MPC acts on cue to revive the economy

The Monetary Policy Committee of the RBI in a somewhat rare show of unanimity cut the policy repo rate from 6 per cent to 5.75 per cent — the third cut in a row — and what is more important, shifted the policy stance from ‘neutral’ to ‘accommodative’ in its second bi-monthly meeting. As many as 31 out of 43 economists who responded to a survey by a news agency just before the policy correctly forecast the rate cut, with three of them even predicting a more aggressive cut by 50 basis points.

The MPC has justified the easing by noting that the output gap has further widened since the last policy, terming the recent sharp slowdown in investment activity, alongside the continuing moderation in private consumption growth as a matter of concern. The shift in policy stance was also aided by the fact that the headline CPI remains closer to the lower end of the 2 per cent-6 per cent range, even after taking into account the expected transmission of the past two policy rate cuts.

This underscores the current perception shared by both the lay and the cognoscenti that the growth impulses of the Indian economy have turned bearish. Both the domestic and external drivers of aggregate demand are weak. And, since there is no room for any fiscal stimulus to boost aggregate demand in any worthwhile manner, the onus is now on the RBI to do the heavy-lifting. This action by the MPC also comes against the backdrop of recent easings in Australia, New Zealand, Malaysia and the Philippines. Even the US Federal Reserve is now expected to cut policy rate later this year.

The equity market shed some points after the policy while the government security prices gained a bit. The dollar-rupee rate was more or less unchanged. The market is not yet certain if the change in stance signals further rate cuts in the current fiscal. The possible answer to this quintessential question is almost likely to be the expression which is a cliché by now: ‘It will be data-dependent’.

The MPC has justified the easing by noting that the output gap has further widened since the last policy, terming the recent sharp slowdown in investment activity, alongside the continuing moderation in private consumption growth as a matter of concern. The shift in policy stance was also aided by the fact that the headline CPI remains closer to the lower end of the 2 per cent-6 per cent range, even after taking into account the expected transmission of the past two policy rate cuts. The MPC has slashed the GDP growth projection for 2019-20 vis-à-vis the numbers put out in the April policy: It is now revised to 7 per cent as against 7.2 per cent previously. The CPI projections are more or less unchanged: 3-3.1 per cent for H1:2019-20 and to 3.4-3.7 per cent for H2:2019-20.

Shadow-banking woes

Both the first and the second bi-monthly MPC meetings were held against the backdrop of a worsening credit crunch in the NBFC/HFC sector, causing considerable pains to the financial sector and the real economy. Hours before the unveiling of the policy announcement by the RBI, came the news of default by India’s third largest HFC in servicing interest on a tranche of its NCD, prompting major credit rating agencies to downgrade it to the ‘default’ category.

To provide some international perspective, the ratio of the aggregate assets of NBFCs/HFCs to that of the banks in India is around 17 per cent, which is way above the 4 per cent and 1 per cent in the case of China and the US, respectively. NBFCs/HFCs in India hold about 46 per cent share of the mortgage loans.

One of the immediate consequences of this risk event is a likely drop to the tune of 75 per cent in the value of its debt papers held by mutual funds, estimated at about ₹5,000 crore in aggregate. Banks having large exposures to this HFC, by way of bonds and loans will also be required to make hefty impairment/loan loss provisions in the days to come. As per one analyst, the default of this HFC with aggregate borrowings of about ₹1 trillion will have serious systemic consequences, as was the case with the previous shock default by IL&FS in the second half of 2018.

In a move that will not surprise anyone, the government has just announced that the matter will be investigated into. Also, since this HFC is a deposit-taking large HFC, one would have expected that it would be subjected to rigorous and effective supervisory oversight. One is not sure, though, if this has indeed been the case.

To provide some international perspective, the ratio of the aggregate assets of NBFCs/HFCs to that of the banks in India is around 17 per cent, which is way above the 4 per cent and 1 per cent in the case of China and the US, respectively. NBFCs/HFCs in India hold about 46 per cent share of the mortgage loans. Hence, the current turmoil in the credit market caused by the travails of the NBFCs/HFCs will have deleterious impact on the economy.

The dependence of the construction sector on NBFCS/HFCs is very significant, so are of the commercial vehicles and two-wheelers and MSMEs, especially those in the rural and semi-urban centres. Anecdotally, the recent drop in the growth of auto sales and private consumption can be attributed to the problems being faced by NBFCs/HFCs.

Transmission of the cumulative reduction of 50 bps in the previous two meetings was 21 bps to the weighted average lending rate (WALR) on fresh rupee loans. However, the WALR on the outstanding rupee loans increased by 4 bps as the past loans continue to be priced at high rates. Given this reality, it is time the earlier proposal to link lending rates to external benchmarks is revived and implemented.

Needless to say, there is a crying need for a fresh thinking on reforming the shadow banking sector in India, that would provide for a new regulatory and supervisory policy regime for NBFCs/HFCs. The upshot of the above is also that the RBI providing direct liquidity support to NBFCs/HFCs is not a solution. Apart from the significant ‘moral hazard’ that it would entail, it will also give rise to a type of large credit risk that the RBI is not familiar with.

Whither transmission?

It is well-known fact of life in India that while any rate tightening is transmitted by banks in the form of higher lending rates, the reverse is not true. As revealed by the MPC, transmission of the cumulative reduction of 50 bps in the previous two meetings was 21 bps to the weighted average lending rate (WALR) on fresh rupee loans. However, the WALR on the outstanding rupee loans increased by 4 bps as the past loans continue to be priced at high rates. Given this reality, it is time the earlier proposal to link lending rates to external benchmarks is revived and implemented.On the development policy initiatives, the decision to review the liquidity management framework is especially welcome. Overall, it is a sensible and timely policy.

(The writer is a former central banker and consultant to the IMF)