One Year Later, What Changes Should We Expect in the RBI’s Pandemic Playbook? 

Almost one year down the line, circumstances have changed to a great extent, thus making the response from the central bank less obvious and straightforward compared with March 2020.

The COVID-19 pandemic has kept all Indian policymakers on their toes over the last year, including the Reserve Bank of India (RBI).

So far, the response from India’s central bank has been exactly what the doctor had ordered to alleviate the implications of the pandemic.  The RBI responded with a mix of conventional and unconventional measures, which has included reduction in policy rates by at least 115 bps, sustained forward guidance in the form of an accommodative monetary policy stance, ample liquidity support via open market operations, special OMOs, management of the yield curve to keep cost of borrowings for the government under check, regulatory forbearance and much more from its policy arsenal.

With almost one year down the line, circumstances have changed to a great extent, thus making the response less obvious and straightforward compared with March 2020.

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Unwinding of the liquidity surplus?

The banking system has been flushed with liquidity throughout the pandemic phase and it has been above Rs 4 lakh crore. The RBI governor has maintained the stance of providing liquidity support from here on as well. Although part of the reason for this sustained liquidity surplus has been robust growth in deposits (8.9% during April till February 12, 2021) outpacing credit growth (3.2% during the same period), RBI’s intervention via OMO purchases of Rs 4.64 lakh crore in FY21 so far and dollar purchase above Rs 5 lakh crore are important considerations as well.

Investor fears have been assuaged by these interventions but the bond markets want more liquidity injection given the sizeable borrowing programme of the central and state governments.

On the other hand, RBI has taken one step in the direction of unwinding in the form of gradual increase in the cash reserve requirement from 3% (announced in March 2020) to 4% by May 2021 in a two-step process. A fine balancing act between additional liquidity support and unwinding of the same amidst improvement in the economic recovery process will be more challenging than its sustained liquidity support and accommodative stance during March 2020.

Inflation dynamics persists

The retail inflation has been a blessing during December 2020-January 2021 and has followed the trajectory which the MPC members of the RBI had envisaged in prior MPC meetings. Food inflation has been the chief reason for the decline but the persistently sticky core inflation and elevated inflation expectations have impeded policy rate cut actions.

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The demand in the economy is picking up at a gradual pace and coupled with firming up of global commodity prices, the possibility of retail inflation rising will certainly be on the anvil of the MPC members. The demand destruction and supply disruptions at the peak of the pandemic leading to negative output gaps have been the primary reasons for an accommodative stance of the MPC. But, with inflation inching up and economic recovery gaining traction, the continuation of the accommodative stance for a long period looks uncertain and could also turn neutral, earlier than expected.

 Government’s debt management concerns

As we know, the RBI is the banker to the government and it has judiciously ensured a check on government bond yields for the majority of the pandemic. The weighted average yields during April-February 2021 has been around 5.8% compared with 6.85% in the corresponding period of the previous year. During the initial phase of the pandemic, the yields in the primary and second market were relatively benign on account of the accommodative monetary policy stance, despite expectations of an increase in the gross market borrowing programme of the central and state governments.

However, with the recent spike in secondary market yields in India and globally, the devolvement of bids to the primary dealers in the weekly GSec auction, reversal of cash reserve ratio requirements and sizeable government market borrowings plan for FY22 (both Centre and states), the debt management of the government is likely to be more onerous than few months back. Also, in case the RBI continues with additional OMOs, its subsequent impact on liquidity – credit off-take and eventually inflation will have to be closely monitored by the central bank.

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Resurfacing of the banking asset quality problem

RBI’s announcement of the forbearance during March to August 2020 was a major solace for both retail individuals and companies while the Supreme Court’s order for the bankers to not declare non-performing assets (NPAs) till further orders have led to lower provisioning and improved profitability. Gross NPAs have eased to around 7% till the quarter ended December 2020 but as per the Financial Stability report, it could surge to almost 13.5% by September 2021. The weakness in the asset quality of the banking which can resurface any time soon could further weigh on overall bank credit and bring out ambiguity in policy action.

During the peak of the pandemic, the RBI was playing on a cricket pitch similar to the one Indian Cricket Team played in the second test against England – a difficult rank turn with myriad challenges. Despite that, the responses from the RBI have been on target, albeit on expected lines and policy actions were crafted for various stakeholders in the economy.

Now, circumstances for the RBI have shifted to a cricket pitch similar to the Ahmedabad Test Match, where prima facie the challenges look less daunting but can creep up from anytime and anywhere. Therefore, RBI’s policy arsenal will be tested once again but will have to be utilised differently from March 2020.

Sushant Hede is an associate economist at CARE Ratings Limited. Views expressed here are personal.