RBI takes a pause; announces additional measures

Morningstar Investment Management team shares its take on the central bank's policy measures.
By Morningstar Analysts |  07-08-20 | 
 

The RBI’s Monetary Policy Committee (MPC), decided to keep the policy rate unchanged at 4%. Consequently, the reverse repo rate stands unchanged at 3.35%, and the marginal standing facility (MSF) rate and the Bank Rate at 4.25%. All members of the MPC voted unanimously to keep rates unchanged and continue with the accommodative stance as long as necessary to revive growth and mitigate the impact of Covid-19 on the economy, while ensuring that inflation remains within the target range of 4% +/- 2% going forward. The MPC stated to remain watchful for a durable reduction in inflation (June CPI at 6.09%) to use the available space.

The MPC also announced an additional set of measures to enhance liquidity support, key measures to ease financial stress for the corporate sector and banks, and improve the flow of credit.

1. Additional liquidity facility of INR 5,000 crores to National Housing Bank, over and above INR 10,000 crores already provided – this should further help in easing out stress for HFCs and housing sector

2. Additional liquidity facility of INR 5,000 crores to NABARD, over and above INR 25,000 crores already provided – this should help in easing out the financial stress and improve credit flow to small NBFCs and financial institutions

3. Resolution framework for corporate & personal loans which have seen an impact on their financial condition due to Covid-19 related economic shutdowns

4. Restructuring of MSME debt for borrowers facing stress on account of the economic fallout of the pandemic

5. Increase loan-to-value ratio for loans against gold for non-agricultural purpose from 75% to 90%

Our Take

Since March, the RBI has delivered a host of measures to support growth, improve liquidity, ease financial stress, monetary transmission, and flow of credit. This along with a 115 bps cut in the policy rate has helped in bringing down the borrowing cost for individuals and corporates. Banks, to a large extent, have been able to transmit lower rates – supported by significant surplus liquidity in the banking system. However, monetary transmission and surplus banking system liquidity has so far not resulted in higher credit growth, mainly due to weak business and consumer sentiments amid a highly uncertain market environment.

The MPC stated that the inflation is expected to remain elevated in Q2: FY21 as supply chain disruptions on account of Covid-19 persist along with high taxes on petrol and diesel. Although, it is expected to moderate in the second half of FY21 aided by base effect and favorable food inflation outlook. Unlike previous monetary policy statements, this time RBI has avoided providing forecast ranges for inflation and growth probably due to the significant uncertainties around the pandemic and its impact on the economy.

Some of the high-frequency lead indicators suggest growth improvement in June and July as the lockdown restrictions were eased. Companies reported high passenger vehicle sales in July as compared to June amid unlocking of pent-up demand, although y-o-y growth is still negative. Tractor sales and two-wheeler sales also increased significantly in the last couple of months – early signs of rural demand pick-up. Whereas, the latest manufacturing PMI number suggests a drop in output as compared to June amid weak demand conditions. Service sector business activity continues to be severely impacted by Covid-19 and ensuing lockdown. Ideally, negative real rates should incentivize consumption spending over savings. However, in the current uncertain economic environment, this may not play out as hoarding cash is the prime focus.

Separately, RBI hasn’t announced any extension of the moratorium period for corporate, MSME, and personal loans which is due to end on 31st August. The financial sector has expressed concerns about a rise in NPAs after the moratorium period ends. RBI’s measures for the resolution of stressed corporate & personal loans due to the economic fallout of the pandemic are positive for banks and borrowers. Provisioning requirements for such restructured loans would be significantly lower as compared to other stressed assets thereby saving capital, providing impetus to banks to increase lending, and a lifeline to corporates.

The global growth contraction and slower domestic recovery cast doubt on the Indian growth prospects in the near term with real GDP growth for 2020-21 expected to be negative. However, over the medium to long term, productive capacity should return with a pick-up in government expenditure and consumer spending, reviving economic growth.

10-year benchmark G-sec yield rose 6 bps intra-day as participants were expecting some guidance on bond purchases, although yields fell back with the benchmark security closing at 5.86%. Over the last year, the yield curve has seen a significant downward shift and steepening with surplus liquidity and policy rate cuts largely getting transmitted at the short end. The long end of the curve faces the risk of worsening fiscal conditions. RBI’s targeted approach has also led to yields falling at the longer end thereby bringing down the borrowing cost for corporates. With short-term rates coming off massively, the current term spread in the medium-long term segment is significantly above the long-term historical average – improving its relative attractiveness over short-term debt and cash.

The corporate bond segment is coming back to normalcy after facing a massive liquidity crunch in March/April. Mutual fund redemptions have stabilized, credit flow has improved supported by measures announced by the RBI. As a result, credit spreads have narrowed from the levels seen in March/April period. However, the spreads across the rating profile continue to be above their long-term average amid weak business outlook. We see an improved opportunity in the credit markets with spreads offering a decent reward for risk. Based on our valuation-implied return forecasts, the corporate bond segment (3-5 years) looks relatively attractive over the short-term debt (G-sec) segment. The attractiveness of the credit segment relative to the banking & PSU debt segment has also improved with money flowing towards the latter – a recent drop in yields and spread compression in the banking & PSU segment reduces the return expectations. The case for investing in this segment has improved. Of course, risks remain elevated; however, we believe the yields on offer are compelling for long-term investors.

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