RBI's pause and no change in stance may continue

The Budget of aspiration, economic development and care for all is behind us. Let’s focus on the next big event — the last bimonthly meeting of the central bank’s Monetary Policy Committee (MPC) in the current financial year. The Budget is its backdrop. The Reserve Bank of India (RBI) has got a new deputy governor, Michael Patra, overseeing the monetary policy department, including its forecasting and modelling unit. There is also a new member — Executive Director Janak Raj — at the central bank’s rate-setting body, the MPC. 

On expected lines, the Budget has revised the fiscal deficit target for 2020 to 3.8 per cent of GDP and pegged the deficit for the next financial year at 3.5 per cent. The original estimate for the fiscal deficit for 2020 was 3.3 per cent; the half a per cent rise is in sync with the so-called escape clause in the Fiscal Responsibility and Budget Management Act which, among other things, allows such a deviation in case there are far-reaching structural reforms in the economy with unanticipated fiscal implications. Of course, it mandates that such a deviation should be accompanied by a clear commitment to return to the original fiscal target in the ensuing fiscal year. For 2021, the estimated deficit target is 3.5 per cent of GDP.

There is no surprise in the government borrowing targets too. In the current fiscal, the gross borrowing target remains unchanged at Rs 7.1 trillion. For the next year, the gross borrowing target has been raised to Rs 8.1 trillion. It may look a bit intimidating but it will sail through without putting pressure on the bond yields. In fact, yields could drop this week. 

There is ample liquidity in the system (surplus daily liquidity is currently pegged around Rs 2.80 trillion, thanks to government spending) and it is fairly certain that the RBI would continue with its Operation Twist (OT) to manage the yield.

From December 2019, the RBI started conducting OT by simultaneous buy and sale of government securities. It is buying long-tenure bonds (10-year papers) and selling short-term ones (up to two years) to bring down the bond yields and flatten the curve, narrowing the term premium. The 10-year bond yield, which rose to 6.8 per cent in the recent past fearing higher government borrowing to bridge the widening fiscal deficit, closed last week at 6.6 per cent. 
Just before the first round of such buy-sell auction took place, the 10-year government bond yield was 6.75 per cent. However, the 15 basis points (bps) drop in bond yield does not give the correct assessment of the impact of OT. In the absence of this, the bond yield would have risen further, inching towards 7 per cent. One bps is a hundredth of a percentage point.

OT “manages” bond yields, brings down the cost of borrowing for the government and saves banks from treasury losses. However, what we are seeing now is a combination of OT and the so-called open market operations (OMO) of the RBI as it is buying more and selling less. Through four such auctions, the central bank has bought bonds worth Rs 40,000 crore but sold Rs 28,200 crore. Traditionally, bond buying through OMO is done to create liquidity; this time around, the objective is clearly to “manage” bond yields. This is likely to continue to ensure a smooth  sailing for the government borrowing programme without increasing the cost.

The Indian economy grew at 4.5 per cent in the September quarter, falling for the sixth quarter in a row. The Economic Survey has pegged the growth for the current year at 5 per cent and the next year at 6-6.5 per cent. The Budget estimate of growth for 2021 is more conservative — a nominal GDP growth of 10 per cent. What will be MPC’s projection of growth in this round? Since February, each policy meeting, including the last in December, cut the growth estimate — overall by 240 bps, from 7.4 per cent to 5 per cent. 

In December, all six members of the MPC took a call for status quo. Before that, since the beginning of the rate cutting cycle in February 2019, the MPC always cut the rate — cumulatively by 135 bps, from 6.5 per cent to 5.15 per cent. 

Of course, in December it had an unambiguous forward guidance: The pause is temporary and there is monetary policy space for future action.

With further rise in inflation, one would assume the RBI would continue to be in a pause mode but there would not be any change in its accommodative stance. The future action will depend on data — both inflation and growth. 

In the December policy, the RBI moved the retail inflation projection sharply upwards to 5.1-4.7 per cent for the second quarter of 2020 with food, fuel and a hike in telecom tariff contributing to it. The December retail inflation rose to 7.35 per cent, a 64-month high, breaching consensus estimates of analysts and sailing past the upper end of RBI’s inflation target band (4-6 per cent). In November, the retail inflation was 5.5 per cent. 

 
Most analysts expect the January inflation number to be way above 7 per cent and more than 6 per cent at least till March. The surge may not last for long and, in the second half of 2021, retail inflation could come down to 5 per cent and drop further.

The MPC will keep a hawk’s eye on inflation but is unlikely to act at this point. An extended pause and accommodative stance are likely to continue till the growth momentum picks up. Depending on the growth-inflation dynamics, we may see a rate cut or even a hike in the second half of 2021. 

TamalBandyo 



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