Exiting the Easy Money Circle
More than a decade after the global financial crisis, the exit from an ultra-loose monetary policy - such as near-zero interest rates and helicopter money - in the US is still a work in progress. The US Federal Reserve's balance sheet has expanded from under $1 trillion before 2008 to $4.5 trillion in the aftermath of the financial meltdown. The Covid outbreak has further pushed the unwinding as the Fed's balance sheet is expected to jump to 50 per cent of the country's GDP from the current 34 per cent. The eventual exit would mean liquidity tightening and higher interest rates in the US, which would have implications for emerging markets, including India, by way of dollar outflows from stock market and currency depreciation.
The Reserve Bank of India (RBI), too, gave regulatory forbearance to banks post the financial crisis. It followed an extended period of loan-restructuring relaxations without classifying stressed loans as non-performing assets (NPAs). This created huge hidden stress in the banking system in the last decade by way of under-reporting of NPAs, lower provisioning, over-stating of profits and capital levels, and encouraging zombie lending (the practice of providing credit to entities that do not have the capability to repay). A delayed exit from forbearance, after almost seven years of the crisis, saw NPAs rising to a high of 11.5 per cent by March 2018, and led to losses in banks' books, depleting capital levels and companies defaulting on loan obligations. The Indian banking system, which is still to come out of 2008 shock, has entered the new crisis with very weak financials. Former Chief Economic Advisor Arvind Subramanian once described Indian policymakers' predicament as Mahabharata's chakravyuha challenge - 'the ability to enter but not exit'.
Once again, governments and regulators world over are caught in a chakravyuha - This time the question is how and when to exit? "The size and scale of monetary policy expansion is at an unprecedented level. There are not one, but dozens of regulatory relaxations to banks. The monetary policy has been used to the hilt," says the CEO of a public sector bank. Any delay in exit could have far-reaching consequences. It could lead to hyper inflation, higher interest rates, a weak RBI balance sheet, currency depreciation and massive fall in asset prices in the future. Also, regulatory relaxations create an artificial sense of robustness in the financial system by hiding NPAs.
So, what should be the roadmap for exit from exceptional monetary and regulatory measures without impacting economic recovery and disrupting the banking sector and the financial market?
Ending Regulatory Forbearance
The RBI has been quite accommodative ever since Governor Shaktikanta Das took charge in December 2018. The central bank's focus was to revive growth and protect the NBFC sector post the IL&FS debacle. In the last 18 months, the RBI has taken a series of measures, including higher lending to corporate groups, and reduction and rationalisation of capital allocation on consumer loans and loan moratorium, to protect balance sheets of banks and help corporates, especially MSMEs and retail borrowers, from defaulting post-Covid. The big challenge now is to back-pedal the relaxations in a time-bound manner to protect banks and also create cushions by way of capital and provisions from profits to absorb future shocks. "The regulatory forbearance has an expiry date built into it," says R. Gandhi, Former Deputy Governor, RBI. The danger is the extension of such relaxations.
"When the second wave of Covid gets under control, it would be time to go back on capital forbearance related to some aspects of Basel III implementation and build capital levels proactively. Capital is necessary, but not sufficient. It should be backed by reforms in the banking sector covering areas such as corporate governance etc," says Anand Sinha, Former Deputy Governor, RBI. Basel III rules, set after 2008 financial crisis, further strengthen banks' regulations and risk management.
One area that needs urgent stress testing is banks' MSME loan portfolio, according to experts. There is a lot of stress hidden in these small loans because of a government guarantee cover for collateral-free loans and a one-time restructuring scheme, they add. For instance, the RBI had announced a restructuring scheme for MSME loans up to Rs 25 crore, which was to end in March 2020, but was extended for another year due to the Covid outbreak. The government had come out with an emergency credit line guarantee scheme of Rs 3 lakh crore offering 100 per cent credit guarantee on loans disbursed to MSMEs. The RBI had also offered a one-time, two-year restructuring of retail and corporate loans. So, if not a stress test, there is at least a need for higher provisioning from profits to avoid major defaults. "Given their role in employment and income generation, stress in MSME segments need flexible restructuring and resolution measures than additional provisioning or AQR ( asset quality review)," says Gandhi.
Sinha agrees that current provisioning requirements are reasonable, but the adequacy of provisions depends on proper asset classification and forward-looking provisioning to counter procyclicality in the system. Forward-looking provisioning depends on implementation of IND-AS, currently on hold as far as banks are concerned. "This is another area that needs to be looked into," says Sinha. The new IND-AS (Indian Accounting Standards) aligns with international accounting standards for better reporting of financial numbers .
The RBI has prescribed a minimum 10 per cent provisioning for restructured loans. Some banks, which are going by the minimum rule, risk overstating profits if delinquencies turn out higher than expected. If moratorium of loans is any indication of likely stress, 45 per cent borrowers (40 per cent in value terms) actually took the moratorium benefit. "A lot of banks have taken the hit upfront (in terms of provisioning). We have also done that," says Amitabh Chaudhry, Managing Director and CEO, Axis Bank.
Gross NPAs at 7.5 per cent at the end of September 2020 don't show the actual picture because of the NPA asset classification standstill, which was ended by the Supreme Court in March. The RBI's own stress testing has indicated gross NPAs rising to 13.5 per cent in the coming months and close to 15 per cent by September this year under an extreme scenario. In fact, Das has been advising banks to proactively build capital buffers by raising fresh funds and through contingency liquidity planning. The central bank has already deferred the last tranche of capital conservation buffer (0.625 per cent of the core capital) for the second time till April 2021. The capital conservation buffer ensures banks have an additional layer of capital, which can be tapped into when losses are incurred. But, the move has also given more capital in the hands of bankers to lend to the industry. Similarly, there are lower risk weights for protecting banks' lending activities, which have to be restored. In August last year, the RBI had reduced the risk weight requirement (the capital banks keep aside as provisioning to cover loan defaults) for consumer credit, including personal loans (except credit cards) to 100 per cent from 125 per cent. There is, however, no sunset clause for reverting back to the earlier position.
The RBI had also reduced risk weights for bank lending to non-banking financial companies (NBFCs). This was to increase banks' exposure limit to NBFCs to 20 per cent of their core capital from 15 per cent. But, higher exposure to NBFCs exposes banks, since the former also lends to non-salaried and other risky customers. Similarly, banks' unsecured loan portfolio also needs attention. There was a cap on unsecured loans for regulatory purposes, but now it is left to bank boards to decide the limits. Products such as credit cards are by nature unsecured.
The other category would be small borrowers like MSMEs who do not have adequate collateral to offer, but deserve credit from banks and other formal channels because of their importance for the economy. Such lendings are supported by credit guarantee schemes and developments in credit assessment of such borrowers through the use of data from various sources and application of modern techniques such as Machine Learning and AI. "That leaves larger advances where borrowers have the wherewithal to offer collaterals, but in many cases is not insisted upon for competitive reasons," says Sinha.
Some experts suggest that it will be necessary to increase the capital requirement or build capital buffers when the economy is well into the growth path. They argue that with the twin problem of GDP contraction and low credit growth, India is unlikely to be in that situation in 2021/22.
Meanwhile, the process of getting back to normal liquidity coverage ratio (LCR) for banks has already begun with the RBI deciding to gradually restore the LCR back in two phases - 90 per cent by October 2020 and 100 per cent by April this year. The objective of reducing the LCR was to ensure that banks have enough short-term liquid assets to dispose off to meet any sudden demand for cash at ATMs or payback fixed depositors. The faster exit from the lower LCR ratio was imminent as risk-averse bankers were sitting on a high LCR of over 130 per cent.
Insider says the RBI is adopting a wait-and-watch approach for exiting many of the regulatory relaxations. Experts suggest rather than waiting for the RBI's exit roadmap, banks should follow a 'conservative' approach to deal with the current situation. "Banks should follow a conservative approach during the pre-sanction appraisal process. The character and capacity of the borrower and well as post-credit end-use verification," says a RBI official on the condition of anonymity. This also means a cautious approach in building a loan book and making higher NPA provisioning than the regulatory requirement.
Return To Normal Policy
Nearly two years ago, the RBI had switched from liquidity 'deficit' in the system to the 'surplus' mode by using various tools such as forex operations (buying forex and releasing rupee resources ) and open market operations (buying government securities and releasing liquidity), followed by long-term repo operations (LTROs) and targeted LTROs in the aftermath of the Covid outbreak. Under LTRO, the RBI provides longer term (one- to three-year) loans to banks at the prevailing repo rate. Long-term funds at lower rates help banks reduce their cost of funds. By September last year, the RBI had pumped in over Rs 11 lakh crore of surplus liquidity, 5.5 per cent of GDP. The RBI had also cut the repo rate by 250 basis points to 4 per cent to support the economy. The big challenge now for the central bank is to return to normal monetary policy operations.
Gandhi says for a review of the current accommodative stance, GDP data for the fourth quarter of 2020/21 and the first quarter of 2021/22 will be critical. "If GDP for these quarters beats forecast, indicating heating up the economy, coupled with distinct increase in capacity utilisation, there could be a change in the RBI's stance."
In February, the Monetary Policy Committee (MPC) had clearly mentioned that the accommodative stance will continue well into 2021/22, but in April it changed track to continue 'as long as necessary to sustain growth'.
The Options And The Problems
First, the ultra-loose monetary policy has already created distortions in the money market. Credit is not picking up despite surplus liquidity. "The demand is reviving, but it is not enough to absorb the surplus liquidity. Low-interest rates do not support the investment theory," says Arun Singh, Chief Economist at Dun & Bradstreet.
Second, the RBI has to restore the pre-covid liquidity corridor of 25 basis points between repo (4 per cent) and reverse repo rate (3.35 per cent), which has been widened to 65 basis points since May last year, to discourage banks from parking surplus liquidity with the central bank.
The yields on short-term treasury bills, commercial papers (CPs) and certificates of deposits (CDs) have also crashed below the repo rate (RBI's lending rate) and the reverse repo (the RBI's rate for absorbing liquidity from banks). This makes monetary policy operations ineffective.
The central bank, however, has taken some steps to restore the cash reserve ratio (CRR), which was reduced by 100 per cent, to pre-Covid level of 4.0 per cent by May 2021. But certain CRR exemptions for auto, housing and MSMEs still continue. With a second Covid wave and localised lockdowns , the RBI's exit has become more difficult. CRR is the portion of bank deposits that has to be kept with the RBI. In April, it extended Targeted Long-Term Repo Operations (TLTRO) for six months and infused an additional Rs 50,000-crore liquidity into NABARD, SIDBI and NHB.
"Complete exit from the accommodative monetary policy stance is not on policymakers' radar in 2021. It has to be gradual, tracking economic recovery. The RBI might be looking towards a calibrated unwinding of monetary measures over the next year," says H.K. Pradhan, Professor of Finance & Economics, XLRI.
Experts suggest that the RBI's exit strategy of monetary measures will align with the government's fiscal policy to revive growth. Budget 2021/22 has laid out a clear roadmap for increased spending to push growth. The government plans to borrow Rs 12 lakh crore in 2021/22, a tad below than that in 2020/21. There is also a five-year long fiscal consolidation path - to bring down fiscal deficit to 4.5 per cent of GDP by 2025/26 from 9.5 per cent in 2010/21. "The real challenge would be to maintain market interest rates on the face of a significantly higher government borrowing target," says XLRI's Pradhan.
In a note issued recently, Oxford Economics said it expects monetary policy normalisation to be delayed to support economic recovery amid fiscal consolidation. Former RBI Deputy Governor Rakesh Mohan had even suggested a 5 per cent CPI or retail inflation target instead of the current 4 per cent, but the government has retained the latter. There is a view that a bit of higher inflation is good for the economy. Higher CPI target would have given the MPC some leeway to keep interest rates low for a longer period.
"On the contrary, an upward revision of the target inflation rate would have implications as it would make economic agents revise their cost-price benchmark. At the same time, making the band wider may be perceived as a shift towards 'softness' in policy targeting," says XLRI's Pradhan.
Inflation Targeting
Globally, inflation-targeting countries have tweaked their 'target' and 'benchmark'. For instance, the US Fed has made a shift from month-to-month to 'average inflation' targeting in 2021. This would provide it leeway to tolerate higher inflation. Within a span of a decade, Thailand, which also adjusted the inflation-targeting regime, has changed both the benchmark and the target. Brazil, too, had made changes in its inflation-targeting mandate.
Despite inflation concerns and rising yields, the RBI governor has been putting up a brave face. While outlining plans to raise government borrowings during a conclave held last month, Das said there was no reason why the central bank should do less open market operations (OMO) in 2021/22 than what it did (Rs 3 lakh crore) in 2020/21. The RBI has already created room for banks to buy more government securities by hiking the limit of securities held to maturity (HTM) to 22 per cent of deposits from the earlier limit of 19.5 per cent. This dispensation, which was available up to end of March this year, has been extended for another year. The HTM facility will protect banks from interest rate risks. "It opens up space for another Rs 4 lakh crore," Das had said during the conclave. Together, OMO and HTM would cover Rs 7 lakh crore of borrowings. "Net borrowing is Rs 9 lakh crore in 2021/22, so, the borrowing requirement of the Government of India is very much manageable," Das had said. In April, the RBI announced a secondary market G-sec buying programme (G-SAP 1.0) of Rs 1 lakh crore to soften yields.
So far, the RBI also has the support of the MPC to continue with its accommodative stance, provided inflation remains at the targeted level. But the situation could change given the rising inflation. The benchmark 10-year G-sec yield has already crossed the 6-per cent mark to hover around 6.13 per cent despite the RBI's efforts to keep it low. Till February, the central bank was very adamant on not accepting yields of over 6 per cent, but it seems to have succumbed to market pressure.
"The RBI is surrendering to the market as the G-sec yields or the borrowing cost of the government is gradually rising. The central bank also has limitations to control rising yields," says Govind Gurnani, a former RBI official.
Some optimists see clues in the Australian Central Bank's aggressive bond-buying last month when it was faced with a higher yield situation. But, as they say, there are no free lunches. The RBI's bond-buying initiative is increasing money supply in the economy. The central bank's balance sheet, too, is swelling, which has negative implications for the economy. Excess liquidity is finding its way into asset prices with stock markets at all-time highs. If liquidity is not managed properly, asset prices and inflation could create havoc in the market. Similarly, a prolonged regulatory forbearance to banks and financial institutions is likely to create another NPA cycle.
Das, however, has refused to give any timeline on exit. "The inflation outlook is uncertain. Ultimately, at the current juncture, growth is of paramount importance and we will take action as the situation emerges," the RBI governor said on April 7 during an online interaction after announcing the first monetary policy of FY22.
@anandadhikari
