Will RBI Follow Fed and Go for Policy Normalization Earlier Than Expected?

Published 10-08-2021, 04:30 pm

India’s benchmark stock index Nifty (NSEI) closed around 16238.20 Friday, slips almost -56 points (-0.35%) and over -100 points from the lifetime high 16349.45 made on Thursday. On Friday, Nifty was primarily dragged by index heavyweight RIL by almost -34 points coupled with financials/banks (apart from HDFC Bank (NS:HDBK)). RIL slumped after India’s Supreme Court (SC) upholds an arbitration order preventing RIL’s $3.4B deal to buy Future Retail (NS:FURE). Banks & financials were under stress on less dovish hold by RBI (split voting on the concern of surging inflation). The RBI also raised its inflation forecast for FY22 and doing backdoor QE tapering like Fed (huge reverse repo) to suck excess liquidity from the banking system in an indirect effort to rein on surging inflation.

On Friday, India’s Central Bank RBI kept its benchmark repo rate at 4% during its August policy meeting, as unanimously expected, saying it will maintain an accommodative monetary policy stance as long as necessary to support the economic recovery from the COVID recession and to help mitigate the negative impact of COVID. The RBI also left the reverse repo rate unchanged at 3.35% and raised its projection for retail inflation for FY22 to 5.7% from prior estimates of 5.1% adding to concerns about a need to reverse the policy if price/inflation pressures fail to abate. RBI policymakers projected GDP growth at +9.5% for FY22 against +10.1% from a previous forecast.

Highlights of RBI policy meet (6th Aug):

  • All policy rates unchanged as unanimously by MPC as highly expected (6-0 votes)
  • RBI forward guidance: ‘to continue with the accommodative stance as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target, going forward’
  • RBI forward guidance was approved by 5-1 MPC votes against 6-0 prior/market expectations; MPC member Varma expressed reservations on elevated inflation scenario
  • RBI refrained from indicating any further ‘elbow room available’ for policy rate action (cut) amid surging inflation
  • Like Fed, RBI is now effectively doing backdoor QE tapering-variable rate reverse repo (VRRR) auctions and other regular reverse repo operations; cumulative daily liquidity absorptions through RR around Rs.8.5T in Aug’21; but there is ample system liquidity even after considering all types of reverse repo
  • The average amount in daily VRRR (reverse repo) almost doubled from Rs.2T to Rs.4T as banks are more eager to deploy funds with the RBI and the RBI is also offering them higher remunerations/returns
  • Despite elevated inflation, RBI is giving priority to economic growth as it virtually changed its primary mandate from price to growth stability
  • RBI reiterated extraordinary COVID disruptions require an extraordinary solution
  • Elevated inflation is much higher than RBI target, but it’s now a secondary issue for RBI; prime importance is a revival of economic growth in a sustainable manner
  • RBI sees most of the issues behind elevated inflation as transitory like supply chain disruption, not due to higher demand and thus does not consider currently higher inflation as a prerequisite for policy normalization
  • RBI changed its inflation mandate to average inflation targeting; i.e. over some time, not at a point in time
  • RBI will prefer a hotter economy rather than a cooler (disinflationary)
  • RBI said average inflation between 2016-20 was around +4.00%; looking ahead, RBI also vows to keep average inflation around 4% in 2021-25 period
  • Between 2016-20, average inflation was around +0.41% sequentially (m/m); i.e. around +4.92% on an annualized basis
  • In 2021, till June, average sequential inflation is around +0.53% (m/m); i.e.+6.36% on an annualized basis
  • Projected average CPI for FY22: +5.7% vs previous estimate +5.1%; normal monsoon, buffer stock, and effective supply-side actions by governments to keep food inflation in check; surging commodity prices causing cost pressures along with higher margin at retail levels (profiteering) and supply chain disruptions; thus both state and federal governments should take proper policy action to ensure price stability of essential items
  • Projected GDP growth for FY22: +9.5% vs previous +11.0%; the impact of COVID 2nd wave on activity is seen to be contained and should be less than 1st wave due to localized partial/full lockdowns rather than an all-out national lockdown
  • RBI is very cautious about elevated structural pandemic NPA/NPL in the banking system including NBFCs and stressed adequate provisioning, capital buffers, and sound corporate governance
  • Tough times call for tough choices, decisions; unprecedented times call for unprecedented policy actions
  • Forecast of normal monsoon tailwind for economic revival
  • Domestically, expected rapid progress of COVID vaccinations (at least a single dose for maximum vulnerable people) and Indian ‘innovation’ to cope with COVID restrictions may help
  • RBI is not concerned about the present state of bond yield steepening or consistent 10Y bond yield around 6%; RBI is focused on orderly evolution of bond yield curve, while yield may both go up and down in an orderly manner; i.e. RBI is not stressing too much on back door YCC
  • RBI is not thinking about policy rate normalization in any way for the foreseeable future despite headline CPI consistently much above target (+4.0%)
  • RBI will ensure money/FX market stability by appropriate policy action (strategy) from time to time
  • RBI is not in a position to advise fiscal policy prescriptions, but RBI thinks demand will eventually revive due to huge infra/fiscal stimulus (as it will create jobs and income) and signs of plateauing of COVID curve; RBI sees more normalization/reopenings in the coming days
  • RBI is ensuring adequate FX reserve to fight any Fed-induced taper tantrum
  • Higher government transfer by RBI is purely an accounting issue due to lower provisioning for contingency; i.e. it may be transitory
  • RBI is less concerned about price stability than a revival of growth at this moment as RBI thinks higher inflation currently is a supply-side issue rather than demand-side; RBI will take an appropriate approach on price stability mandate when it sees higher demand (i.e. higher liquidity) is causing higher inflation; at this point, RBI is focusing mainly on the revival of growth in a sustainable manner; RBI will not speculate about possible higher demand and higher inflation in Q3FY22 when the economy may reopen significantly; RBI will wait for actual data, not mere assumptions
  • RBI thinks there is some spare capacity in the economy and thus will continue to provide accommodative monetary policy to nature higher growth
  • RBI is not pushing banks for irresponsible lending; Banks have to make a lending decision depending upon the quality of the borrower and underlying projects; RBI will patiently wait for the revival of demand and credit, not in a hurry to force banks to lend indiscriminately
  • RBI is not in a position to advise the government on the fiscal deficit; RBI hopes that both Federal and state governments will take coordinated policy action to ensure price stability of essential items including petrol and diesel tax issues, but at the same time RBI is also aware of the reality of the situation as exorbitant petrol/diesel tax is also a prime source of easy revenue for states/centers and thus RBI hopes a balanced approach to deal with the situation
  • Overall, RBI is satisfied with rate cut transmissions by banks so far and not pressuring them for more
  • RBI is confident there will be not an abnormal spike in NPA/NPL because of 2nd COVID wave because of quality and responsible lending, but RBI is also ensuring adequate capital buffers and provisioning for banks and shadow banks (NBFCs)
  • RBI sees adequate support of government borrowings through its secondary market operations (QE-Lite/GSAPs/OMOs etc); RBI is comfortable to keep government borrowing costs around +6.00%; in FY21, average government borrowing costs were around +5.90%
  • RBI is not thinking about policy rate normalization as of now
  • RBI is not concerned too much on NPA/NPL because of COVID 2nd wave, but watching the evolving situation constantly and banks/NBFCs are also pro-actively setting aside adequate provisions well in advance
  • RBI is also quite satisfied with legacy NPA recovery under NCLT/IBC mechanism despite huge hair cut (loan settlement) recently in some cases; under the old regime of Lok Adalat and DRT, although average hair cut was around 5-6% (2015-20), the recovery rate was also poor around 5-6%. But now under NCLT/IBC, the recovery rate is 40-45% on an average. Also, NCLT/IBC is a better regulatory process under judicial supervision/review and far more effective than the earlier SARFESI/DRT mechanism
  • The recent amendment of retrospective tax amendment (Vodafone (LON:VOD), Cairn fiasco) is a welcome and timely decision by the government rather than further dragging the long-pending issue
  • The economic recovery is still uneven/K-shaped as contact-sensitive/consumer-facing service industry such as travel & tourism, leisure & hospitality still facing headwinds, whereas the manufacturing industry has not suffered significantly in the 2nd wave as they were able to adapt with the COVID as new normal
  • RBI reviewing PCA status of some public sector banks will take appropriate action in due course of time

Bottom line:

Maintaining price stability is the basic objective of any central bank including RBI despite transitory rhetorics. RBI will follow Fed in normalization and may also go for QE/GSAP tapering from Q1CY22 and may also go for gradual rate hikes from Dec’22 or Mar’23 (in line with Fed); earlier RBI vows to not hike at least till Mar’24. If RBI can’t bring core CPI sustainably below 4% in the longer term, India’s 10Y bond yield will never fall below 5% on a sustainable basis. In that scenario, India’s debt interest cost may continue to be around 50% of core tax revenue, which is unsustainable and a red flag for the economy in the long run. The Indian government/RBI needs to amend its official single mandate of only price stability toa dual mandate of maximum employment with 4% price stability. India also needs to ensure official monthly data on the employment situation of the country (like BLS/NFP job data in the U.S.), so that policymakers can’t have to drive the car at the night without headlamps.

Latest comments

Loading next article…
Risk Disclosure: Trading in financial instruments and/or cryptocurrencies involves high risks including the risk of losing some, or all, of your investment amount, and may not be suitable for all investors. Prices of cryptocurrencies are extremely volatile and may be affected by external factors such as financial, regulatory or political events. Trading on margin increases the financial risks.
Before deciding to trade in financial instrument or cryptocurrencies you should be fully informed of the risks and costs associated with trading the financial markets, carefully consider your investment objectives, level of experience, and risk appetite, and seek professional advice where needed.
Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. The data and prices on the website are not necessarily provided by any market or exchange, but may be provided by market makers, and so prices may not be accurate and may differ from the actual price at any given market, meaning prices are indicative and not appropriate for trading purposes. Fusion Media and any provider of the data contained in this website will not accept liability for any loss or damage as a result of your trading, or your reliance on the information contained within this website.
It is prohibited to use, store, reproduce, display, modify, transmit or distribute the data contained in this website without the explicit prior written permission of Fusion Media and/or the data provider. All intellectual property rights are reserved by the providers and/or the exchange providing the data contained in this website.
Fusion Media may be compensated by the advertisers that appear on the website, based on your interaction with the advertisements or advertisers.
© 2007-2025 - Fusion Media Limited. All Rights Reserved.