Severe shock to consumption, economy will take longer to recover: RBI

"Retrenchment in activity that is unprecedented in history," says the annual report released by the central bank

The contraction in economic activity will likely prolong as states have re-imposed stricter lockdown, said the Annual Report of the Reserve Bank of India (RBI), released on Tuesday. It is important to withdraw the stimulus once the cure to Covid-19 is found, the report added.

High-frequency indicators so far pointed to a “retrenchment in activity that is unprecedented in history”, the report said, adding, “the upticks that became visible in May and June after the lockdown was eased in several parts of the country, appear to have lost strength in July and August, mainly due to re-imposition or stricter imposition of lockdowns, suggesting that contraction in economic activity will likely prolong into the second quarter”.

The central bank noted the shock to consumption was severe, and it would take some time to mend and regain the pre-pandemic momentum.

Public finances are stretched, and supporting demand-led activities would be diminished.

“In the case of state finances, space is likely to be squeezed so much that cuts in growth-giving capital expenditure seem quite probable.”

The future path of fiscal policy is likely to be conditioned by the large overhang of debt and contingent liabilities incurred during the pandemic.

“A credible consolidation plan, specifying actionables for reduction of debt and deficit levels, will earn confidence and acceptability, rather than just extending the path of touchdown,” the report said.

The RBI suggested the government use big data and technology to track and identify tax defaulters and increase the tax base.

At the same time, goods and services tax (GST) rules should be rationalised and simplified. 

Employment generation should be the focus and fiscal incentives can be given to productive labour-intensive companies.

The Central and state governments must also explore monetising assets in steel, coal, power, land, and railways, and privatising major ports to revive and crowd in private investment.

According to the RBI, banks and non-banking financial companies (NBFCs) are losing their importance as primary financial intermediaries for companies because they are now accessing capital and bond markets more. Nevertheless, financial companies need to shed risk aversion, which is impeding the flow of credit to the productive sectors of the economy.

“In all this, the usual risks are relegated to the background where they may be sinisterly mutating – fiscal dominance; inflation; leverage; market failure. Meanwhile, the crisis presents opportunities and the shape of the future will depend on how well they are exploited,” the report noted.

Macroeconomic deterioration will impinge on the asset quality, capital adequacy, and profitability of banks.

“Regulatory dispensations that the pandemic has necessitated in terms of the moratorium on loan instalments, deferment of interest payments and restructuring may also have implications for the financial health of banks, unless they are closely monitored and judiciously used.”

Regulatory accommodation announced in the wake of the pandemic has masked the consequent build-up of stress, but that should surface later. The stress test reported in the June edition of the Financial Stability Report showed non-performing assets could surge 1.5 times their March 2020 levels under the baseline scenario and by 1.7 times in a very severe stress scenario. 

The system level capital adequacy ratio could drop to 13.3 per cent in March 2021 from its March 2020 level under the baseline scenario and to 11.8 per cent under the very severe stress scenario. Therefore, both public and private sector banks need to be recapitalised, as the capital requirements calculated on the basis of historical loss events “may no longer suffice to absorb post-pandemic losses”.