RBI: Emerging Risks, Preponed MPC Announcement and Interest Rate Signaling

The MPC announcement on 22nd March highlights the mounting pressure and potential risks to the Indian financial system, deteriorating inflation, and growth outlook due to SARS-CoV2 (COVID - 19). The Reserve bank continued with the accommodative stance stating the necessity to revive growth and mitigate the impact of coronavirus (COVID-19) on the economy. The policy repo rate was trimmed by 40bps to 4 percent, correspondingly the MSF and Bank Rate were reduced to 4.25 percent from 4.65 percent.

In addition to regulation and supervision measures announced for the ease of compliance and incentives to businesses, banks, and other stakeholders, the rationale and outlook which prompted this intervention were based on the following issues:

a) Global Developments:

• The macroeconomic outlook across the globe continues to witness an economic fallout. Advanced economies (US. Euro area, Japan, and the UK) saw a contraction of 3 to 14.2 percent in Output (Q1 2020). The growth ranged between 20.1 – 6.8 percent.

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• Emerging Market Economies (EMEs) continue to witness asset price volatility along with increased capital flows in March.

• The Manufacturing PMI dipped to 11-year low in April while the Services PMI also declined to a historical low.

PMI Heat map Scale

PMI Heat-map of Emerging Economies in ASIA

• In the commodity markets, low crude oil prices have dried the revenue sources while the gold prices continue to remain elevated as a safe haven.

• Global trade has contracted by 3 percent in Q1 2020 (UNCTAD).

b) Domestic Developments:

• The domestic economic activity has been severely impacted due to lockdown. Top six industrialized states contributing more than 60 percent to total output are still in Orange or Red zones.

• High-frequency indicators reflecting the demand for both rural and urban areas since march 2020 point towards contraction.

• The fiscal position of the states and the union government is deteriorating due to shrinking demand and stand still production units.

• Investment demand has halted by the decline in the production of capital goods by 36 percent in March which was coincident with a 27 percent fall in imports of capital goods in March and 57.5 percent in April.

• Further, a fall of 91% in finished steel consumption in April and 35% shrinkage in cement production during the march.

• Manufacturing PMI in April recorded the sharpest contraction to 27.4, spread across all the sectors.

• The Services PMI to an all-time low of 5.4 % in April 2020.

• The green shoots in the economy have been received from agriculture and allied activities.

• Food production witnessed an increase of 3.78 percent as compared to the previous year.

• Kharif sowing was higher by 44 percent as compared to April of the previous year.

• The Indian Metrological Department has forecasted normal Southwest Monsoon which promises moderating inflation. But, the current inflation outlook is getting complicated with partial insights from NSO. Food Inflation has jumped to 8.6 percent in April 2020 with vegetables, pulses, oilseeds, cereals counting for the maximum surge.

c) External sector:

• The worst slump in 30 years Merchandise exports declined by 60.3 % and imports fell by 58.6%

• Forex reserves have increased by 9.2 billion in April and currently stand at 487 billion USD which can meet a one-year import bill.

Overall, the Inflation and growth outlook remains uncertain. Supply shock may persist depending on lockdown and time lag in restoring supply chains. Oil, metals, and industrial raw materials are likely to remain cheap which is welcoming for the industry in the near future as India gradually heads toward phased relaxation. Deficient demand may keep core inflation low but the future course of the policy depends much on the recovery after COVID-19. One must note that the growth risks have been projected highest with GDP estimates likely to remain negative in 2021, and the forward guidance for policy remains directional. A clearer picture will be available as soon as new data arrives. The market reaction to the proposed stance was not very welcoming. The government bonds declined by 3-8 bps on 22nd May. So far, the sentiment of the market has not been upbeat and the interest signaling should address the doubts among stakeholders. The efforts in terms of easing the compliance requirement and smooth liquidity access to the businesses and financial intuitions should remain continuous, taking inputs from the feedback generated day by day. The RBI still has a window of 4 percent, though hitting the zero lower bound is not immediately desirable given the lag impact of policy transmission. Further the unconventional tools like LTRO etc., are in hand to proactively intervene whenever required.