India’s jumped to a fresh lifetime high of around 32683.50 early Wednesday on hopes of more rate cuts by RBI (monetary stimulus) as India’s headline inflation (CPI) for December finally dips below 6% (after almost 10-months). In December, CPI slips to a 15-months low at +4.59% (prior Nov: +6.93%; market estimate: +5.28%-y/y). In December, the CPI was dragged by mainly food inflation (seasonal factor). The market is now expecting a -0.50% RBI rate cut by H1-2022 (June’22) due to lower inflation and the fact that India’s mass-vaccinations will not start before Jan’22, leading to uneven/subdued economic growth in FY22.
But India’s core inflation was still sticky in December, printed at +5.65% against November’s +5.84%, much above RBI’s 4% target. In any way, unlike major global central banks, India’s RBI now follows volatile headline CPI, not core CPI. RBI’s official CPI target is +4.00% and there is virtually no scope of any further rate cuts in Q4FY21 (Mar’21) or even in FY22 due to transmission issues (by banks). Moreover, after the winter season, India’s food inflation may surge again (despite bird flu and lower Chicken meat/egg prices) because it’s a legacy issue of supply/demand, logistics, and multiple middlemen.
Indian headline CPI
Indian core CPI
Although, there is no official/government’ regular employment/unemployment data for India, unofficial/private data indicates India’s headline unemployment rate was at 6.50% in November, almost at par with pre-COVID levels and long term average. Thus, in that sense, the Indian economy is now under maximum (possible) employment, but inflation is much above +4.00% targets.
The Indian central bank RBI has officially one mandate; i.e. price stability (headline CPI) target of +4.00% (with +/- 2% band), while ‘keeping in mind the objective of growth’. This is in contrast with Fed’s dual mandate: price stability (+2.00% core PCE inflation) and maximum employment (usually below 4% unemployment levels pre-COVID).
In that sense, RBI, as a central bank, should now hike (under normal circumstances) instead of cut/hold; but COVID is an unprecedented scenario, requires equally unprecedented action. And after cutting from +6.50% to +4.00% in 2020 (pandemic cuts), the Indian headline interest rate is now at a lifetime low and in fact, the real rate of interest (RRI) is negative to the tune of -1.5% (interest 4% -CPI 6.5% on an average). RBI’s huge pandemic monetary stimulus around Rs.12.71T (till Oct’20: nominal liquidity) is equivalent to over 6% of India’s GDP.
The overall loan growth by banks is now hovering around 6%, in line with India’s potential GDP growth in the coming days and off the 2017s low of 4%, but also still way below 2019 levels of 15%, which was unsustainable. In brief, there is no lack of liquidity in the banking system, but as usual, there is a lack of quality & eligible borrowers even at lower borrowing costs.
And Indian banks are now quite cautious with irresponsible & indiscriminate lending. Private as-well-as PSU banks are now lending prudently and also emphasizing the return of capital rather than return on capital. As a result, banks are now parking a record amount of excess fund in RBI reverse repo window to earn a risk-free decent return then to lend to a potentially bad borrower for possible default in the coming days.
During, COVID pandemic days, there is over a 25% increase in retail/household and SME loans. The RBI is now quite concerned about growing/brewing retail NPA/NPL (fresh stressed assets) in the banking system, especially for stressed households and SMEs.
In its latest Financial Stability Report (FSR) dtd 11th Jan, RBI highlighted:
In the initial phase of the COVID-19 pandemic, policy actions were geared towards restoring normal functioning and mitigating stress; the focus is now being oriented towards supporting the recovery and preserving the solvency of businesses and households.
Positive news on vaccine development has underpinned optimism on the outlook, though it is marred by the second wave of the virus including more virulent strains. Policy measures by the regulators and the government have ensured the smooth functioning of domestic markets and financial institutions; managing market volatility amidst rising spillovers has become challenging especially when the movements in certain segments of the financial markets are not in sync with developments in the real sector.
Bank credit growth has remained subdued, with the moderation being broad-based across bank groups. Performance parameters of banks have improved significantly, aided by regulatory dispensations extended in response to the COVID-19 pandemic. The capital to risk-weighted assets ratio (CRAR) of Scheduled Commercial Banks (SCBs) improved to 15.8 percent in September 2020 from 14.7 percent in March 2020, while their gross non-performing asset (GNPA) ratio declined to 7.5 percent from 8.4 percent, and the provision coverage ratio (PCR) improved to 72.4 percent from 66.2 percent over this period.
Macro stress tests incorporating the first advance estimates of gross domestic product (GDP) for 2020-21 released on January 7, 2021, indicate that the GNPA ratio of all SCBs may increase from 7.5 percent in September 2020 to 13.5 percent by September 2021 under the baseline scenario; the ratio may escalate to 14.8 percent under a severe stress scenario. This highlights the need for proactive building up of adequate capital to withstand possible asset quality deterioration. Network analysis reveals that total bilateral exposures among entities in the financial system increased marginally during the quarter ended September 2020. With the inter-bank market continuing to shrink and with a better capitalization of banks, the contagion risk to the banking system under various scenarios declined as compared to March 2020.
Overall, the RBI report (FSR) is not as bad as the general news headlines suggested on Tuesday. Thus on Wednesday, banks got an additional boost. The RBI has noted overall improving operational parameters of banks despite COVID pandemic challenge as Indian banks did go for prudent lending; thus despite huge unprecedented liquidity, bank loan growth was subdued. RBI has simply noted the recent NSO/government estimate of the FY21 GDP report, where the NSO forecasted higher GNPA/GNPL from present 7.5% (Sep’20) to 13.5% (under baseline scenario) or even 14.8% (under more adverse scenario) by Sep’21.
As the NSO predicted an almost doubling of GNPA, the RBI advised the need for proactive capital building by the banks to deal with the situation in the coming days. In other words, the RBI urged for caution as a policy prescription, but overall, RBI said the threat of COVID contagion risk on the financial system (banks) has reduced significantly since March’20 due to strong capital buffer and lower bank-to-bank lending (unlike during 2008 GFC days). Thus on Wednesday overall, the challenge for RBI is now to keep the Indian benchmark 10Y bond yield as-well-as borrowing cost for Main Street and especially for the government at minimum levels to fund the COVID stimulus at least till FY22-23. The weightage average borrowing cost for the government was around +5.80% in Q3-2020. The 10Y Indian bond yield (GSEC) made a low around +5.75% in June’20 and was hovering around +5.90% on an average in Q3-2020.
In the last few days, the 10Y GSEC yield is again trading around +5.95%, eyeing the above 6% levels in line with global peers. The U.S. 10Y bond yield is again above 1% and well-off the March’20 low of +0.318% on Bidenflation (reflation-higher growth and higher inflation) and higher borrowing to fund CARES Act (COVID fiscal stimulus).
The Fed will watch primarily the corona curve for its QE tapering and subsequent gradual hikes (policy normalization). The U.S. COVID curve (reported active cases) is still far from the flattening process. But it should start to flatten by Dec’21 and by Mar’22; there could be a visible flattening due to mass-vaccinations and natural infections. By then, the U.S. unemployment rate should also fall below 5% and core PCE may advance towards 2%. Thus, the Fed may start its gradual QE tapering from Jan-Mar’22 and may also start to hike rates from Dec’22- Mar’23 and ECB may also follow the Fed, at least in pandemic QE tapering.
And the RBI is bound to follow Fed/ECB to keep the bond yield differential attractive enough for the angel investors; otherwise who will go to fund Modinomics despite the narrative of 5D (democracy, demography, demand, deregulation, and digitalization) and the mantra of reform, perform & transform.
RBI may not go for further rate cuts or any other additional monetary stimulus in line with Fed. As India’s COVID curve is also flattening fast due to natural infections, the country may achieve herd immunity earlier by 2022 (even without significant mass-vaccinations). This will pave the way for policy normalization by RBI from FY23 as per its guidance. And like Fed, the RBI will also keep the market well prepared for gradual rate hikes from FY23. Thus, both Wall Street as-well-as Dalal Street may go for a healthy correction in the coming days.
Various Fed policymakers are now actively discussing the eventual QE tapering as per their usual strategy of jawboning and keeping the market well-prepared for an orderly correction so that 2013 like taper tantrum volatility does not repeat. Apart from incoming Biden admin, U.S. politics & policies, all focus would be also on 28th Jan FOMC meeting-whether Powell provide any further guidance about the inevitable QE tapering and normalization of monetary policies.
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