COVID19-led lockdown disruptions: Why interest rate cuts aren't helping

Sahil Kapoor

Back in 2018 when oil prices were hitting $85 in global markets, India was nervous. The external trade looked burdensome and traders were fretting, rather sweating over the fate of currency markets.

Many expected that the Reserve Bank of India (RBI) might raise rates and it appeared, in theory along with Street estimates at that time, the right thing to do.

RBI in its quintessential conservative fashion exercised refrain and stood pat. That turned out to be a decisive non-action. In Central Banking, as in life, everything is an action, even non-action. But are we seeing RBI in action, is it enough?

Over the better part of the last few years, I have commented that India's real interest rates are too high. Real interest rates are the cost of borrowing adjusted for the expected level of inflation one year hence.

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Sahil Kapoor

Chief Market Strategist|Edelweiss Investment Research.

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For instance, if the 10-Year yield is at 6 percent and the inflation benchmark at 4 percent then the real rate will be 2 percent. The inflation benchmark that India's central banks used for policymaking was the wholesale price index (WPI) which measures the changes in prices at the bulk, before-retail, wholesale level.

The RBI adopted the consumer price inflation benchmark (CPI) in 2014. Indian real interest rates have averaged 80bps during the decade, and a half of the last two decades when WPI was the benchmark.

Since 2014, India changed the inflation benchmark from WPI to CPI and added an incremental 150bps of real rates on top of it.

CPI has been nearly 200bps higher than WPI over the years. The result has been a long 5 year period with real interest rates in excess of 350bps to 450bps during most periods.

The high real rates were coupled with a tight money supply, which was growing below trend not only because of poor credit growth but also because of sub-optimal increase in narrow money.

India's incremental credit growth to GDP has been abysmal over the last few years. With a non-financial Debt-to-GDP ratio of 123 percent, at the current nominal GDP of INR200trn India needs to add nearly INR35trn in incremental credit each year to grow at a nominal pace of 10 percent.

Instead India's financial flows to the commercial sector have been languishing around INR20trn or lower, a massive shortfall. The non-food credit from banks has grown at INR6trn in FY20, nearly half of what they should have for a healthy and growing economy.

With Centre, State and CPSE set to borrow nearly INR29 trn credit conditions are tight. The government and private sector are both net borrowers that leave only the household sector as net savers.

At this juncture with heightened wage pressure on households the credit markets in India need a back-up.

The credit flow to weaker sections of the bond market, SMEs, and non-banks have suffered a great deal. For instance in FY20 incremental credit from Non-Banks to the commercial sector has de-grown in the first three-quarters of FY20 and is set to de-grown in the H1FY21.

But, this has roots in enacting fiscally constraining, regulatory tough to execute policies during a period when monetary conditions were too tight.

It is like trying to swim against the current with an air tube on. Policies like demonetization, GST, RERA, and others were all well-intentioned but done with poor monetary conditions in the backdrop along with their own inherent challenges.

This brings us to where we stand today. The credit markets remain a beauty contest with suitors eyeing for only the best 'looking' paper.

This renders them inefficient and creates a negative loop for all market participants involved in genuine business practices. The yield curve, depicting the bond yields for varying maturities when plotted in increasing order of their maturity is too steep.

Yield curve invert ahead of recessions and create ideal conditions for economic recovery by making long term financing cheaper. When yield curves remain steep but growth fails to pick up, the central banks need to intervene and correct this anomaly.

One of the most important components of financial markets is the risk capital. The capital ready to take on opportunities with higher levels of uncertainty and effort.

But, this requires well-defined rules of the game. The Indian debt market has seen far too many disruptions in the last 18 months.

From IL&FS defaults to problems with non-banks to the current COVID19 led lockdown disruptions. What these crises have done is undermine confidence, drive away risk capital, and cause corporate to pay exorbitant spread to borrow, if at all they have been able to.

The AA Corporate bond spread on has traded nearly 70bps higher than its long period average for the better part of the last 18 months. In some cases the borrowing costs have been excessively high negating the entire easing cycle which began in Feb'19.

When the cost of credit is contingent on the perception of risk and solvency of the counterparty the level of interest rates is of little help.

Thus rate cuts have had limited success because they haven't pervaded the part of the market which needs it most. This by no means suggests that lowering the benchmark rates is a bad policy. It is an important policy tool and necessary. But, it is insufficient at this time.

We need tools to tackle, to force the entire yield curve for not only G-Sec but all ratings of corporate bonds to decline, to shift lower.

When rate cuts fail to bring down the entire yield curve the policy decision needs to front-load ammunition to achieve the desired goals. Monetary policy has to shift to principles of inclusion and not selectivity.

The solution lies in restoring order and confidence in the system. A large part of the Indian economic narrative and its proponent believe and propagate that financial markets are just a part of the economy and not too important.

The critique against the stocks and bond markets is quite pervasive. This misses the point entirely. No economic system can't work without a well-oiled financial market.

Even in the case of India which has a larger unorganized financial market the repercussions of a financial system in freeze are deep. The ability of Govt to enact socialist policies depends entirely on the resources it raises through taxes and non-taxes which are entirely driven by the organized sector.

Even the gargantuan gold bullion is linked to the vagaries of the FX markets and real estate to the ability of builders to fund the completion of projects. Therefore the solution for repairing the economy lies first in fixing our financial markets along with enacting measures to boost consumption and investments.

These aren't steps to be taken in isolation. The economy works more like the human body. It's not intelligent to expect supernormal performance when a vital organ of the body isn't functioning properly aka the financial system for the economy.

I suppose the current state of the economy requires RBI and the government to step in as the lender of the last resort and help the corporate sector repair its balance sheets.

Ideas around the structure and vehicles are available to the government but need implementation. While enacting policies it is important to overwhelm the system positively and not disappoint.

We need to act, communicate, and then act more forcefully. I am hopeful that we will act, tide through the storm and win.

(The author is Chief Market Strategist, Research, Edelweiss Wealth Management)

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