India: RBI maintains a dovish stance
- RBI’s monetary policy committee leaves the policy repo rate and LAF corridor unchanged
- Liquidity management is likely to increasingly shift to the variable operations
- On the fiscal end, strong tax buoyancy will help absorb higher spending demand in FY22
- With an eye on Covid and US Fed’s policy path, we maintain our rate hike call
RBI’s monetary policy committee held the repo rate unchanged at 4% in a unanimous decision, with a 5-1 vote to extend the accommodative stance. The corridor was also held steady, with the reverse repo rate at 3.35% vs our expectation of a 20bps increase, and Marginal Standing facility (MSF) at 4.25%.
In accordance with the revised liquidity management framework tabled in February 2020, operations will increasingly shift out of the fixed rate overnight reverse repo window into the variable rate reverse repo (VRRR) auctions. Governor Das reinforced that the objective was to re-establish the 14-day VRRR auction as the main instrument for liquidity management. This might be complemented by longer-tenor auctions, if required. The earlier announced glide path had seen the auction amount gradually raised to INR 6trn, which will now be increased to INR 6.5trn on Dec 17 and INR 7.5trn on Dec 31. From Jan22 onwards, absorption will be mainly undertaken and fine-tuned through the auction route.
Growth and inflation projections were held unchanged. On growth, the committee drew confidence from the pickup in 2QFY22 growth but doubts over durability of the recovery path, complicated by the emergence of the new variant Omicron, backed their decision to extend their pause on rates. Recovery was seen as becoming broad-based, helped by the vaccination rollout, government’s capex push, better rural demand, and spurt in contact-intensive services, but downside risks were seen from volatile commodity prices, persistent global supply disruptions, new Covid mutations and financial market volatility. With risks evenly balanced, the FY22 growth forecast was held at 9.5% yoy, with minor tweaks to the 3Q-4QFY22 projections (see table).
Inflation is seen as biased for further upside, likely to peak in the Mar22 quarter. Two-way forces are underway, according to the RBI, with pressures to soften on a) spurt in vegetable prices to reverse as winter approaches; b) on track rabi sowing; c) pro-active supply side interventions by the Government; and d) retreat in global commodity prices especially oil. These were, however offset by cost-push pressures from high industrial raw material prices, transportation costs, global logistics and supply chain bottlenecks, which are seen as underpinning core inflation. The FY22 inflation projection was held at 5.3% yoy.
Our take is that inflation risks cannot be dismissed as the pullback in Sep-Oct inflation is expected to be short-lived and CPI inflation to edge back towards the upper end of the RBI’s target range into early 2022, lifted by volatility in perishable food items, telecom price hikes, sticky inflationary expectations and pass-through of elevated input prices. These might necessitate an upward revision in the inflation forecast at the upcoming rate review.
RBI’s stance on Wednesday points to a long and gradual road towards policy normalisation. Guidance reinforced that the MPC’s priority is to secure growth impulses and preserve policy room to meet this objective, diverging from the global policy shifts, particularly that of the US Fed. Even as inflation risks were highlighted on imported pressures and volatility in food, ‘flexibility’ in the price stability mandate will see the recovery path dictate policy direction. There was little by way of a proposed normalisation plan.
On liquidity, the central bank signaled that the VRRR auctions will be the primary route to modulate surplus conditions from 2022. Liquidity absorbed by the fixed reverse repo window has moderated in recent months as guided by the central bank, hovering at around INR 2trn late last month, from the region of INR 5-6trn in August. The RBI clarified in the press conference, that the plan was not to completely run-down funds placed under the fixed reverse repo window, but rather finetune the surfeit through variable rate auctions. With more liquidity being absorbed by the high-yielding VRRRs, the relevance of the fixed RRR window, apart from being limited to entities that don’t have access to the RBI windows, might fall further. To recap, the 2020 Liquidity Management Framework highlights a combination of 14-Day VRRR, tenors of upto overnight to 13 days, fixed RRR, MSF, FX swaps and Standing Deposit Facility (SDF) as instruments to manage short-term liquidity. Durable liquidity ought to be managed through VRRR >14days, OMOs and FX swap auctions. Separately, allowing the repayment of earlier LTROs is perceived as another small step to lower liquidity, as banks could utilise their surplus towards this end.
Existing liquidity has already been repriced higher courtesy the string of VRRR auctions, which in turn has driven up money market/short-term rates. The weighted average rate of the variable and fixed RR was at 3.8% ahead of the policy, closing in on the repo rate, thus amounting to stealth normalisation in liquidity conditions, even as the fixed RRR stays at 3.35%. Persistence in the banking system liquidity at levels well in excess of pre-pandemic surplus, will require further action into 2022. Increase in the reverse repo rate might be taken in February or outside of the formal reviews, and with money market rates also adjusting up, any hike in the RRR is likely to be non-disruptive.
Emergence of a new Covid variant underscores the uncertain path of the pandemic, with global public health organisations in the midst of determining its virulence and fatality rate. Whilst the endgame of the pandemic is shrouded in considerable uncertainty, we assume that the world is entering a stage where the pandemic is likely to become endemic. The next policy will be in February 2022, soon after the Union Budget. We expect the committee to take stock of the economy, shape of the borrowings program for FY23 and state of the pandemic before arriving at the decision. Against this backdrop and that the US Fed continues to taper asset purchases and hike rates thereafter, we expect India’s repo rate to also be gradually adjusted higher from 2H22.
The pandemic situation is the key wildcard. Signs of a worsening outbreak/third wave will push policymakers to err on the side of caution and slip into an extended status quo, in light of the wide output gap and demand compression.
Financial conditions index – an update
Our Financial Conditions Index for India (Mapping India’s Financial Conditions Index (FCI)) shows the aggregate monthly index was close to the baseline (zero) mark as of late-Nov. The sub-segments i.e., bond and currency indices signal incipient tightness, which is negated in part by gains in the equity sub-index (to arrive at the aggregate). The bond market FCI was a smidge above the baseline, mirroring the modest rise in yields and markets-based borrowing costs. This lift is also partly exogenous i.e., policy normalisation expectations in the US – taper might be completed earlier and hikes thereafter – have lifted the US yield curve, alongside rally in commodity prices, which has resulted in inflationary concerns. The currency sub-index has inched above the base line as a global dollar rally has weighed on the INR.
Fiscal policy: Spending needs unlikely to disrupt the math
Strong revenues and slow expenditure have helped to keep the FY22 fiscal slippage in check yet far. Apr-Oct21 deficit stood at 36.3% of the full year budgeted estimate, modest compared to ~120% same time last year and longer-term average of 70-80%. Tax revenues stood at 68% of the target, whilst spending catches up at 52%.
Revenue collections have notched strong growth compared to the pandemic inflicted FY21 as well as pre-pandemic FY20, led by excise duties (27% in FY22 vs FY21) and direct taxes up 70%. The strength in GST collections was reflected in higher e-way bill generation, with the broader improvement put to accelerated formalisation in wake of the pandemic, stronger compliance, reopening gains as vaccination gains pace and festive buoyancy in late 3Q21. Higher than expected transfer by the RBI was an additional boost. However, non-debt capital receipts which includes divestment is at 10% of the FY22 target. Assurances that one-two big ticket offerings (LIC, BPCL) might be successfully conducted within the fiscal year, will be watched closely.
Strong direct tax revenues (70% yoy) points to high tax buoyancy in FY22, compared to a double-digit nominal growth (DBSF: 16.5% vs budgeted 14.4%). Whilst this provides sufficient cushion to the fiscal math, higher spending demand is likely to narrow the potential overshoot in the deficit balance. Firstly, quarterly caps on ministries were lifted and given the need to spur capex/ infra growth and ahead of upcoming state elections. Secondly, the centre has proposed a second additional net spending of ~INR3trn (net of INR 745bn to be met by savings) comprising of a) fertiliser subsidy (INR 584bn); b) exports incentives (INR 531bn); c) national employment scheme NREGA (INR220bn); d) national carrier Air India debt to be cleared (INR 620bn) and e) higher food subsidy outlay (INR 498bn). This is in addition to the parliament nod of additional spending of INR 237bn in the first batch of supplementary demands for grants in August.
These spending demands are likely to be offset by the anticipated buoyancy in revenues but is unlikely to disrupt the fiscal math. Stronger-than-budgeted nominal GDP growth will also amount to an additional buffer of ~0.2% of GDP. From an anticipated -6.6-6.8% this year, we expect the budgeted deficit to be set at a narrower -6% of GDP in FY23.
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