The RBI’s Growth Gamble: More Hope Than Strategy

The Reserve Bank of India stepped off its well-traversed path of interest rate cuts last week by announcing a series of steps aimed at reviving growth.

The central bank announced what it called ‘Long-Term Repo Operations’ along with relief in setting aside cash reserve ratio against lending to some sectors, while also providing asset classification forbearance to some of these segments.

The idea, if you connect the dots, is to incentivise banks to lend more to sectors that are believed to have a strong multiplier effect.

While the central bank probably sees these three steps as being in sync with each other, it may be worth looking at each step individually. For, in the process of each of the steps playing out, much could go wrong.

Long-Term Repo Operations

Long-term repo operations were used in western economies when their respective central banks had hit the zero-lower bound on interest rates. In India, the RBI has adopted this tool well before that and despite the fact that it continues to guide towards more interest rate cuts.

But since it believed that the impact of policy rate cuts was dulled by weak lending, the RBI decided to try and shake up banks and push them into lending.

By providing banks assured liquidity for a relatively long term (1-3 years), at a low cost (the benchmark policy rate), the RBI hopes that banks will lend more than they have been doing so far.

The reasons behind weak lending appear to be a complex mix of factors. In some cases, it is continuing fear of scrutiny from vigilance agencies, in other cases it stems from genuine signs of rising risk, in still others, it is about limited management bandwidth due to mergers which are underway. The result is that banks are parking surplus funds with the RBI instead of lending.

The RBI is betting that by providing a certain amount of assured long-term money at a low cost, banks will shake off some of the inertia that has gripped them and restart lending. Sure, that’s worth an effort, would be one response.

But, just as easily, it may not play out that way.

“We need to watch the end-use of the money tapped under LTROs. If the borrowed money is parked in government bonds, it effectively can lead to advancing of demand for government bonds for statutory liquidity ratio from next year,” said Anubhuti Sahay, head of South Asia economic research at Standard Chartered Bank. This, in turn, can lead to a rise in yields whenever monetary policy falls out of sync with fiscal policy, particularly if fiscal consolidation gets pushed back further, Sahay said.

Also it is worth pointing out that between ‘Operation Twist’ and the ‘Long-Term Repo Operations’, the RBI has now distorted the yield curve both at the short end and the long end. In doing so, it has perhaps only managed to paper over genuine concerns such as fiscal slippage and credit risk that were being priced into interest rates.

“We are assuming risk-free transmission of monetary policy and we are forgetting that perceived credit risk is increasing in a weak economy. Also there is now more sensitivity to pricing in credit risk,” said Deep Mukherjee, risk consultant and visiting faculty at IIM-Calcutta. LTRO will reduce the liquidity premium but increased credit premium remains unaddressed, Mukherjee said.

CRR Exemption

The second piece in the RBI’s growth gamble is the CRR exemption.

The extent of incremental auto loans, retail housing loans and micro, small and medium enterprises loans can be deducted from the deposit’s base before setting aside CRR. This will reduce the ‘negative carry’ on these loans and push banks into lending to these segments could be the arguments to support this view.

Of these three segments, retail housing loans are growing at 17 percent year-on-year as of December 2019. That is more than twice the nominal GDP growth. Growth in vehicle loans has slowed to 7 percent but many would argue that in the case of automobiles, it’s the slowdown in sales that led to the slowdown in credit and not vice versa.

As for small business loans, the problem is of genuine credit risk that banks have to worry about. Also there are schemes such as the Mudra Yojana and the MSME restructuring that are already intended to provide support to that segment.

By pushing banks to lend to these sectors, are you incentivising riskier behaviour? To be sure, the RBI has not reduced risk weights against lending to these sectors; so perhaps it hopes that even if increased sanctions to these segments entail higher risk, bank balance sheets would have adequate buffers against this risk.

Restructuring Forbearance

And that brings us to the final element in RBI’s pro-growth strategy, which is extended restructuring forbearance to MSMEs and some elbow room for delayed real estate projects.

Past experience has shown that the restructuring proves to only delay recognition of bad loans. We not only saw this in the case of large corporate loans but also in small business loans in the aftermath of demonetisation. When the forbearance ends, banks inevitably see a jump in bad loans.

Fitch Ratings, in a note on Monday, raised concerns over this part of the RBI’s decision.

“The RBI’s extension of the one-time restructuring scheme for micro, small and medium-sized enterprises and the announced relaxation in asset classification for certain real-estate projects mark a further dilution of the regulator's drive to enhance loan recognition,” said Saswata Guha, director for financial ratings at Fitch Ratings.

Fitch believes that these extensions are only likely to defer asset-quality pressures unless there is a sustained improvement in macroeconomic conditions, Guha added.

In final analysis, in addressing the growth risks that the Indian economy is facing, the central bank is taking some risks of its own. It ought to watch closely to see whether those risks are paying off in the intended way or if they are leading to unintended consequences.

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