A growth supportive monetary policy

Labourers work at the site of metro railway flyover under construction in Ahmedabad, India, March 31, 2016. India's infrastructure output grew an annual 5.7 percent in February, its fastest pace in at least 13 months, mainly driven by a surge in production of cement and fertilizers, government data showed on Thursday. REUTERS/Amit Dave - RTSCZAY

As COVID-19 has produced an unusual economic recession in India and given rise to patchy recovery, the monetary policy committee (MPC) members On December 4 unanimously voted to leave the policy repo rate unchanged at 4 percent and keep the accommodative stance at least in the current and the next financial year.

While some high frequency indicators are showing sequential improvement, signs of recovery are far from being broad-based. Private investment is still slack and capacity utilisation has not fully recovered. On the other hand, outlook for retail inflation has turned adverse due to supply chain disruptions and cost-push pressures. A combination of high inflation with weak growth has prompted the Reserve Bank of India (RBI) to continue with its powerful and targeted monetary response to protect the economy until the pandemic passes.

Currently the RBI is taking comfort from the fact that inflation is still not demand driven and could be controlled by appropriate supply management. Given its focus on reviving growth, the RBI wants to support its ongoing monetary policy actions with many more measures.

First, it wishes to bring 26 additional stressed sectors identified by the Kamath Committee within the ambit of its existing ‘On Tap TLTRO Scheme’ for five sectors. The present scheme will be expanded in synergy with the credit guarantee available under the Emergency Credit Line Guarantee Scheme (ECLGS 2.0) of the government to encourage banks to lend to these sectors at lower cost.

Second, it proposes to deepen financial markets: (1) by giving access to regional rural banks (RRBs) to liquidity adjustment facility (LAF) and call money market, (2) by pushing forward the development of derivatives market; and, (3) by taking measures to bring consistency across products (like call, notice & term money market, CDs, CPs and NCDs) in terms of issuers, investors and other participants.

Third, it proposes to strengthen the regulation of ‘banks and NBFCs’ to promote financial stability. Given the state of affairs in the banking sector, the RBI has now allowed banks to retain their FY20 profits and not to make any dividend pay-out in order to conserve capital. Given the growing systemic importance of the NBFCs, the RBI now wants to put in place a more transparent criterion for declaration of dividends.

Also, it wishes to adopt a scale-based regulatory approach for the NBFCs that is linked to their systemic risk contribution. Additionally, it proposes to introduce a risk-based internal audit in large NBFCs and co-operative banks to improve the quality of their financial reporting.

The other measures announced on December 4 include facilitation of external trade by improving ‘ease of doing business’ for exporters (like permission to write off unrealised export bills, permission to set off export receivables against import payables and permission to consider requests for refund of export proceeds) and upgradation of payment system services to expand financial inclusion and improve customer service.

Factoring in the current trends in macro variables, the MPC has revised upwards both the output and inflation projections for FY21. It expects real GDP growth in FY21 to be at -7.5 percent instead of -9.5 percent projected earlier. Similarly, it expects CPI inflation at 6.8 percent in Q3, FY21 and at 5.8 percent in Q4, FY21, which takes the entire year’s inflation average to 6.5 percent in FY21 versus 4.8 percent in FY20. Whether it is a demand-pull or cost-push phenomenon, such a jump in inflation will certainly weigh on the market sentiment, going forward.

The RBI’s management of exchange rate has been laudable in the pandemic year. As surges of foreign capital have flooded into India chasing for returns, the RBI’s systematic interventions in the forex market have dampened exchange rate volatility and increased the stock of forex reserves to the rich level of $575 billion as on November 20. But these interventions have also been adding to the surplus liquidity in the system that has now crossed Rs 6 trillion.

In the December 4 press conference, the RBI Governor has assured that the RBI is mindful of the consequences of its forex interventions for domestic liquidity and will try to sterilise these liquidity injections either through the reverse repo or other measures.

There is no doubt that the RBI has done the heavy lifting to support growth in these exceptional circumstances. However, excess liquidity creation amid growing concerns about inflation and fiscal slippage will continue to interfere with market dynamics.