No Rate Cut, All Eyes On Reserve Bank’s 2021 GDP Projection

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Early September, when the National Statistical Office announced that India’s gross domestic product (GDP) for the first quarter of the current fiscal year had contracted by 23.9 per cent, almost every analyst and her aunt rushed to revise their GDP projections downwards. Roughly, the projections now range between 8 per cent and 12 per cent contraction of the GDP for FY2021.

Of course, there are outliers such as Goldman Sachs, the US investment bank and financial services company, which expects India’s economy to contract 14.8 per cent in 2021, the lowest forecast so far, compared with 11.8 per cent predicted earlier. On the other hand, ICICI Securities Primary Dealership Ltd, an arm of ICICI Bank Ltd, has stuck to 7 per cent contraction.

All eyes are on the Reserve Bank of India’s (RBI) October 1 monetary policy — not for any action in terms of rate cut but for the central bank’s assessment of the GDP growth for the current year. So far, it has refrained from giving any projection. The official reason for this is the uncertainty surrounding the Covid-19 pandemic and its impact on the economy.

The government has also been shy of talking about the current year’s contraction in economy. Krishnamurthy Subramanian, chief economic adviser in the finance ministry, says many sectors are on a recovery path and the reforms undertaken will deliver a long-lasting growth impetus. In a recent presentation to the ministry, Subramanian has pegged the growth of nominal GDP – as opposed to real GDP, adjusted for inflation — in 2022 at 19 per cent, but he is silent on 2021.

The RBI is expected to give its projections for GDP at the forthcoming policy. What the figure could be is anybody’s guess but I will not be surprised if the Monetary Policy Committee (MPC) with three new members on board plays safe and gives a range in single digits for an estimated growth contraction, say 6-8 per cent.

It will also probably give its estimate for inflation for the second half of the year. The flexible inflation target mandate for the MPC is 4 per cent with a band of 2 percentage points on either side. In eight of the past nine months (between December 2019 and August 2020) inflation crossed the upper end of the band, the highest being 7.59 per cent in January 2020. It was within the range only in March 2020 (5.84 per cent).

The base effect will come into play soon and inflation is bound to go down. In the October-December quarter, it could be around 5 per cent or slightly more, dropping to 4.5-5 per cent in the January-March quarter and sliding further to around 4 per cent in the first quarter of FY2022. The MPC may spell this out and use the inflation projection as a guidance to the market, keeping alive the hope of a rate cut next year.

Even though a severe growth contraction is for real, the RBI won’t cut the rate yet again now to push demand for credit. In May, it went for an out-of-turn rate cut for the second time in a row, paring its policy repo rate to a historic low of 4 per cent. Since March, it has cut the repo rate, or the rate at which bank borrows from the RBI, by 115 basis points. The reverse repo rate, or the rate at which banks keep money with the central bank, is also at its lowest now, at 3.35 per cent.

Since the system is flush with liquidity, the reverse repo rate is the de facto policy rate now. Indeed, the excess liquidity, which was over Rs 5 trillion in April, has been halved but with no sign of credit demand, none is complaining.

Beside cutting the policy rate sharply, the RBI has also flooded the system with money through a Rs 1.25 trillion long-term repo operation, or LTRO, and another Rs 1.129 trillion such facility, targeted for particular segments of economy (called TLTRO). Of the Rs1.25 trillion liquidity infusion in tranches in February and March through the LTRO window, close to Rs 1.235 trillion has flown back to the RBI.

The challenge before the RBI is ensuring the government’s borrowing during the year to bridge the high fiscal deficit at low cost. Simply put, keeping the bond yield low. The yield and prices of bonds move in opposite directions. Rising prices attracts buyers – mostly banks. The 10-year bond yield, which rose to 6.27 per cent in the last week of August, is now hovering around 6 per cent.

The market wants the yields to drop; the central bank too doesn’t want the yields to rise. Which is why there have been devolvement of bond auctions on the primary dealers (around Rs 58,000 crore) and the RBI did not entertain a single bid at its first Rs 10,000 crore bond buying through open market operations (OMO) last week.

The central government plans a gross borrowing of Rs 12.06 trillion during the year. Out of this, it has raised Rs 7.68 trillion in the first half of the year (exercising green shoe options). The borrowing calendar of the second half, expected to be released before the policy, should be Rs 5 trillion but extra borrowing can always be announced later. Add to that the borrowings by the state governments, which will gain momentum as the fiscal year progresses. As a substantial revenue shortfall is staring at the government, the combined borrowing of the Centre and the states could be Rs 22 trillion, or even more.

Will there be takers for such a lot of government papers? If the demand sags, won’t the bond yield rise? To manage the yield, the RBI has so far done simultaneous purchase and sale of government securities under the OMO to the tune of Rs 1.37 trillion.

The twist or Indian version of quantitative easing will not be enough to manage the massive government borrowing programme with ease. What we may see now is the RBI purchasing bonds from the secondary market under OMO or covert monetisation. The first such OMO last week did not succeed as the RBI was not willing to accept higher yield. It can buy at least bonds worth Rs 1.235 trillion through this route – the LTRO money that has flown back to it – without expanding its balance sheet.

If that’s not enough, it can go for overt monetisation – printing money. No one will quibble with that at the current juncture. Along with rate cuts, we have seen non-monetary measures such as twists, OMOs and reshuffling of banks’ bond portfolio. Direct monetisation won’t surprise anyone. After all, the RBI is committed to “do whatever is necessary to revive the economy and preserve financial stability”.

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