India’s Financial Economy: Post 1

In the inaugural post of the weekly series on India’s financial economy, I thought that there is no better place to start this journey than the RBI.

RBI has emerged as a dark knight for our economy at a time when most other parts are reeling under extreme duress caused by COVID-19 and the ensuing lock-down imposed by the government. In this post we will focus exclusively on RBI’s role as the custodian of India’s financial markets. On later posts we will look at RBI’s role as a the Regulator of Banks and the custodian of our exchange rate.

I will first walk you though the various steps taken by RBI ever since this crisis started unfolding in early March. Post that we will also evaluate the impact of these actions on the real economy.

But first we have to start with Inflation. This is because post the establishment of the Monetary Policy Committee, RBI’s action on this front is constrained by the mandate to contain CPI inflation between 2% to 6%. Not only that the act is very specific about timelines over which this mandate has to be met and failing to do, gives government the right to scrap the committee. Moreover, the body is constituted in such a fashion that most members are unlikely to risk that and will likely stay well within the bounds of the MPC. This is a fundamental difference between RBI and monetary authorities in developed markets such as Federal Reserve and ECB. Their inflation mandate is “In Principle” and there is no enforceable legal limit on inflation.

Now coming to India’s inflation scenario. We only have data on inflation till March since a part of the survey couldn't be completed because of the lock-down. You would recall that in the February MPC meeting, the MPC decided to standstill on the policy rate despite a sharp deterioration in their own estimate of GDP growth. This is because there was a sharp spike in CPI inflation. CPI inflation of December 2019 stood at 7.4%, the highest since the MPC was constituted in 2014. The principal culprit was food inflation which was running as high as 12%. Since then food inflation has cooled off and is sequentially down 5% from December to March 2020. However despite good growth in agriculture, supply constraints owing to the lock-down led to a spike in food inflation in April. There is abundant anecdotal evidence to suggest that this is only getting more acute, especially in urban India. Unless and until the administration ensures that there logistical constraints are eliminated, this stand to significantly constrain the RBI’s ability to provide monetary accommodation to tide over this crisis.

Now lets come to the steps taken by the RBI since the COVID crisis broke out. The RBI’s action has spanned 3 main areas: 1. Policy Rate 2. Liquidity Management 3. Steps to improve transmission

Policy Rate: The MPC in two off-cycle meetings decided to bring down the policy rate from 5.15% to 4%, the first 75bps was done in their 27th March meeting and the remaining 40bps happened on 22nd May.

Liquidity: RBI has 4 sets of avenues to influence the liquidity condition of the financial inter-mediation channel. They are as follows: 1. Policy Corridor of LAF 2. Reserve Money Tools 3. Credit to Government 4. Liquidity Management

1. Policy Corridor: RBI has widened the policy corridor through a two pronged approach. The primarily objective of this is that the reduction in reverse repo rate has been sharper than that of the policy rate: 160 bps vs 120bps. Reverse Repo rate determines the rate that banks obtain if they park excess funds with RBI. Liquidity condition was already in surplus and this has increased over the course of the last few months, with banks parking even larger daily surplus with RBI. By reducing this rate to 3.35%, the RBI is trying to nudge banks to take credit risk.
2. Reserve Money Tools: RBI has quite a few tools at their disposal to influence reserve money.
   a) CRR: The RBI has reduced CRR by 100bps to 3%. They have also brought down daily reserve maintenance criteria from 90% to 80% until June 26th. This essentially frees up bank’s capital that earlier would have had to be placed with RBI
   b) LTRO: RBI started doing targeted Long term Repo operations (LTRO) in the mid of February as a way of providing long term liquidity to the banking system at repo-rates without distorting the market dynamics of the G-Sec market. Post COVID they augmented the tool to further sharpen its specificity, which was called Targeted LTRO (TLTRO). RBI has announced TLTRO capacity of 1.5 lakh crore and has already conducted LTRO of 75000 crore since March. This instrument is being used to both direct some of the liquidity to the secondary bond market, which was frozen in the initial days of the crisis and also to target specific parts of the economy where liquidity is not finding its way (TLTRO 2.0 had specific allocations for areas such as mid size NBFC, MFI etc)
   c) On-lending Facility to National Financial Institutions: RBI has provided refinance facilities to NABARD, SIDBI and NHB amounting to 50,000 crore at the policy rates. These institutions can then direct this capital to specific sections of the economy by lending to NBFCs that operate in those segments.
   d) OMO: During this period RBI has purchased G-Sec bonds amounting to 1.63 lakh crore.
3. Credit to Government: RBI has stepped up on its role as a banker to the union and state governments at a time when most governments are going through a revenue glut due to weak tax collections owing to the lockdown. RBI has expanded the ways and means advance facility for both state and central governments. In fact the debt outstanding of RBI to central government has gone up drastically to 1.26 lakh crores, while for states it has gone up by 2X. RBI has also facilitated short term short term cash management bill for the central government, which raised 80,000 in late March. On 22nd May RBI announced that they will facilitate withdrawal of funds for the state government from the Consolidated Sinking Fund, a bulk of which will go towards meeting the maturity payment of bonds that are expiring in this financial year.
4. Liquidity Management: RBI’s role in managing liquidity is primarily geared towards ensuring that the policy rate is transmitted across the economy, started with the call money market. To this end, RBI provides liquidity through various instruments such as variable term Repo to operation twist. During this timeframe RBI has done variable term repo to the tune of 2.28 Lakh crore to iron out frictional liquidity in the 1–14 day horizon. At the same time they did one tranche of operation twist of 10,000 crore which entailed simultaneous selling and buying of G-Sec at the short end and long end respectively to transmit on the longer end of the curve.

Now coming to the impact of all these measures on the real economy. We will access the impact on a few parts of the economy

1. Money: From early March to early May, RBI has expanded reserve money by 2.4% and broad money by 4.5%. This is commendable because even in this crisis they have been able to expand the Money Multiplier. Typically in times of crisis people tend to sit on cash and thus the cash to deposit ratio comes down. RBI’s step to reduce CRR has enabled it to maintain the multiplier, which has in turn helped them expand broad money. Inline with the cut in policy rate, the weighted average call money rate has come down from around 5% to 3.89%.
2. Debt: Here we are primarily concerned with the borrowing cost of the government. At the short end, T Bill rates have come up by 160 bps to 3.5%. At the higher end 10 year government bond yields have gone down by 90bps to 5.75%. It is important to bear in mind that this reduction has happened despite a weakening of the government’s fiscal condition and a sharp increase in planned borrowing. At a high level this is the true test of any monetary authority: can they bring down the borrowing cost of the sovereign at a time when the same agency has become financially weaker but has to borrow more from the market? RBI has passed that test.
3. Credit: The Credit market has two parts. One is the bond market where the effects are visible real-time and the second is the bank credit market, where things take some time to percolate. In the Bond Market, transmission has been very weak with the reduction in yield of AAA securities limited to only 40 to 10 bps across the term structure with the 3M tenor having the highest reduction. There is a slight reduction in credit spread for AAA securities but for notches below that the credit spread has actually gone up. In the banking system, credit offtake has been muted with non-food credit only growing by 1.4% during this 3 month period. The weighted average lending rate on incremental lending was down 40 bps between Feb to March. Whereas between February to May the savings and term deposit rates are down 50bps at an aggregate level. the banking channel is doing a better job at transmission but there is more that needs to be done both in terms of bringing down rates and on driving credit growth.