India’s Financial Economy: Post 7
In this article we will talk about the swift recovery in India’s Financial economy post the COVID episode and the role played by the key principal agents. These agents are the RBI, the Government Sector and the Banking Sector. I hope to un-entangle the interaction mechanisms between them and how that has engineered this recovery.
Before we begin lets take a quick look at the real economy. We have the latest forecast from the NSO for the GDP of FY21. NSO FY21 GDP forecast of -7.4% growth implies that FY21H2 growth of -0.1%. Since the recovery is back-ended this implies that in real terms the economy is trending at close to YoY flat levels in real terms. Now lets review the role played by each of these institutions during the last 10 months of 2020.
Reserve Bank
We can summarize the main role played by RBI below:
- Reserve Money Management: Adjusted for the CRR cut of 100 bps, the RBI has increased base money by around 14% or 4.29 Lakh crore during this period.
- Interest Rate Management: RBI was able to effectively reduce interest rates in the overall system. Repo rate was cut by 115bps. These actions affected the Sovereign Yield Curve along with rates in the Banking and the Corporate Bond segment.
The table above breakdown the sources through which RBI expanded the Base money. It is quite evident that the banking sector’s tendency to park excess capital with the RBI has been a major detractor for Base money, but the RBI has more than compensated for it by building FX reserves which has released base money in the domestic economy.
Now coming to Broad Money measures. We can see that apart from things that are directly controlled by RBI, the two main drivers have been Credit Expansion and Allocation towards Government bonds. The incremental money multiplier is at 3.5X which is significantly lower than historical trend levels of 6X. The main reason for that is the low credit offtake in the economy.
On the interest rate front, RBI has taken a number of initiatives. Outlining some of the critical ones below:
1. Repo Rate Reduction: Repo rate was reduced by 115 bps to 4%.
2. Expanding the Policy Corridor: This decision led to the Reverse Repo being 40 bps lower than the Repo instead of the usual 25 bps. This step brought down the Reverse Repo rate to 3.35%.
3. Long Term Repo Operations: Amounting to 1.25 Lakh crore for a duration of 1 to 3 years provided at Repo rate.
4. Expanding HTM Limit of Banks: RBI expanded the HTM limit for banks to 22% of NDTL
5. Operation Twist: Simultaneous sale and purchase of around 140,000 cr of Government securities in order to bring down the yields at the long end of the GSec yield curve.
6. Outright OMO: The RBI has conducted outright OMO to the tune of 240,000 crore.
I have summarized the impact on the interest rate environment in the table below. Apart from that, these steps have also influenced market appetite for Government Securities. This is important because we can see that the Banking Sector in aggregate has absorbed bulk of the incremental borrowing undertaken by the government.
During this COVID period, RBI approach to liquidity management for the banking system has been two-fold:
1. Keep the system at a liquidity surplus: We have seen record amounts of Reverse Repo being undertaken by RBI. At its peak it reached up to 8 Lakh Crores on some days
2. Keep the liquidity rolling on a day to day basis: RBI has been absorbing the excess liquidity everyday with 1 day reverse repo operations, which fetch the banks a fixed rate.
Unfortunately this has had two unintended consequences. In the secured Repo segment of the market, rates have fallen below the Reverse Repo rate. This is because non-bank entities like Mutual Funds and Insurance firms do not have access to the Call Money market and instead participate in the Tripartite Repo market. This has had an impact on other parts of the short term market. T-Bills rates hit 2.9% in late November 2020. In the CP Market rates fell to as low at 2.6% in early December 2020. To counter this imbalance, RBI has reverted back to conducting Variable Rate Reverse Repo auctions on a bi-weekly basis. Thus far two actions have taken place amounting to 2 Lakh crore each for a duration of 14 days. These transactions were done at a rate of ~3.50% which is higher than the Reverse Repo rate. Post this announcement, short term rates have started going up since some portion of the excess liquidity that was available everyday is now tied up for a slightly longer period. By setting the rate at higher than Reverse Repo, RBI has short term rates on a upward trajectory. Operationally this also indicates RBI’s stance to normalize the liquidity situation by bringing short term rates closer to the policy corridor.
Government Sector
The key role played by the government can be summarized below
- Primary Deficit: In this 9 months period the Central Government has undertaken a primary deficit of about ~7 lakh crore. By some estimate the primary deficit of the states for FY21 so far is about 3 lakh crore. This takes the total primary deficit undertaken by the government to around 10 lakh crore.
- Debt Expansion: The Net Borrowing increase from the market by state and central government stands at around 12.71 Lakh crore. Including borrowing provided by RBI this comes to around 14 lakh crore.
Thus it implies that at a time when the economic output had fallen by 14% in FY21H1 and is just about getting back to similar levels as last year, the Government was able to borrow from the market and added about 14 lakh crore of additional spending in the economy. On FY20 GDP this stands at about 7% of GDP.
Banking Sector
At an aggregate level during this 9 month period, the total Deposit Base of the banking sector increased by about 12 Lakh crores. A bulk of this deposit increase has happened due to the excess spending done by the Government sector, which invariably ends up in the bank accounts of the various parts of the economy that directly or indirectly benefit from the government net spending activity.
In addition to this deposit increase, the CRR cut has further released 1.37 lakh crore of free reserve to the banking sector. This takes the total incremental resources of the banking sector to about 13 lakh crore. With this number in mind we can now study how the banking sector in aggregate has allocated this incremental flow of resources.
We can see that the bulk of this pool has gone towards buying Government Securities and reducing the short term borrowings of the banking sector. Only 25% of this total pool has been directed towards credit expansion. This explains why the money multiplier has been low and the fact that the recovery in the real economy has been slower than expected.
To summarize, we can see how the three legs of the monetary economy came together during this difficult period and restored stability in the financial sector. The RBI created base money in the system and brought down rates in the economy. This enabled the Government sector to run a large deficit at a time when private sector economic activity had come down sharply aided by the banking sector which accounted for bulk of the incremental borrowing done by the government.
However it is important to highlight that this kind of a monetary resolution is only suitable for a short period of time. This approach relies on a low Money Multiplier, thus necessitating large base money creation by the Reserve Bank, which is inherently inflationary. High incremental lending to the Government Sector is margin dilutive for the aggregate banking sector and Indian banks are already at their highest level of SLR securities. Furthermore high level of Government debt on the balance sheet of banks, could make overall banking sector equity and profits vulnerable to market’s pricing of government yields thus leading to macro-prudential risks.
