No change in stance, more light on forex depletion: Mint 1st October 2022

 There weren’t any major surprises in the credit policy announced by the governor of the Reserve Bank of India. Intense debate on the possibilities in the policy were flagged in the run-up to this announcement as all analysts and economists tried reading into the mind of the central bank. The summary of MPC meeting indicates that almost all announcements were in accordance with the market expectation, with a possible deviation being only on the stance. The market can take solace from the fact that the RBI has assured that in its view, the economy is resilient and that inflationary pressures, caused by a variety of factors would stay for this year.

The RBI has increased the repo rate by 50 bps, which was expected given that in the prelude to this announcement, the governor spoke of the third shock that we are witnessing i.e. central banks across the world raising rates to tackle inflation. The other two shocks were covid and Ukraine war. Hence, while the impression so far was that policy is normally driven by domestic considerations, there has been an indirect reference made on the approach taken by the Fed and ECB which affect us through the investment route and also add to currency volatility. This being the case, the forward guidance provided by the major central banks is directed towards more aggressive increases in policy rates. The implication is that this may not be the last rate hike for us and that there could be more coming, which can take it to 6.4-6.5% by March. The one-year overnight indexed swap (OIS) was pointing at a number in the range of 6.5-6.75% for quite some time. The overall inflation target for the year remains unchanged at 6.7% as the pressures remain on food even while producers of manufactured goods are still in the process of passing on higher input costs to the consumers. The red flag is, however, more on the agricultural side where lower output of rice and pulses as well as the delayed withdrawal of monsoon can impact inflation. Hence the onion and tomato syndrome has to be watched out for where late withdrawal of monsoon damages crops and causes sharp increases in overall inflation.

The GDP growth forecast has been lowered marginally to 7% which is due to the statistical realignment which has taken place after the first quarter number came in lower than the RBI’s expectation. The RBI has actually increased its projections for Q2, Q3 and Q4 relative to its expectations in the August policy and backed it up with a strong story line on how the economy is faring based on all high frequency data such as PMIs, consumption, capacity utilization, import of non-oil goods etc. Therefore, for all practical purposes, the indication is that the growth trajectory is on the expected path and presently, there is no reason to believe that anything can upset the apple cart. This is premised on consumption continuing in Q3, which is the post-harvest and festival season when consumerism peaks in both rural and urban India.

The other part of the commentary which the market was looking at is the stance. Here, there may have been a surprise because the concept of withdrawal of accommodation will continue. It was felt that since the daily surplus liquidity had dwindled to a deficit at times would provoke some affirmative action by the RBI in terms of announcing Open Market Operations (OMOs). However, the RBI has explained that the temporary distortion was more due to advance tax payments and as the government will spend more aggressively in the second half due to habit, liquidity would be back to the above ₹2 trillion mark. Therefore, the stance has not really changed as there is space for further ‘withdrawal’.

Is the market comforted by the stance on the currency? Here only time will tell as the RBI is comfortable with the level of reserves and has reiterated that it has no number in mind and is more worried about volatility. The critical statistic that has been mentioned here is that in the fiscal year, of the $70 billion drop in forex reserves, two-thirds has been due to valuation of reserves. This should be comforting to the market as it was not quite clear if the RBI has been selling large quantities of dollars in the market to steady the rupee.

The RBI has been steadying the ship through inclement weather in the last three years or so ever since the pandemic began. Shocks have come from unexpected quarters which has made policy formulation tricky as the goal post has shifted from inflation to growth to inflation. The calibrated approach has ensured there have been no ugly shocks which is how it should be.

How will the credit policy affect us? Free Press Journal 1st October 2022

 For the common man a credit policy is important as it lays out the relationship between an individual and the bank. The RBI has hiked the repo rate by 50 bps which now takes it up to 5.90%. The indication is that there could be some more rate hikes coming and the level of 6% will definitely be crossed in course of time. How will this affect us?

Deposit holders would seek some solace from this move as the average return on a 1 year deposit is 5.8% which is still negative in real terms when juxtaposed with inflation that is running at 7% and will remain in the 6.5-7% range for the year. The issue is that when the repo rate goes up, the deposit rates do not move up by the same quantum. This is so because banks change interest rates depending on their requirements and may not typically like to lock in deposits for a long period of time. Over the last one year, this average rate has gone up by 50 bps while the repo was up by 140 bps. Therefore the response of deposit rates is slow. Yet higher rates will be beneficial given that RBI data on savings show that people have moved from deposits to stocks and mutual funds ostensibly due to expectations of higher returns. Increase in deposit rates can reverse this movement.

The government has also increased returns on some of the small savings schemes by between 10-30 bps yesterday keeping in tune with the rising bond yields in the market. However, this has been done selectively with PPF and NSC remaining unchanged which are typically for a longer duration compared with post office savings. This can be another nudge to banks to relook at their deposit rates as there is a clear gap between increase in deposits and credit this year in the banking system as the former has trailed. There is a negative gap of around Rs 70,000 crore in the system today which needs to be reversed as liquidity has tightened in the market.

Borrowers would have been prepared for this increase in repo rate and will have to fork out more on loans. Home loans and SME loans have been linked to an external benchmark, which is the repo rate. This means that as the repo rate increases, the interest rate to be paid goes up automatically. The SMEs will be hit directly if not part of the ECLGS scheme and individuals with mortgages will see longer EMIs. The 190 bps increase in repo rate since may will increase the cost of borrowing by an equivalent amount. However, loans which are based on MCLR would be less affected and hence the larger corporates will not really see their cost go up proportionately. MCLRs (marginal cost lending rate) has increased by 45 bps on an average basis in the last one year.

It is unlikely that higher interest rates will come in the way of growth because business invests when it sees growth prospects. Business is also aware of the fact that there are interest rate cycles when rates rise and fall. Therefore higher rates will not really be a deterrent though they would weight options in borrowing. The same holds for home buyers who are aware that in a 10-20 year tenure of loans, there would be phases when rates would go up thus elongating the EMI payments.

The important thing is that in this cycle of rising interest rates, the market should be prepared for these anomalies. The RBI had brought down the repo rate to 4% in March 2020 when the lockdown was announced as the goal was to support growth at any cost, hence even while inflation has ranged between 5.5-6.5% for two years until March 2022 the repo rate was kept depressed with several other liquidity measures being invoked like long term repo operations which targeted sectors that got loans at the linked repo rate. These were unusual conditions.

However, with normalcy coming back the repo rate had to be rolled back, because the general thought process was that there should always be a real return of 1-2%, and with inflation being above 5% since 2020, there was a strong case for the repo rate to be raised. It was only after RBI was certain that growth was here to stay which also coincided with the Ukraine war when inflation spiked faster to cross 7% that the stance changed to targeting inflation. This is what all central banks are doing. Hence the cost of capital was going to rise in the next cycle, which is what is being witnessed today. This cycle will continue till id-2023 for certain and the future inflation numbers will drive decisions on repo rate next year.

The RBI has sounded confident on growth which is a good message because there has been quite a bit of noise on how this number will look. The RBI has a downward revision from 7.2 to 7% which is more due to statistical reasons than loss of faith in the growth process. The inflation forecast has been unchanged at 6.7% though there can be an upside risk due to shortfalls in rice and pulses production and possible damage to horticulture crops.

With the festival season on the way there is a lot of hope being placed on consumer demand remaining buoyant and steady. This will need to be monitored because we have seen that high inflation has not so far deterred consumption due to pent up demand. The question is whether this scene will play out in the next three months too.

Views on pre and post credit policy.

 Pre-credit policy on Business Standard .

https://www.business-standard.com/shows/banking-show/business-standard-panel-on-rbi-s-policy-decision-and-rupee-expectations-1565.htm

Post credit policy on Business Today TV.

https://www.youtube.com/watch?v=4xyCjztINQU

The RBI’s rupee headache: Buisness Line 27th September 2022

 

DOLLAR STORY. For the central bank the biggest dilemma is to what extent it should intervene to shore up the rupee

The currency level for any country in the market is quite ironically in the hands of the central bank today. This rather unique situation has arisen due to the ‘dollar story’. The dollar has been appreciating relentlessly against the euro, which is the starting point.

Consequently all currencies have borne the brunt and central banks everywhere have to decide how to counter this phenomenon.

Let us see why the dollar is getting stronger even while everyone talks of a recession in the US. The Fed has been increasing rates which are now at 3-3.25 per cent and are set to edge higher. The median projections for the Fed fund rates are 4.4 per cent in 2022 and 4.6 per cent in 2023. This means there will be more rate hikes.

It is possible to assume that the US is a strong economy, which makes the dollar more attractive. But as the rates increase, inflation gets tempered and activity slows down, there could well be a recession. However, higher rates also mean that the US is back to becoming attractive as an investment destination.

Now, other central banks are also increasing their rates with the Bank of England increasing them by 50 bps. The ECB may be next with another 75 bps. But the Fed will be ahead and the dollar will get stronger.

Theoretically, after a point of time when the recession sets in, the dollar should weaken and the euro should be back to the level of $1.05-1.10. But this is still some way off.

In such a situation what should the RBI do? If the RBI sits back and lets the rupee fall, rupee depreciation will become a self-fulfilling prophecy. The market will conclude that the RBI is okay with a level of 81 or 82 and probably push for 83 depending on the feelers that it is getting.

Exporters will hold back their earnings hoping to convert at a higher rate at a later date. Importers will rush in to buy future dollars to cover their imports.

Speculative risks

This will create a demand-supply gap and push down the rupee further. Speculators will also punt on the rupee in the non-deliverable forwards (NDF) market and widen the gap, thus accelerating the movement. Once this happens the rupee could be in free fall.

The central bank cannot allow this to happen. There are advantages surely in having a weak rupee. It supposedly gives a country a competitive advantage. But when the world is slowing down and the other currencies too are falling, this may not turn into an advantage.

Exports usually do well when the global economy is robust. A weak world economy is not beneficial for exports. On the other side, a weakening rupee without checks will lead to higher cost of imports. And as India has a large trade deficit with imports being higher than exports, this will result in imported inflation.

Higher inflation will become an issue for the central bank at MPC meetings. Therefore, the central bank doing nothing is not a good idea.

The RBI has so far been selling dollars in the market to stabilise the rupee. Hence, while the rupee has fallen, it has been better performing better than other currencies. Meanwhile, forex currency reserves have now fallen by $93 billion on a year-on-year basis and $55 billion since March 2022.

A part of this decline can be attributed to revaluation of reserves which happens automatically when the dollar strengthens and the euro, pound and yen (which are other minor components of our forex reserves) weaken. The RBI has also taken positions in the forwards market to drive sentiment. Evidently, the impact has been limited with the Fed factor dominating all movement of currencies.

Forex reserves

The question is: how much forex assets can the RBI keep supplying in the market to stabilise the rupee? The global reaction to the Fed is getting stronger. FPI flows are becoming volatile once again. August was a good month for us while the same cannot be said about September so far. The RBI has managed to control the rupee up to the ₹80/$ threshold. The market believed that the RBI would use reserves which had been built up in the past to defend the rupee.

But it should be remembered that all these reserves have come in not due to a current account surplus but capital flows, and cannot, or rather should not, ideally be used to protect a current account deficit which is also being driven by global factors.

The rupee has crossed the 80 mark and is now testing 82. It does appear that the RBI will now let the rupee slide a little more and probably would use other tools to intervene.

One way out is to go in for larger rate hikes. While these cannot match the Fed’s rate hikes, they will still send the signal that we are on the same page. Policy announcements are already in place such as getting in more ECBs, NRI deposits and FPIs. Those measures announced a couple of months back have not quite brought in funds and would take time to work under normal conditions.

As currency management gets interlinked with monetary management, the rupee movement cannot be left to the market. For the RBI there will be trade-offs. Forex management is now becoming an integral part of policy formulation as it affects not just inflation but also liquidity. Every time dollars are sold to banks, liquidity falls and it comes back to the door of the RBI; with liquidity now being tight, measures for inducing liquidity have to be part of the agenda. It is tough being a central banker in these times.

Indian banking in a breeze: Here’s a book guiding for quick and effective banking system: Financial Express 26th September 2022

 Raravikar’s new booklet on Indian banking is just the kind of quick reading for a novice who would like to have a grasp of the Indian banking system over the past 75 years. The timing is appropriate as the nation celebrates its 75th year of independence. A foreword by Bibek Debroy adds the embellishment to this work.

Raravikar, who works in the RBI, has a ringside view of the system and working with the ministry of finance earlier adds to the nuanced view he takes on the system. He traces the history of the banking system even before independence and it will be of interest to note that professional banking started around 500 BC.

There is also mention of such activity in Kautilya’s Arthashatra where the concept of bills of exchanges, also called hundis, were used for carrying out transactions. The first bank in India was Bank of Bombay which was set up in 1720. This kind of trivia would hold the interest of the reader as the evolution process has been put together in just around 50 pages.

The author divides his narration across time periods, the first one starting post-independence till around 1967. Banking was largely driven by private players and the concept of interconnected lending remained where deposits mobilised were used for financing their own group of companies. There was not much focus on what we call inclusive banking today, which at that time pertained to agriculture. There were bank failures as early as 1948 and the RBI was not what it is today. The RBI got its authority in 1949 with the Banking Companies Act being passed. The author takes us then through the concept of bank mergers of failed banks as well as the setting up of Deposit Insurance Corporation of India in 1962. The Sixties were also typified by droughts where the government had to spend a lot of money and the RBI followed an accommodative stance. To enable this, interest rates also tended to be fixed with minimum and maximum rates.

The phase post 1967 till the time of reforms was typified by nationalisation, when the structure of banking was geared more towards meeting the larger expectations of the national aspirations. Public control of banks made it easier to also push through government agenda on spreading banking to rural areas as also ensuring banks lent money to agriculture, which was the need of the hour post the droughts. This also led to ‘loan melas’ to further credit growth. The author subtly points out that all this led to quite a bit of chaos in the system as the government, too, was borrowing from the system with the SLR being kept very high. Inflation resulted in rather large numbers. In a way the author is also indirectly cautioning on what could happen if the system is not regulated in an appropriate manner today.

The post 1991 scenario is split by the author in two phases, where the first one takes us swiftly through the myriad changes with a thrust on soundness and freeing the markets in every way. In a way it is a tribute to the Narasimham Committee that drew the blueprints for financial sector reforms. The focus continues with a larger description of what all was done on the recovery front post-1998, which was when the Asian crisis erupted. The models which were used in some of those countries were templates that could be used in India. The concept of what we talk of bad banks today as well as ARC sand SARFAESI concepts germinated from these experiences.

The author then takes us through the phase post financial crisis of 2008 with Basel being the fulcrum as BIS set the guidelines that all central banks took up and followed at their pace depending on local conditions. The reform under Indradhanush was the next big thing for Indian banking in 2014, which is still in the process of being followed.

The author also highlights governance issues where he believes the board and management need to be given more autonomy for running banks in a professional manner. One can guess that he is alluding to public sector banks as there is also talk of alignment of compensation of staff. This is a strong message being transmitted here.

This is a rather interesting narrative on the evolution of the banking system with some strong messaging along the way probably highlighting what pushed us back in the past which should not be repeated. The booklet should be useful for anyone who wants to know everything about this story in a concise form.

Indian Banking in Retrospect: 75 Years of Independence
Ashutosh Raravikar
Aswad Prakashan
Pp 79, Rs 99

After US Fed's hike, RBI action in the next two days to decide rupee's fate: Business Standard 22nd September 2022

 The rupee at 80 may be transient if one goes by recent history. Every time the rupee has crossed this mark there has been intervention to steady the volatility. The currency market today is being driven by one overwhelming feature - the dollar-euro relation - which has tended to put relentless pressure on all currencies. The US Federal Reserve has increased rates by 75 bps and the indication is that the rate will go past 4 per cent to 4.4 per cent by the end of the year. This means that the dollar will continue to strengthen and collateral effects will be felt on other currencies.

The rupee is already being pressured by the widening Current Account Deficit (CAD). It can go up to 3-3.5 per cent for the year. The reason is not hard to guess. The trade account is widening fast as exports growth is now moving closer to the negative zone with the global economy slowing. Imports are rising as India is still a fast growing economy at around 7 per cent. What is comforting is that commodity prices are moving southwards which is good for the trade deficit. But with the deficit widening, there is pressure on CAD. Add to this the invisibles account, which tends to slow down when parts of the world move into a recession as remittances and software receipts take a backseat, and we can expect pressure on the CAD.

At present there is quite a bit of support coming from capital flows, especially FPIs, which have been buoyant and have provided cover for the current account. In fact, the Indian stock market has also tended to be more buoyant and in a way resilient to these developments relative to the western ones. But for sure, volatility in these flows will affect the net inflows, especially in the equity segment.

The Reserve Bank of India (RBI) on its part, has played a critical role in managing the rupee. There have been overt sales in the market as evidenced by the decline in forex reserves. Action taken in the forwards market of around $19 bn by July and about $36 bn in the spot (which would have increased in August) has helped stabilise the rupee. The policy changes announced in liberalisation of the capital account for FDI, NRI and ECB accounts would work over a period of time and may not in the short run deliver the support for the balance of payments.

Therefore, looking ahead, the two critical factors would be how the dollar-euro relation works out, which at present, looks heavily tilted towards further appreciation in the medium term. But one must realise that the sudden fall today is more an immediate response to the Fed move which was not different from what the market expected. Hence there is reason to believe that the rupee will be back to the 79.5-80 mark soon.

The critical part in the forex market is, however, the reaction of the RBI. Any intervention through spot or forwards transactions, or even indirect nudging through the NDF market will allay fears of the market. Curiously, no action from the RBI will be interpreted as the central bank being happy with the depreciation, which in turn would become self-fulfilling. Exports will hold back their earnings, while importers will rush to buy dollars thus spiking up the rate.

Hence, a lot will hinge on RBI action in next two days as it will set the tone for market behaviour. The rupee has been one of the best performing currencies and the RBI will be setting the goal post by its actions. If it sits back, the 81 mark will then be tested. That’s how the market will work.

PLIs alone can’t spur investment: Business Line 21st September 2022

 

When demand is stagnant, there is less inducement to invest. Consumption spending needs to rise

There could be some impatience on the part of the government over the rather indifferent response of the corporate sector when it comes to investment. Schemes such as PLI have been floated by the government to encourage industry to invest more in capital that will result in higher output which, in turn, will be rewarded with a cash-back of 4-6 per cent. Yet, the capital formation rate has moved rather sluggishly to 29.2 per cent, which is well below levels of 36.1 per cent seen in FY12.

There are two issues here. The first is the structure of capital formation in the economy in terms of which sector or institution provides the impetus. The second is consumption, which needs to increase to induce industry to invest more as capacity utilisation rates improve.

CSO data on gross capital formation presents an interesting picture on the entities involved in build-up of investment for the country. In FY21, which is the latest year for which this information is available, the biggest contributor was the household sector with a share of 39 per cent. Of this, 25.4 per cent was in houses, and 13.4 per cent was accounted for by plant and machinery. Therefore, it is necessary for individuals to buy more homes to drive investments.

The second part is the contribution of SMEs and this is the Achilles Heel. The plant and machinery emanating from the household sector is the investment made by SMEs. This segment has been buffeted quite sharply by the lockdowns and is in the process of recovering. Several micro and small units have also closed down, thus making the pushback stronger.

While the emergency credit line which guarantees loans taken by them help, the funds have been used for working capital, and hence survival, rather than growth. The government can consider a plan to provide a similar guarantee for pure investment purposes, which can be done through SIDBI.

The second largest player in capital formation is private non-financial corporate sector which has a share of around a third. Here, the main challenge is that companies will invest provided there is demand. The third important entity is the government with a share of around 16 per cent. These three segments account for almost 88 per cent of the country’s total capital formation.

Most of the government investment is in construction that gets reflected in roads and urban development. The challenge here is that while the Centre manages to meet its budgetary commitments, the States do not because they are grappling with fiscal constraints that often lead to cut back on capex spending to ensure fiscal deficit targets are not breached. The other significant entity is the PSU (non-financial) with a share of around 10 per cent. With several of them either in the throes of regulation (oil) or under financial strain (Discoms) or just being unviable and waiting to be disinvested, the drive for further investment is limited.

The other interesting aspect to capital formation in the economy is looking at it from the point of view of economic sectors that contribute to investment. The dominant sector here is real estate, with a share of 26.5 per cent, followed by manufacturing with 14.3 per cent. Hence, if one looks at the focus of the government on, say, the PLI, it impacts just one segment of the economy.

The ‘Transport, communications, storage’ segment has a share of 9.5 per cent of which, communications has 5.5 per cent. Investments here will be driven by the regulatory environment as telecom is one sector that has been embroiled in several controversies since the start of the last decade. The government sector has a share of 12.3 per cent (public administration, etc.) and agriculture 9.2 per cent. Electricity, gas, water, etc., has a share of 7.5 per cent.

Twofold problem

Some questions need to be posed. Are we doing enough on agriculture to push up investment here? Are we clear about how the telecom sector should grow, as with MNCs being involved, lack of clarity can be a deterrent (the Vodafone case)? Have we ironed out the problem on the power side (Discom issue)? What kind of push is being given to the real estate sector?

Therefore investment needs to go beyond the PLI which pertains to manufacturing to address challenges in terms of demand. When demand is stagnant there is less inducement to invest as there is a cost of capital as well as cost of holding inventory involved.

The problem today is twofold. The first is that jobs have not been created commensurate with economic growth, which was an issue even before the pandemic. This is why growth in income has been slower and has come in the way of incremental demand. The second issue is inflation. High inflation in some of the key consumption segments has militated against demand.

The overall consumption basket is skewed in the following manner. Food products account for a third of the basket followed by housing and transport which have a share of around 14.5 per cent each. Then come health, clothing and education with shares close to 5 per cent each. The CPI inflation has been persistently high in all these segments barring housing. As consumers maintain their consumption of these products or services, which are considered essential, there is less left for discretionary consumption thus leading to the demand-supply gap with the latter being higher. Such a scenario plays out also in non-consumption goods because at the end of the day all goods produced are linked to consumption. For steel demand to increase there needs to be either more cars being produced or houses constructed or factories coming up.

Therefore, the situation is quite complex and for investment to increase on a large scale, consumption too should be rising at a smart pace. This can be accomplished with more spending, through higher incomes being spent after being generated, which in turn leads to the issue of job creation. Also, we have to look at all sectors when providing incentives, and not just manufacturing. This can be a pointer for future policy decisions on investment.