When the RBI meeting of Monetary Policy Committee (MPC) in August commences, it would probably be the strangest voting decision. On one hand, RBI may be acutely sensitive to the diminished consumer confidence and risk aversion the pandemic and subsequent lockdown would have wrecked. On the other hand, the MPC would wonder whether their votes and the monetary policy changes (if any) would be consequential in an economy hit by lockdown. The Adam Smith’s “invisible hand” of individual interests acting with mutual sympathy i.e. trust which found frequent mention in Economic Survey may no longer be functioning smoothly afflicted by Covid-19. Risk across the spectrum has risen fast and steeply as never before in history of RBI. With latest systemic risk survey indicating all major risk groups viz. global risks, risk perception on macro-economic conditions, financial market risks and institutional positions perceived as “high”, Indian economy is staring at uncertainty at all levels except one where there can be broad agreement – certainty of loss of risk appetite.¹

It is a rarest of rare incident when RBI will contend with the prospect of economic growth in 2019-20 changing to estimates of a GDP contraction within a span of months. The Government of India has already announced a comprehensive package in five tranches covering measures to create rural unemployment, infrastructure and support to MSME sector. The package put together along with RBI measures comes to about 10% of the Gross Domestic Product (GDP). The borrowing limits of State Governments have been increased from 3% to 5% of GSDP.² With debt almost 40 percentage points higher than at the onset of Global Financial Crisis (GFC), the global economy is more leveraged now than during the GFC.³

The optimism in Indian financial market is in stark contrast to the weakening of real economy. While unprecedented policy measures of central banks have buoyed up asset prices and improved sentiment of Institutional Investors towards equity markets, the retail investor sees opportunity of a quick rebound post-pandemic. With a V-shaped recovery increasingly looking unlikely, the disconnect between financial markets and economy is rising. The International Monetary Fund (IMF) in Global Financial Stability Report (GFSR) June 2020 warned about tightening global financial conditions much more than baseline scenario of global output contraction by 4.9 percent. With the Organization for Economic Cooperation and Development (OECD) predicting the global economy to contract 7.6 percent in case of second wave of infections, the optimism in the financial sector is akin to a bubble led by monetary policy and backed by optimism of returning to pre-Covid-19 normalcy.⁴

The headline inflation for the month of June stood at 6.09 which is slightly above the target range of Monetary Policy Committee (MPC). As disruptions in supply chains eased with country entering Unlock-1 phase, the contribution of food to overall inflation has declined. With satisfactory sowing of Kharif crop and good monsoon, food inflation may decline further. With supply side disruptions slowly expected to be lifted, the inflation data doesn’t truly capture the price dynamics. While rural headline inflation hovered around 6.20 percent for May and June, urban inflation declined more than 50 basis points in the ensuing period from 6.43 percent to 5.90 percent.⁵ The high food grain production figures don’t seem to raise concerns of runaway food inflation in the immediate future if supply chains function in a robust manner.

The RBI prior to pandemic has been on a rate cutting spree in a bid to boost growth. An estimate of having the worst of Non-performing Assets(NPA) crisis behind led to comfortable easing but the pandemic played spoilsport as liquidity is no longer to chase growth but to restrict downward momentum of GDP contraction.

The Indian unemployment rate is down to 10.99% in June compared to a staggering 23.48% in May.⁶ The June figures clearly point to the positive impact of lifting of lockdown in several key sectors. The unlocking process in urban areas, allocation under rural employment guarantee scheme and improved agricultural activities may have contributed to the improving statistics. While manufacturing segment continues to underperform due to weak demand and supply side disruptions along with layoffs in formal sector, the rural agricultural sector is in far better shape. With layoffs across various sector rising and lower incomes among the employed, the disposable income is set to reduce even as rising uncertainty threatens to reduce spending and postpone long term economic commitments. The Financial Stability Report (FSR) points out real estate sector as amongst the three sectors apart from aviation and tourism which stares at a bleak outlook. Among the three sectors, real estate sector woes can add worry into the labour market with a significant number of labourers in urban areas gainfully employed in the sector.

Bank credit growth during the second half of 2019-20 had moderated while 2020-21 began in a lockdown mode. The moratorium’s implication for loan classification, increasing credit risk combined with higher exposure of Banks to Non-Banking Financial Companies (NBFCs) and Housing Finance Companies (HFCs) will further weigh down the risk appetite even though there is moderation of contagion risks due to shrinking interbank market. Further, the bleak outlook for real estate sector being one of three worst affected as per FSR 2020 will increase credit risk to HFC’s and will further reduce the overall sentiments.⁷

The stress test of financial Institutions by RBI indicate Gross Non-performing Advances (GNPA) ratio of Scheduled Commercial Banks (SCBs) to increase from 8.5 per cent in March 2020 to 12.5 per cent by March 2021 in baseline scenario while it may escalate to 14.7 per cent if the macro economic scenario worsens further.⁸ While the GNPA ratio of Scheduled Commercial Banks was flat at 9.3 per cent at end of September 2019 and March 2019, there was every reason to believe that GNPA was on declining trend from March 2020 if not for the pandemic.⁹ Risk aversion by banks was one of the drivers with SCB’s choosing to invest thrice the amount in Government securities (G-secs) in 2019-20 compared to previous year while reducing credit off-take by more than four-fifths.¹⁰ The pandemic not just disturbed the GNPA decline but also threatens to take risk aversion to extreme heights. The RBI policies to stimulate credit would be undermined by the practical difficulty of Public Sector Banks (PSBs) to lend in a risky economy while also trying to limit losses and restrict impairment of capital bases.

With system level Capital to Risk-Weighted Asset Ratio (CRAR) projected by RBI to drop from 14.6 per cent in March 2020 to 11.81 per cent under severe stress scenario, some banks may have to raise capital to maintain capital 1 per cent above regulatory requirement of 12.1 per cent by October 2020. ¹¹ Banks would be as much wary of impairment as much as fund raising. From the bank’s point of view, a 20-year high in bad loans isn’t ideal time to lend in a macroeconomic scenario ravaged by pandemic.¹²

The NBFC’s aren’t in an optimistic position either while being systemically very important. The RBI decision to increase or decrease liquidity in the system will have bearings on the NBFC sector which saw GNPA ratio surging in March 2020 quarter. With macro-economic risk and unemployment rising, the GNPA situation is set to get worse while the CRAR of the sector stood at 19.6 per cent in March 2020 lower than level a year ago.¹³ The IL&FS crisis had dealt a heavy blow to the risk perception and credibility of the sector as a whole and the declining share of market funding for NBFC’s is rightly pointed out as an area of concern in the Financial Stability Report. The stress tests indicating decline of CRAR from 19.4 per cent to 15.2 per cent is worrying given the risk aversion expected in the market.¹⁴ There would be substantial impact of moratorium on private NBFC’s/HFC’s. NBFC’s and HFC’s being the largest borrowers from the financial system can be the cause of contagion losses with Public Sector Undertakings (PSU) and NBFC’s inflicting contagion losses between 4.3 per cent to 5 per cent of banking system’s Tier-1 capital and risk bank failures. Non-PSU NBFC’s too can inflict substantial losses knocking off 2.7 per cent of Tier-1 capital without leading to failure of bank.¹⁵ Failure of HFC can cause as much as 6.77 per cent losses on Tier-1 capital.¹⁶

Apart from NPA crisis, contagion crisis inflicted by NBFC or HFC, the banking system faces macroeconomic shocks which mostly lie beyond the domain of RBI. The Central Government and State Governments will have a crucial role to play in bringing in confidence in the system while lifting lockdown completely and allowing economic activities to resume. Whether it’s the general risk aversion or the business failures or new entrepreneurial activities, the Government efforts in kick starting every sector of the economy and getting pre-Covid-19 level consumption to start will determine the extent of transmission of credit and increased optimism in the industry.

The rural economy in stark contrast to the urban centres comes as a relief to the overall economy. In June 2020, tractor sales jumped 22.5 per cent to 92,888 units while the comparable figure in June 2019 was 75,858 units. ¹⁷ While the June 2020 figures may indicate pent up demand of April and May, the sales figures for next few months will paint a clearer picture of revival. While tractor sales can indicate that farmers especially big farmers are doing well, it can also mean that marginal farmer is relatively well off compared to crop failure years. The sales of Tractors and Motorbikes clearly point to the economic resilience the lifting of lockdown combined with high agriculture produce brought to the rural areas. The increased allocation to rural jobs programs on the back of migrant labourers returning not just prevented an economic catastrophe but also aided in the growth. Higher monsoon rainfall across the country has boosted sowing of kharif crops driving confidence in the rural economy and keeping the consumption resilient. As sowing areas under all categories are higher in year-on-year basis, there may be a new record from last year’s record 144 million tonne of production.¹⁸ The other factor which works positively is the new Rozgar scheme targeting the reverse-migrant labour for a span of four months with a total of Rs.50000 crore covering 116 districts in six states.

With the bulk of the districts coming from the relatively lower income Eastern States, much of the rural distress will be addressed. An additional Rs. 40000 crore in the Atmanirbhar programme allocation would boost economic activities in rural areas even as much of urban areas are going through lockdowns at local level.¹⁹ While rural economy with lesser impact of covid-19 is doing well compared to urban economy, the work demand in MNREGA is marching at breakneck speed indicating worries about extreme distress labour employment. The extraordinary boom in MNREGA may point to a larger malaise in rural economy which necessitated high reliance on government scheme. Telangana touching the level of 365 days of 2019-20 in less than 75 days and unusually high work in States like Andhra Pradesh, Telangana and Chhattisgarh is matter of concern and should be up for closer scrutiny to judge the consumption in rural economy. While the high turnout for the rural job scheme may be maintained during these times, the same can signify extreme lack of employment available in the private sector.²⁰

With ordinance allowing barrier-free trade in agricultural produce even outside the Agricultural Produce Market Committee (APMC), the rural economy will find the invisible hand unleashed even while urban economy is crippled by lockdown. While Agriculture accounts for just 14% of GDP and 30% of rural economy, the masses comprising 60% of workers are engaged in agriculture and will drive consumption even though not offset the losses in urban areas. One significant reform of Government which will have a direct bearing on the inflation is an ordinance approved by the Union Cabinet to introduce a new subsection (1A) in Section 3 of The Essential Commodities Act, 1955 (ECA). While the Act gave power to the central government to add or remove the commodity in the Schedule, the power to implement provisions of the act was delegated to the States. The Act gave powers to impose stockholding limits on commodity, restrict movement of goods and mandate compulsory purchases under system of levy.

The overarching aim was to regulate agricultural marketing and production and restrict hoarding and limit price volatility of essential commodities to insure the availability to the poor. However the mechanism led to distortions in Agricultural market as stockholding limit apply to the entire supply chain without distinguishing firms that genuinely need to hold stocks and firms that hoard stocks speculatively. The Economic Survey notes that “In the long term, the Act disincentivizes development of storage infrastructure thereby leading to increased volatility in prices following production/consumption shocks – the opposite of what it is intended for”. From the perspective of RBI, the high volatility which ECA failed to address impacted the inflation figures with Government intervention having the exact opposite outcome than intended.

Under the amended ECA, agri-food stuffs can only be regulated under extraordinary circumstances such as war, famine, extraordinary price rise and natural calamity. A price limit will trigger imposing of stock limits. In case of horticulture produce, a 100 per cent increase in retail prices of commodity over the immediately preceding 12 months or the average retail price of the last five years, whichever is lower, will be the trigger for invoking the stock limit. For non-perishable agricultural foodstuffs, the price trigger will be a 50 per cent increase in retail price over the immediately preceding 12 months or average retail price of the last five years, whichever is lower.²¹ With Government intent clear on allowing the price discovery mechanism of Essential commodities to take its natural course in market, RBI may see accurate inflation figures devoid of Government interventions and the resulting volatility.

One of the underrated successes of the current ruling dispensation apart from improving ease of doing business ranking has been the significant strides in new entrepreneurial activities. As per Entrepreneurship data on growth rate of new firms, the rise from 70000 new firms in 2014 to 124000 in 2018 has been significant.²² The staggering growth rate of 80% over the period is among the lesser known achievements of the current dispensation which bodes well for an emerging economy like India. The thriving entrepreneurial minds at the grassroots level have the potential to not just provide employment in large numbers but also boost momentum of growth. A 10 percent increase in registration of new firms translates into a 1.80 percent increase in Gross Domestic District Product (GDDP).²³ It may not be off-the-mark in the midst of lockdown to estimate that significant portion of the urban and semi-urban entrepreneurial activities and MSME sector is going through severe strain in cash generation while the resilient rural economy may limit downside risk of business failures in many districts substantially.

While a range of factors including the present economic situation will determine the MPC votes, the one factor which may weigh heavily is the question mark on “effectiveness” of any measure. On one hand, rising risk aversion in the economy may reduce demand for credit even in a low interest market. On the other hand, rate cuts may not be effective in pushing ahead monetary transmission. The monetary transmission of rate cuts had been less than satisfactory even before the pandemic. The Economic Survey notes that the transmission had varied across different market segments. While transmission to short-term treasury bills was full since February 2019 when RBI reduced policy repo rate by 135 basis points, the transmission to credit market evident from Weighted Average Lending rate (WALR) of Scheduled Commercial Banks on fresh rupee loans reducing by only 33 basis points.²⁴ New borrowers effectively were transmitted less than a quarter of rate cuts.

With PSB’s under increasing risk due to possible spike in NPA’s and risk aversion zooming ahead, the RBI will have to contend with the fact that monetary policy ceases to be of much consequences unless the Covid-19 situation is under control and a semblance of normalcy returns to the economy. Any attempt to flush in liquidity into the system should ensure its availability throughout the economy which seems to be a daunting task now as the demand-supply dynamics fail to operate smoothly. The more important question the RBI might ask itself is whether any changes in rates may convert into impact at all. With Central banks cutting rate aggressively to near zero, Federal Reserve and many others face the bleak prospect of diminishing returns on rate cuts or no longer having the effective instrument of rate cuts to stimulate economy. RBI may consider whether the positive impact of a rate cut at this point outweighs the benefits of policy interventions in a future date.

The MPC will likely play a more important role over the next few months after lockdown is completely lifted and market forces are unhindered. The underlying problem and the extent will unravel only when the market players act in rational self-interest as the invisible hand theory posits. Having cut rates by 115 basis points (bps) in 2020 on top of 135 basis points (bps) in 2019, the financial system hasn’t ensured effective transmission of credit to boost growth. It’s even more unlikely in the present pandemic hit scenario that a rate cut would translate into anything substantive. RBI may wait and watch for a semblance of normalcy to return along with consumer confidence while preserving financial stability keeping a hawk eye on systemic risks and liquidity conditions.

The growth strategy would be determined more by the broader measures undertaken by government than monetary policy interventions. While increasing risk aversion by financers and borrowers can reduce both demand and supply of credit, conversely it can also be argued that individuals in desperation after loss of livelihood and businesses facing crisis may rush to leverage more to avoid immediate bankruptcy regardless of short term rates. The systemic risks in the economy is more than at any point in time in recent history and concerted efforts needs to made by RBI and Government to get back to a growth trajectory in order to chase the $5 trillion target.

References:

1. Financial Stability Report of Reserve Bank of India July 2020: 1.60 Page-18
2. Financial Stability Report of Reserve Bank of India July 2020: 3.17 Page-62
3. Financial Stability Report of Reserve Bank of India July 2020: 1.7 Page-5
4. Financial Stability Report of Reserve Bank of India July 2020: 1.5 Page-4
5. { HYPERLINK https://theprint.in/ilanomics/higher-inflation-doesnt-mean-rbis-monetary-policy-committee-should-increase-interest-rates/467062/
6. CMIE Data - https://www.livemint.com/news/india/june-unemployment-rate-eases-to-10-99-in-sync-with-weekly-trend-11593735703311.html#:~:text=June%20unemployment%20rate%20eases%20to%2010.99%25%2C%20in%20sync%20with%20weekly%20trend,-2%20min%20read&text=NEW%20DELHI%20%3A%20India's%20unemployment%20rate,week%2Don%2D%20week%20data.https://unemploymentinindia.cmie.com/
7. Financial Stability Report of Reserve Bank of India July 2020: 2.84 Page-50.
8. Financial Stability Report of Reserve Bank of India July 2020: 2.50 Page-23.
9. Economic Survey 2019-20, Volume II of Ministry of Finance, Government of India: 4.15 Page-116
10. Economic Survey 2019-20, Volume-II of Ministry of Finance, Government of India: 1.25 Page-12
11. Financial Stability Report of Reserve Bank of India July 2020: 2.15 Page-28
12. { HYPERLINK “https://www.livemint.com/industry/banking/rbi-says-bad-loans-may-rise-to-12-5-by-march-could-even-spike-to-14-7-11595592199601.html” }
13. Financial Stability Report of Reserve Bank of India July 2020: 2.47 Page-38
14. Financial Stability Report of Reserve Bank of India July 2020: 2.51 Page-39
15. Financial Stability Report of Reserve Bank of India July 2020: 2.82 Page-50
16. Financial Stability Report of Reserve Bank of India July 2020: 2.83 Page-50
17. https://www.livemint.com/industry/manufacturing/growing-sales-of-tractors-may-not-propel-recovery-11595343471615.html
18. https://www.financialexpress.com/economy/kharif-sowing-up-19-per-cent-but-no-clarity-on-prices/2034506/
19. https://www.livemint.com/opinion/online-views/opinion-the-challenge-of-overcoming-an-extended-crisis-in-our-economy-11593704561035.html
20. https://timesofindia.indiatimes.com/india/concern-in-govt-over-reasons-for-nrega-boom/articleshow/76700315.cms
21. https://indianexpress.com/article/explained/essential-commodities-act-amendments-explained-6442362/
22. World Bank EODB Entrepreneurship Data mentioned in Economic Survey 2019-20:2.1 Page-27
23. Economic Survey 2019-20 Volume I of Ministry of Finance, Government of India:2.4 Page-30.
24. Economic Survey 2019-20 Volume II of Ministry of Finance, Government of India:1.22 Page-10

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