to 21% of NDTL by 30 June 2023, 20% by 30 September 2023, and 19.5% by 31 December 2023. By keeping the HTM limit for SLR securities higher for one more year, the RBI wants to increase the absorptive capacity for government debt. An additional 2.5% of NDTL translates into Rs 3.75 trillion. However, banks are said to be reluctant to utilise this space. This is because, bond issuances in the last one year were priced at record-low yields.

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Hence, banks may not be able to offload these papers from HTM portfolio without suffering losses anytime soon. Also, traders who suffered big losses (up to 50 basis points on 5-year bond and 25-30 bps on 5-30 year bonds) after the RBI announced resumption of normal liquidity management operations would want more clarity on OMO calendar and the level at which the RBI would target 10-year yield. This level, which was 6% not so long ago, is now believed to be in the range of 6.15%-6.2%.

Secondly, it announced Retail Direct, a facility under which retail investors will be allowed to open gilt securities accounts with the RBI. In a post-policy media interaction, RBI Governor Shaktikanta Das added that as the economy and subsequently savings pie in the economy grows, availability of more savings instruments will not necessarily cut into banks’ deposit mobilisation. In fact, allowing retail investors to invest in gilts directly will broaden the investor base for government securities. Only a few countries in the world (such as the US, Brazil) have allowed this and India is the first country in Asia to allow retail access to gilts. I think it’s difficult to estimate how much money is likely to be mobilised under this. However, it is definitely a welcome step towards increasing the investor base for gilts.

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Making it easier for banks to support recovery

The RBI deferred the implementation of last tranche of capital conservation buffer (CCB) yet again. Now, banks are required to implement last tranche of CCB of 0.625% by 1 October 2021. This move is likely to help banks with thin capital buffers and those who are finding it difficult to raise funds from the capital market. The Governor added that the deferment will enable banks to continue providing necessary support to recovery.

Banks currently have to maintain CCB of 10.875% which will increase to 11.5% from 1 October 2021. Similarly, the central bank also deferred the implementation of the Net Stable Funding Ratio to 1 October 2021.

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Other measures to encourage credit flow to targeted sectors

Keeping in mind NBFCs’ role in the last-mile delivery of credit, the RBI decided to include them in On Tap TLTRO announced on 9 October 2020. Similarly, the RBI also allowed banks to deduct credit extended to new MSME borrowers from calculation of CRR. Both these steps were taken to encourage credit flow to stressed or targeted sectors.

Bond market still jittery; primary auction devolves on PDs

Despite the central bank’s repeated assurances that it will complete government borrowing programme in a non-disruptive manner, bond market is still cautious. On 5 Feb 2021, at a primary auction of Rs 310bn, the RBI accepted bids worth only Rs 1.9bn. Rest of the auction devolved on primary dealers as the central bank did not find rest of the yields acceptable.

Expect pause on rates, change in stance from mid-2021

The MPC kept the stance accommodative despite revising its inflation and growth forecasts higher. Inflation could soften further in the coming months and likely undershoot MPC’s revised trajectory. However, retail inflation is still likely to remain well above the mid-point of MPC’s target range. Growth is also likely to pick up in FY22. Hence, the MPC could change the stance to neutral from accommodative, effectively ruling out rate cuts. The committee could take a prolonged pause on rates through calendar year 2021. The minutes, to be published on 22 February 2021, will provide more clarity on members’ assessment of the economy and future expectations.

(Anagha Deodhar is Chief Economist at ICICI Securities. Views expressed in this article are personal.)