India’s Financial Economy: Post 5

This week I intend to look at the linkage between decisions taken by the RBI and its impact on the real economy during the course of this COVID induced financial crisis.

I will use the following framework to think through this analysis:

1. Inflation
2. Reserve Money and the Economy
3. RBI Measures and Impact on Banking System
4. Term Premium and Impact on Bond Markets

Inflation

I’m starting this analysis with inflation simply because inflation creates restrictions on the monetary and fiscal policy that can be pursued at the current time. The limitations on monetary policy emanate from the Mandate of the Monetary Policy Committee which is legally bound to conduct its operations to as to contain inflation between 4–6%. Fiscal policy is constrained by inflation because Inflation hurts the weaker strata of the society the most and politicians care about the votes of this large demographic.

Core inflation trend before March 2020 was in the 5% trajectory. Inflation survey was incomplete in April to May, but in June and July we can see that the structural has increased to the 6–7% levels. Lets look at the top weights in the CPI basket. Our attention naturally goes towards Food [50% weight] and Fuel [10% weight]. In the case of Fuel we can see that the Government [Both Central and State] has increased their respective taxes, but we see that this trend is now normalizing especially in Diesel. Food inflation is a bit complex because both demand, supply and state interventions drives the prices of food commodities. However study conducted by RBI [Working Paper 2014] and NIPFP [R Bhattacharya 2017] have both isolated MSP Channel and the Rural Wages channel as the primary driver of food inflation. If you read their analysis you will find that MSP works on the supply side, while rural wages and by extension cash transfer work on both demand and supply side. A subsequent study by RBI [S Kundu 2019] shows that rural wage inflation is sticky in the short term and feeds into non-farm wages thus leading to structural inflation.

Reserve Money and the Economy

The reserve money is closely controlled by the RBI and understanding its behavior can give us leading insights into the nature of the real economy.

Lets first study how the broad money has moved in the economy since the COVID crisis broke out from the start of March 2020. In that period this broad money has expanded by 7% despite the economic slowdown. Because of this slowdown the credit growth has been flat, but this gap was filled by direct lending to the Government and RBI Purchase of FX Assets. The share of both Direct lending to the Govt and FX Assets has gone up in M3 composition and this is a direct response by the RBI to insulate the functioning of the financial markets from the economic slump we have been going through.

Now lets look at reserve money. This is controlled by the RBI in a more direct manner. Net of the reduction in CRR the growth in reserve money during his period is about 12%. This has directly come from an increase in FX Assets. RBI has used BoP surplus situation that India is experiencing to shore up their FX reserves and this has in-turn expanded the monetary base. M3 Multiplier to incremental reserve money creation is very low at 2X and this is primarily due to low credit creation.

RBI Measures and Impact on Banking System

From Early March to Now, the RBI has cut the Repo rate by 115bps. Along with that they have announced a number of measures that impact the overall liquidity situation in the banking system.

Here I will try to ascertain the impact of these measures on the banking system on both the asset side and the liability side.

Impact on the liability side
1. Incremental Cost of Deposits: Incremental FD rates have come down by about 120 bps on average.
2. Savings Account Rates: We can see that SA Rates have come down by 50 to 100 bps across most banks.
3. Aggregate CoF: Between December Quarter of 2020 and June Quarter of 2021 aggregate CoF is down by around 40–50 bps

Impact on the asset side:
1. Loan Portfolios: We can see that incremental lending rates have come down only marginally by about 70bps. Rates on outstanding loans are down by 40 bps.
2. Impact on Inter-Bank Market: We see that overall credit growth is muted (0 to 1%) and for many banks slightly negative. Thus a good share of the incremental deposits garnered are placed in the G-Sec Market and the interbank market. In the inter-bank market we see that the WACR is trending below the Repo rate at around 3.4%.
3. GSec Investments: The G-Sec portfolio of Banks constitute about 29% of their NDTL (vs the required level of about 18%). Since G-Sec yields have come off by about 40 bps in this period, the banks also stand to make MTM gains on their bond portfolios. The recognition of this gains is subject to how these bonds are classified but suffices to say that these add to the equity buffer of banks. The spread between GSec and FD rates are reasonably steep and thus banks have parked about 60% of incremental deposits in government securities.

Thus we can see that as a consequence of the steps taken by RBI banks are facing a cumulative reduction in CoF by about 40 bps. At the same time the rates in the Inter-Bank market where the incremental deposits could be deployed have come down by 150 bps from 5% to 3.5%. Thus we see some transmission in the lending channel but credit growth is yet to happen.

Term Premium and Impact on Bond Markets

From the start of March 2020 to now the Central Governments Debt outstanding has gone up by 11%. Out of the total stock addition, 40% each has been absorbed by Banks and Insurance Companies, while RBI has absorbed 15%. Because of RBI’s action on the policy front and liquidity management the 10 years GSec Yield has come down by about 40 bps in this timeframe. But despite all these measures the term premium in India has actually gone up. The 10 Year G-Sec — 3M T Bill is at its highest ever level at 2.7%. As expected the other parts of the term structure are equally steep.

The Term Premium of the Sovereign tends to set the price on borrowing cost for everyone else. Lets get into the two pathways on how that actually plays out.

1. Corporate Bond Market: AAA 10 Year Yields have come off by 50 bps in this period. Therefore the AAA credit spreads have come down marginally. This channel is critical because bond holders do not have to deal with static liability profile like banks do and are thus the quickest to re-price the cost of new issuances. Since large corporates are ambivalent in borrowing from either the Bond market or Banks, this channel bring competitive intensity to the banking channel and thus forces them to lower rates at a faster pace.
2. Non-Bank Funding Rate: The NBFC Long Duration Yields have not reduced at all in the entire COVID period. Here we can see that credit spreads' here have gone up. This channel is critical, because a large share of retail credit is serviced by NBFCs and a reduction in Cost of funds for NBFCs would enable them to ultimately charge a lower yield on their loans to consumers and drive credit growth at the ground level. The most important development on this side is that the absolute freeze on the liquidity side of the NBFC segment has actually thawed and since then companies have been able to raise Debt though primary issuances. This has also been helped by equity capital raise that a few large players have done.