RBI’s 2021 Agenda: Sequencing The Exit From Covid-Relief

From returning to tighter management of bank asset quality to slowly withdrawing a slush of liquidity – a return to steady state will be the challenge for India’s full service central bank this year.

Restructuring Window Closes

A beginning towards this return to normal has been made.

Last week, as the year turned, the RBI allowed its one-time loan restructuring scheme to close as scheduled. The window permitted restructuring for advances which were not in the non performing category before the Covid crisis hit, without a downgrade in asset classification. Announced in September, the provision had marked a return to the dreaded past of regulatory forbearance.

The outcome of the restructuring exercise has been surprising. BloombergQuint reported that only about Rs 2 lakh crore in advances were submitted for restructuring under the provision. That is less that 5% of the near Rs 40 lakh crore in outstanding advances that availed of the RBI-permitted moratorium on loan payments between April and August.

The message in that outcome is ambiguous. Does it suggest that bank asset quality was actually better than feared? Or does it suggest that banks were reluctant to restructure loans but may see bad loans rise over the next few quarters? While the answers to those questions may take time to emerge, in closing the window on schedule, at least for large corporations, the RBI has shown some discipline.

The same cannot be said for MSME restructuring provisions. First put in place in January 2019, MSME restructuring without an asset classification downgrade has now continued for more than two years. The window is scheduled to close on March 31, 2021, and the regulator should avoid extending it further.

Subtle Shift In Messaging

The next and more challenging step for the central bank will be normalising easy monetary and liquidity policies particularly if inflation continues to be sticky. As central banks world over have realised since the global financial crisis, communicating and maneuvering this exit is as tricky as it gets. Think taper tantrum.

In India’s case, two things happened after the onset of the Covid crisis. First, the central bank slashed interest rates and allowed a flood of liquidity to persist. Second, it signaled that it was looking through a bout of above-target inflation. The combination of the two helped keep interest rates in check despite record high government borrowing.

What appears to have happened alongside is that bond market’s perception of the RBI’s commitment to its inflation target of 4 (+/-2)% shifted. A view emerged that perhaps the regulator was adopting a more liberal interpretation of its inflation target.

Words from top central officials in recent communications have signaled to the markets that this is not the case.

The first signal came in the minutes of the December Monetary Policy Committee meeting. In his written statement, RBI executive director Mridul Saggar made two important comments:

• “Accommodative monetary policy has been misread by some as demise of inflation targeting. Quite to the contrary...”, Saggar wrote explaining that it is the large output gap that is driving the monetary policy stance. With the output gap likely to persist till the second half of 2021-22, there is time to normalise monetary policy, he said.
• But Saggar also said that liquidity, credit and monetary aggregates will need to be “closely monitored” with an eye on macro-financial stability. He noted that the persistence of negative real rates for too long can adversely affect savings, lend support to mispricing of financial asset prices and encourage excessive leveraging.

This may have been the first hint to markets that some normalisation of liquidity conditions is around the corner.

Separately, on the question of the RBI’s view on inflation, a working paper authored by Harendra Behera and deputy governor Michael Patra, showed that a 4% inflation target remains appropriate for India. While the paper may represent the views of the authors rather than the institution, it signals that at least the RBI may continue to back a 4% inflation target.

This too should act as a reality check to the bond markets if they were hoping that the RBI would back a higher inflation target. Of course, the final decision on this rests with the elected government.

Sequencing The Exit

While there may be a shift in direction of the monetary policy winds, the RBI will need to send clearer signals about its exit path if it wants to prevent a localised version of the taper tantrum.

The first thing to do is to shift communication to reflect that the Indian economy is out of crisis mode, even though far from pre-Covid levels, says Soumyajit Niyogi, associate director at India Ratings & Research. A shift in this communication will help prepare the markets.

When should this communication begin? Views differ.

Jayesh Mehta, head of treasury at Bank of America does not see any need for this shift before April. The easy liquidity, he says, is not fuelling a surge in credit growth and hence is not inflationary, at least at the current juncture. As such, the RBI may not need to worry about pulling back immediately, Mehta says.

Kaushik Das, chief India economist at Deutsche Bank believes it could be sooner, particularly as the liquidity surplus persists even after the advance tax outflows. There is “scope for RBI to announce some measures to rectify the price of liquidity before the February 2021 monetary policy meeting,” Das wrote in a December note.

As for the tools that the RBI can use, there are now many given that the central bank has widened the set of options it uses to manage liquidity.

The various tools and instruments used in the last ten months will be useful to unwind ultra-loose policy without touching the Repo rate, says Niyogi. RBI could start with normalisation of cash reserve ratio to 4% in a staggered manner outside the policy review and then look at normalisation of the repo-reverse repo corridor. “At every point, action has to be well guarded by the tactical communication without stoking signal extraction problem.”

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.