RBI's MPC to resume monetary easing amid risks to growth, uncertain outlook

A global recession looks imminent with the outbreak of coronavirus (COVID-19) global pandemic leading to a shutdown in activity across major global economies. Asset markets have seen a very sharp sell-off, increasing the risk of turning a public health crisis into a financial crisis of same proportions as 2008, by tightening financial conditions very sharply. Major global central banks led by the US Federal Reserve (US Fed) have initiated a very swift and sharp monetary policy response.

The US Fed has cut the fed funds rate by 1.5% over the first half of March and has resumed quantitative easing, akin to its reaction post global financial crisis. A targeted fiscal stimulus is also awaited, especially in the US and the EU, to counter the adverse impact on demand. During 2008-2009, over 3.5% of global GDP of fiscal stimulus was administered worldwide.

In India, growth outlook over the next couple of quarters has become more uncertain on the prospects of a global recession and severe investor risk aversion and downside risks have increased due to a local outbreak. At this stage, India is relatively less affected from a global outbreak, due to lower trade dependence and participation in global value chains and smaller tourism receipts. A prolonged local outbreak will however, will erode demand and pull down growth more sharply. The ADB estimates of 1% of GDP loss or $30 billion in a worst case extreme scenario. In their best case scenario, India would be the least affected economy in the region and the impact on domestic activity will be felt largely from a supply side disruption affecting certain sectors.

With monetary policy as the first line of defence against these emerging growth risks, the MPC will look to cut the Repo rate further in its upcoming April meeting. The monetary response this time around however, is likely to be more measured in comparison to the response seen post October 2008. Between October 2008 and April 2009, the RBI cut the policy rates by 2.75%, as WPI inflation collapsed by over 9% and real GDP growth fell sharply from 7.7% in FY2007-08 to 3.1% in FY2008-09.

In the current economic setting, with growth hitting an 11-year low in the current fiscal year, the MPC has cut the repo rate by 1.35% already and the RBI has injected large amounts of liquidity across overnight, one-year and three-year tenors. Thus monetary policy is already in an accommodative mode, as against in 2008 when the RBI was raising rates to counter double-digit WPI inflation amidst a strong growth setting.

A sharp spike in headline CPI inflation due to high food inflation, led to the MPC to pause. With headline CPI easing in February after it peaked in January around 7.6% and with sharply lower crude oil prices, falling food prices and stable core inflation, the future outlook now looks more comfortable on the inflation front. The MPC, therefore, is likely to go in for another 25-40 bps cut in the April meeting, extending the easing cycle further, to support growth. More easing may be required and will be subject to strengthening of downside risk to growth from a demand slowdown getting stronger.

Other than supply disruptions, portfolio capital outflows and downward pressure on the Rupee remain the main channels of the negative external shock transmission. The ongoing global asset sell-off and acute investor risk aversion, has been main driver of this move, though the depreciation in the INR against the USD, so far this year, has been in line with other Asian currencies. Among the fundamental drivers, a collapse in oil prices and weak demand driven fall in non-oil non-gold imports, will help shrink the current account deficit (CAD) further over the coming year. The CAD can fall to about 0.3% of GDP in FY2020-21 from 0.6% this fiscal year. That, in turn, will reduce the financing requirement through net capital inflows. In all likelihood India’s balance of payments would be in a surplus during FY21 too, after recording the highest surplus in the last five years during this fiscal.

In the near-term, portfolio capital outflows will continue drive the market action and keep the Rupee under pressure. With foreign exchange reserve position much stronger than in 2018, the last time Rupee witnessed a sell-off, the RBI is better equipped to curb any dislocation and sharp movements in the currency market. However, in terms of the balance of risks at this stage, downside risks will dominate at least during the first quarter of the coming fiscal year. Active market intervention by the RBI will crucial in keeping the pressure on the Rupee in check during that time.

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Disclaimer: The author is the chief economist of IndusInd Bank. Views are personal.