PwC's Financial RegTech Insights: April 2020

RBI’s Monetary Policy Report

The global economic growth trajectory remains uncertain as the COVID-19 situation is evolving. The crisis is impacting both demand and supply elements of the Indian economy. Global lockdowns and reduction in global trade have affected the Indian economy and the global output is expected to contract in 2020.¹ Economies are experiencing uncertainties in their financial markets, equity markets have witnessed sell-offs, sovereign bond yields have reduced and financial conditions have tightened. The prices of global commodities, especially crude oil, have reduced sharply owing to reduced demand and failed negotiations between the Organization of Petroleum Exporting Countries (OPEC) and Russia.²

COVID-19 and its subsequent impact were the main themes of the half-yearly Monetary Policy Report published by the Reserve Bank of India (RBI) in April 2020.³ The report focuses on the macroeconomic outlook around factors such as inflation, growth, balance of risk, price and liquidity for the country.

Macroeconomic outlook

Crude oil prices (Indian basket) have fluctuated widely from USD 70 per barrel in early January 2020 to USD 23 per barrel on March 30, 2020, and further decreased to USD 19.9 per barrel in April 2020.⁴ The decrease in crude oil prices can be attributed to Saudi Arabia’s decision to reduce prices and increase production, as an arrangement with Russia on production cuts could not be finalised. As per the RBI, the baseline scenarios assume crude oil prices (Indian basket) to average around USD 35 per barrel during financial year 2020–21.⁵

The nominal exchange rate (USD–INR) was volatile between October 2019 and December 2019. The value of INR has weakened considerably from January 2020, reflecting a generalised weakening of currency in emerging markets. As per the RBI, the baseline assumes the exchange rate of 1 US dollar to be at INR 75.⁶

Even before the COVID-19 crisis, the RBI acknowledged that the Indian economy was undergoing a slowdown. The RBI’s Monetary Policy Committee (MPC) met four times between October 2019 and March 2020 to intensify efforts to restore growth amidst the slowdown. As the domestic demand reduced between December 2019 and February 2020, inflation rose sharply and breached the mandated inflation band. In its off-cycle meeting held in March 2020, the MPC noted that the pandemic had severely impacted both demand and supply and they were required to take measures to safeguard the economy. The MPC reduced the policy repo rate by 75 basis points (bps) to 4.4 %.⁷ MPC further reduced repo rate by 40 bps to 4% in May 2020.⁸ The RBI has also taken several measures to improve liquidity, monetary transmission and credit flows to the economy. Changes in the macroeconomic developments between December 2019 and March 2020 warranted for changes in baseline assumptions.

Prices and costs¹¹

Headline inflation measured by the CPI remained below the target rate for 13 consecutive months till Q2 2019– 20 and breached its upper threshold of 6% to reach 7.6% before easing to 6.6% in February 2020. This was due to an increase in vegetable prices. Fuel inflation also increased after December 2019. Core inflation (excluding fuel and food) increased to 4.3% from 3.4% in the same period. Projection errors were observed in CPI inflation (excluding food and fuel inflation) during March 2020 due to cost-push scenarios like higher motor vehicle prices owing to introduction of BS-VI vehicles, a sharp increase in gold prices and higher mobile tariffs. However, easing of fuel prices in this period helped in offsetting the increase and balancing the upside.

Year-on-year (YoY) comparison of CPI inflation indicated a rise in Q3 2019–20 inflation figures. Normally, food prices used to decline in the third quarter of the year, but this time it showed its highest ever increase during the third quarter of any year in the history of the index. Consequently, food price inflation rose up to double digits by the end of Q3 2019–20.

CPI of fuel came out of deflation by signalling a sharp increase to 6.4% in February 2020 from (-)0.3% in July 2019. The increase can be attributed to the supply chain disruptions caused due to geopolitical tensions.

The pattern of core inflation has remained identical with other categories. It registered an increase to 4.3% in January 2020 from 3.4% in October 2019. This was due to volatile movements in crude oil prices. However, this started easing shortly after geopolitical tensions between the US and Iran and the US and China eased, and the price war between OPEC and Russia deescalated. There was an increase in inflation in sectoral CPIs like CPI-IW (industrial worker), CPI-AL (agricultural labourer), CPI-RL (rural labourer) during the August– December 2019 period mainly due to rise in food prices. Wholesale Price Index (WPI) inflation fell during August– October 2019 as opposed to other CPIs because of decline in prices of non-manufactured food products.

Costs were mostly in sync with the WPI inflation. Inflation in farm inputs and industrial raw material prices (extracted from WPI) eased after April 2019 and continued in negative territory during September– November 2019, before gaining a momentum between December 2019–February 2020. This increase is attributed to recovery in prices of global crude oil and petrochemicals. Additionally, the cost of minerals and non-food articles were also impacted due to the price dynamics of non-farm input costs.

Demand and output¹²

The Indian economy in 2019–20 had witnessed the weakening of demand due to decrease in investment and restraint in Government expenditure. On the supply side, there was a mixed sentiment with agriculture and allied activities gaining momentum due to a late surge in monsoon and deacceleration of industrial growth due to reduced manufacturing activity. GDP growth lost momentum, averaging from 5.5% in H1 2019–20 to 4.7% in Q3 2019–20. Gross fixed capital formation (GFCF) growth turned negative in Q2 and Q3 of 2019– 20 and its share in the GDP dropped to 30.2% in 2019– 20 from 31.9% in the previous year. The gross domestic savings rate (GDS) rate also reduced to 30.1% of GDP in 2018–19 from 32.4% of GDP in 2017–18.

Government expenditure saw moderation in H2 2019– 20 due to sharp slowdown in Q4 2019–20. Based on the latest data available, the Centre’s market borrowing was INR 2,68,000 crore during H2 2019–20 which is 5.3% lower than its level a year ago. Total gross borrowing of the country stands at INR 13,44,521 crore. As per the RBI report, the current account deficit (CAD) narrowed to 0.2% of GDP in Q3 2019–20 from 0.9% in Q2 2019–20. This reduction is due to a lower trade deficit and a rise in services receipts. The contraction in imports also helped in narrowing the CAD. Remittances from abroad remained strong and the net outgo of payments remained unchanged as compared to theGovernment expenditure saw moderation in H2 2019– 20 due to sharp slowdown in Q4 2019–20. Based on the latest data available, the Centre’s market borrowing was INR 2,68,000 crore during H2 2019–20 which is 5.3% lower than its level a year ago. Total gross borrowing of the country stands at INR 13,44,521 crore. As per the RBI report, the current account deficit (CAD) narrowed to 0.2% of GDP in Q3 2019–20 from 0.9% in Q2 2019–20. This reduction is due to a lower trade deficit and a rise in services receipts. The contraction in imports also helped in narrowing the CAD. Remittances from abroad remained strong and the net outgo of payments remained unchanged as compared to the previous year. However, the fiscal condition of the Central government has deteriorated due to a reduction in tax rates. Direct taxes contracted by 3.3% and indirect taxes grew by 1.6% during the eleven months of FY19–20, well below the budgeted estimates.

In terms of aggregate supply, gross value added (GVA) growth deaccelerated to 4.7% in H2 2019–20. This decrease is attributed to a slowdown in industrial and services activities. As the economy hit a multi-quarter low in Q3 2019–20 and with the outlook being bleak, aggregate demand is adversely impacted by a likely recession. Private consumption is at a risk due to the pandemic. Domestic production will be impacted due to the nationwide lockdown affecting supply.

Financial markets and liquidity conditions¹³

Equity markets experienced extreme uncertainty in February and came to a standstill in March. This led to a sharp decline in trading activities. The sentiment of finding a safe haven asset and flight to safety led to a decreased confidence in the Indian equity markets and Indian currency. In a move to strengthen the credit market through providing liquidity, long-term repo operation (LTRO) was introduced to reduce the cost of funds for banks.

The money market remained robust owing to the proactive liquidity management steps taken by the RBI. The steps also led to an increase in the share of collateralised money-market debt in the overnight money market. However, the risk premium in the money market increased to 97 bps in H2 2019–20 from 87 bps in H1 2019–20, owing to fears of illiquidity in the market.

With regards to Government securities, the yields of both the new benchmark (6.45% GS 2029) and the old benchmark (7.26% GS 2029) increased in December 2019 post the announcement of the Monetary Policy. This happened due to:

• policy rates remaining unchanged
• foreign portfolio investments (FPIs) selling their stake due to negative growth outlook.

The situation improved soon after the RBI decided to opt for open market operations (OMOs). The new benchmark yield of Government securities increased by 9 bps while the old benchmark yield of Government securities increased by 15 bps. After Union Budget 2019–20, the Government decided against additional borrowing from the market, due to which new and old benchmarks fell by 10 bps and 14 bps, respectively. Corporate bond yields fell in the second half of 2019 due to surplus liquidity conditions. The AAA-rated corporate bond yield fell by 42 bps to 7.02 in March 2020 from 7.44 in September 2019. Overall, AAA 5-year yield came down by 108 bps during 2019–20. Resource mobilisation due to issuance of corporate bonds in the primary market stood at INR 3.1 lakh crore, which was higher by 3% as compared to the previous year.

Equity markets in India experienced gains till mid- January 2020, in the backdrop of easing of global crude oil prices, higher GST collections and increase in manufacturing purchasing manager’s index (PMI). However, the BSE Sensex declined by overall 23% in March 2020, mainly due to the COVID-19 crisis and panic selling. Mutual funds became net buyers at INR 38,939 crore and FPIs became net sellers at INR 5,599 crore in the Indian equity markets.

In the foreign exchange market, INR remained highly volatile. As a result, the Indian rupee depreciated to INR 76.15 against 1 USD on 24 March 2020. However, this decline was relatively modest when compared to other emerging market economies. INR depreciated by about 2.9% in terms of the 36-currency nominal effective exchange rate (NEER) and 1.3% in terms of the 36-currency real effective exchange rate (REER).

Credit growth witnessed a slowdown across all banking institutions, especially private sector banks. Credit growth for agriculture and industry has remained low in the previous five months. Personal loans had a moderate growth on YoY basis to 17% from 16.7%. Also, though there was an overall decrease in the non-performing asset (NPA) ratio across the industry, the overall NPA ratio of scheduled commercial banks (SCBs) remained unchanged.

External environment¹⁴

Economic activity has reduced across major advanced economies as well as emerging market economies. As per the International Monetary Fund (IMF), the global GDP growth rate in 2019 was 2.9%, the lowest since the global financial crisis of 2008–09. On 23 March 2020, the IMF announced that the global economy has entered a recession in 2020. Basis the early incoming data, the GDP of Singapore shrank by 10.6% in Q1 2020 and unemployment claims surged to a peak in the US. Crude oil prices plummeted and prices of global commodities also shrank due to reduced demand. Equity markets across the globe have been affected adversely. Gold and other fixed income assets such as sovereign debt have experienced uncertainty. Central banks across advanced economies as well as emerging markets have resorted to rate cuts. They have also initiated various liquidity-bolstering measures in the wake of difficult financial conditions. Stimulus packages in the range of 0.8–16% of the GDP have been announced by various central banks worldwide.

Most advanced economies and emerging market economies have resorted to conventional and unconventional methods to deal with the economic impact of the COVID-19 crisis.

• The US Federal Reserve has resorted to emergency rate cuts – 50 bps on 3 March and a subsequent rate cut of 100 bps on 15 March. It also reduced the primary credit rate to 0.25%.
• The European Central Bank (ECB) has announced favourable terms for targeted long-term refinancing operations (TLTROs) for one year from June 2020. The ECB has announced a new EUR 750 billion pandemic emergency purchase programme, under which private and public sector securities can be purchased until the end of 2020.
• The Bank of England (BOE) has reduced its bank rate to an all-time low of 0.1% owing to two subsequent rate cuts of 50 bps and 15 bps respectively. It has announced additional asset purchases worth GBP 200 billion in 2020.
• The Bank of Japan has announced the purchase of commercial papers and corporate bonds worth JPY 2 trillion. They have announced to provide loans against corporate debt as collateral at 0% interest, with a maturity period of up to one year.

Sources

1. Monetary Policy Report – April 2020
2. Ibid
3. Ibid
4. Prices:Petroleum Planning & Analysis Cell
5. Monetary Policy Report – April 2020
6. Ibid
7. Ibid
8. Liquidity Adjustment Facility – Repo and Reverse Repo Rates
9. Monetary Policy Report – April 2020
10. Ibid
11. Monetary Policy Report – April 2020
12. Monetary Policy Report – April 2020
13. Monetary Policy Report – April 2020
14. Monetary Policy Report – April 2020