Moody’s upgrades India’s sovereign bond rating after 14 years

—the rationale

Moody's Investors Service has upgraded the Government of India's local and foreign currency issuer ratings to Baa2 from Baa3 and changed the outlook on the rating to stable from positive. Moody's has also raised India's long-term foreign-currency bond ceiling to Baa1 from Baa2, and the long-term foreign-currency bank deposit ceiling to Baa2 from Baa3. The short-term foreign-currency bond ceiling remains unchanged at P-2, and the short-term foreign-currency bank deposit ceiling has been raised to P-2 from P-3. The long-term local currency deposit and bond ceilings remain unchanged at A1. According to the Moody’s PR on 14 November 2017, a rating committee was called to discuss the rating of the India, Government of. The main points raised during the discussion were: The issuer's economic fundamentals, including its economic strength, have not materially changed. The issuer's institutional strength/ framework have not materially changed. The issuer's fiscal or financial strength, including its debt profile, has not materially changed. The issuer's susceptibility to event risks has not materially changed.

The decision to upgrade the ratings is underpinned by the expectation that continued progress on economic and institutional reforms will, over time, enhance India's high growth potential and its large and stable financing base for government debt, and will likely contribute to a gradual decline in the general government debt burden over the medium term. In the meantime, while India's high debt burden remains a constraint on the country's credit profile, Moody's believes that the reforms put in place have reduced the risk of a sharp increase in debt, even in potential downside scenarios. While a number of important reforms remain at the design phase, Moody's believes that those implemented to date will advance the government's objective of improving the business climate, enhancing productivity, stimulating foreign and domestic investment, and ultimately fostering strong and sustainable growth. Measures include the Goods and Services Tax (GST) which among other things, is expected to promote productivity by removing barriers to interstate trade; improvements to the monetary policy framework; measures to address the overhang of non-performing loans (NPLs) in the banking system; and others which work towards fostering stronger institutions and a more formal economy.

Moody's expects real GDP growth to moderate to 6.7% in the fiscal year ending in March 2018 (FY2017-18). However, as disruption fades, assisted by recent government measures to support SMEs and exporters with GST compliance, real GDP growth is expected to rise to 7.5% in FY2018-19. Longer term, India's growth potential is significantly higher than most other Baa-rated sovereigns. While India's high debt burden remains a constraint on the country's credit profile, Moody's estimates that the reforms put in place have reduced the risk of a sharp increase in debt, even in potential downside scenarios.

The upgrade comes within five years of India being classified as one of the "fragile five" economies, struggling with high twin deficits in fiscal and current accounts. Since then a combination of policy decisions and external factors has worked in favour of an upgrade. The Finance Ministry has held on to the targets for fiscal deficit, while the current account has been bolstered by a period of low oil prices followed by a resurgence of global trade. India’s position in the World Bank’s Ease of Doing Business rankings jumped up by a record 30 notches to the 100th spot recently with relevant policy easing. The upgrade has been termed overdue by some as India was earlier in the same risk category as a number of economies with far worse macro-economic performance. Indeed a Bloomberg Economics model had predicted an upgrade based on the divergence between actual ratings and CDS implied credit ratings.

—the benefits

The sovereign rating is an indicator of the government’s ability to meet its financial obligations. Sovereign credit ratings give investors insight into the level of risk associated with investing in a particular country and also include political risks. An upgrade thus lowers the cost of borrowing for the sovereign as it is associated with lower risk. In Moody’s rating, scale, bonds rated Baa3 and above are considered to be investment grade, meaning, these bonds are likely to meet the payment obligations better. India was at the lowest rung of the investment grade until it received this upgrade. The Indian government, it may be noted, does not fund its deficits via offshore commercial bond markets. External debt as a percentage of the Central Government’s total liabilities was at 6.2% in 2015-16. The entire public debt of India is funded via the domestic Rupee (INR) bond market. Foreign investor participation in the bond market, though increasing is very little, and tightly regulated through quotas. However, there are certain other benefits to be derived from a sovereign upgrade.

Sovereign ratings also act as the benchmark for other issuers of debt in the country. Effectively, sovereign upgrades or downgrades can affect borrowing costs for companies, individuals and any entity looking to raise money overseas. Moody’s upgraded some Indian corporate entities, mostly public sector companies along with the sovereign upgrade. This would result in reduction in cost of borrowing for Indian companies looking to raise financing from offshore bond markets. In fact, Reliance recorded the tightest ever spread for an Indian issue over US Treasuries in the offshore market soon after the upgrade.

The sovereign rating is an important indicator of the country’s financial and fiscal health. Foreign investors looking to commit money to direct investments, portfolio investments or local bond markets will all tend to look to the sovereign rating for a quick assessment of the country’s prospects. A ratings upgrade gives out a positive view on policy and builds incremental confidence in foreign investors. A higher rating can increase the range of investors, for example, drawing in global Pension and Life Insurance firms that have minimum ratings criteria for investing. Incrementally higher foreign flows tend to bid up INR too, making investments in a host of other Indian financial assets like equities and real estate more attractive to foreign investors.

—and the caveats

Moody’s mentions that a material deterioration in fiscal metrics and the outlook for general government fiscal consolidation would put negative pressure on the rating. The rating could also face downward pressure if the health of the banking system deteriorated significantly or external vulnerability increased sharply. The upgrade has come in at a time when a gamut of short and long-term indicators has started to worsen. Given the emerging signs of quickening inflation and a widening current account and fiscal deficit a lot of policy balancing is in order.

S&P Global Ratings and Fitch Ratings, who now rate India a notch below Moody’s, hold the view that for an upgrade, India would have to address its weak fiscal balance sheet and weak fiscal performance. S&P Global Ratings, while acknowledging India’s stronger growth prospects and the country’s achievements on the reforms agenda, noted that its ratings were constrained by India’s low wealth levels, measured by GDP per capita. This and the income inequality hidden behind it, is indeed a macro-economic indicator which, on its own, needs far greater policy attention and careful planning than it has received so far.

Sources include:

https://www.moodys.com/research/Moodys-upgrades-Indias-government-bond-rating-to-Baa2-from-Baa3--PR_374998

https://economictimes.indiatimes.com/markets/stocks/news/moodys-upgrade-is-just-a-milestone-in-indias-development-journey/articleshow/61719739.cms

Government’s Rs. 2.11 trillion bank recapitalisation— Sufficient to cover stressed assets but no quick fix

The government, the largest shareholder will recapitalise the banks it owns by infusing an unprecedented amount of Rs. 2.11 trillion (US$32 billion), of which Rs. 1.35 trillion will be through recapitalisation bonds. Infusion of capital would help to fast-track the resolution of non-performing assets (NPAs) and take Indian PSBs closer to global capital adequacy norms. The move is expected help economic recovery with the revival of flow of credit to business and industry, and particularly foster medium and small industries growth and employment generation.

Public sector banks require capital mainly because of a sharp rise in NPAs in the last decade due to delays in repayments from sectors like power, steel and infrastructure. The gross NPA ratio reached 9.7 per cent in FY17, up from 7.8 per cent in FY16. Including loans that have been restructured the ratio of stressed loans rises to 12% of total banking sector loans. Weak credit discipline in banks, right from the appraisal to sanction stage, was recognised, by the RBI, as one of the main bank specific factors in the build-up of stressed assets. Swift, time-bound resolution or liquidation of stressed assets was recognised as critical for de-clogging bank balance sheets and for efficient reallocation of capital and a multi-pronged approach taken.  The Asset Quality Review (AQR) exercise undertaken in 2015-16 was a critical step in recognising the aggregate stock of NPAs across the banking system. Setting up of CRILC (Central Repository of Information on Large Credits) by the RBI in 2014, gave access to an aggregate view of borrower-wise and bank-wise exposures, to supervisors as well as lenders, to track the incipient stress in a particular account in a timely manner. The decision to do away with the regulatory forbearance regarding asset classification on restructuring of loans and advances effective April, 2015, was a significant step from the perspective of aligning the regulatory norms with international best practices. The system of ‘Prompt Corrective Action’ (PCA) ensures timely supervisory action in case banks breach certain risk-related trigger points. The enactment of the Insolvency and Bankruptcy Code, 2016 (IBC) puts a time limit of 180 days (extendable by a further 90 days) within which creditors have to agree to a resolution plan, failing which the adjudicating authority under the law will pass a liquidation order on the insolvent company (https://www.rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1044).

The necessity for capital infusion had also been emphasised by various rating agencies such as Moody’s, CRISIL and Fitch, as well by RBI insiders. Moody’s estimated that the external capital requirements for the 11 rated PSBs, over the next two years would be around Rs. 700-950 billion, factoring in the two main drivers of their capital needs—the need to comply with Basel III requirements, and for conservative recognition and provisioning of their asset quality problems. Such an amount is much higher than the remaining Rs.200 billion previously budgeted by the government for capital infusion until March 2019. Under Basel III norms, being implemented in phases between April 2013 and March 2019, banks need to have a core capital ratio of 8% and a total capital adequacy ratio of 11.5% against 9% now. Capital adequacy is a measure of a bank’s financial strength expressed as a ratio of capital to risk-weighted assets (CRAR). A number of single factor sensitivity stress tests, based on March 2017 data were carried out, by the RBI, on SCBs to assess their vulnerabilities and resilience under various scenarios. SCBs’ resilience with respect to credit, interest rate, and liquidity risks as also due to drop in equity prices was studied. A severe credit shock is likely to impact capital adequacy and profitability of a significant number of banks. Under a severe shock of 3 standard deviations (that is, if the average GNPA ratio of 59 select SCBs moves up to 15.6 per cent from 9.6 per cent), the system level CRAR and Tier-1 CRAR will decline to 10.4 per cent and 7.9 per cent respectively. At the individual bank-level, the stress test results show that 25 banks having a share of 44.4 per cent of SCBs’ total assets might fail to maintain the required CRAR under the shock of a large 3 standard deviations increase in GNPAs. PSBs were found to be severely impacted with the CRAR of 22 PSBs likely to go down below 9 per cent.

The government is yet to disclose details on the structure and pricing of the Rs. 1.35 trillion recap bonds, as well as how it will raise the rest of the cash. It is expected that banks will subscribe to these bonds and hold it on their books as their investment. The funds which will go to the government will be reinvested as equity in the same banks. The programme is expected to have minor impact on its target to shrink the fiscal deficit to 3.2% of GDP in FY18, because the government will probably classify the bonds as off-balance sheet items as per permissible accounting norms. However, the government still has to bear the interest cost; to service the debt it will need to at least bear a cost of Rs. 80-90 billion, according to various unofficial estimates. Apart from the recap bonds, Rs. 0.18 trillion will come from the budget, in line with earlier provisioning under the Indradhanush scheme, leaving Rs. 0.58 trillion to be raised from the market. Front-loading of bonds is expected to increase the equity prices of PSBs. Rating agencies have called the government’s Rs. 2.11 trillion PSU bank recapitalisation plan significantly credit positive. Post the announcement, the 30-share BSE Sensex gained 387.96 points to open on 32,995.28 and the 50-share NSE Nifty gained 113.45 points to open on 10,321.15. Both the indices extended gains with Sensex breaching the 33,000-mark to touch the peak of 33,117.33 and Nifty scaling a fresh high of 10,340.55. PSU Banks were leading the rally in early trade with the Nifty PSU Bank sub-index jumping 22.76 per cent Most public sector banks’ shares have surged more than 20% since the announcement by the MoF.

However, apart from the modalities of the plan, questions that arise relate to its actual effect on the bond market, on governance issues of banks and its actual impact on the economy. The bond market faces a formidable supply load, even in the face of excess liquidity now being managed by RBI. Such large scale financing, though executed over two years and possibly held on books, could nevertheless, hamper the ability of the biggest subscribers, the PSBs, to invest in bonds and may push up yields eventually when liquidity dries up.  A series of banking reforms are to accompany the capital infusion, however, doubts definitely arise about moral hazards of such bail-outs as past experience of the 1990s has demonstrated that banks have not been able to shore up their lending practices so as to stem further build-up of toxic assets. Further, at this stage there are uncertainties about the appetite of borrowers with large overcapacities on GST implementation, and hence capital freed up for lending may not have immediate takers and not have much of the desired effect on economic revival. Again banks too may prioritize asset resolution and provisioning over expansion. Hence, the measure announced should not be seen as a one-shot solution to the banking sector’s and the economy’s current aliments, but rather as an important part of an integrated process, which still needs much careful planning and monitoring at each stage.

Highlights of RBI’s Fourth Bi-monthly Monetary Policy Statement, 2017-18:

Policy Measures

• The Monetary Policy Committee (MPC) decided to keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 6.00%.
• Consequently, the reverse repo rate under the LAF remains unchanged at 5.75%, and the marginal standing facility (MSF) rate and the Bank Rate are at 6.25%.
• The decision of the MPC is consistent with a neutral stance of monetary policy in consonance with the objective of achieving the medium-term target for consumer price index (CPI) inflation of 4% within a band of +/- 2%, while supporting growth. 

 Assessment

Global economic activity has strengthened further and become broad-based. Among advanced economies (AEs), the US has continued to expand with revised Q2 GDP growing at its strongest pace in more than two years, supported by robust consumer spending and business fixed investment. Euro area economic recovery gained further traction, underpinned by domestic demand. While private consumption benefited from employment gains, investment rose on the back of favourable financing conditions. The Japanese economy continued on a path of healthy expansion despite a downward revision in growth since March 2017 on weaker than expected capital expenditure. Strong growth in Q2 in China was powered by retail sales, and imports grew at a rapid pace, suggesting robust domestic demand. The Brazilian economy expanded for two consecutive quarters in Q2 on improving terms of trade, even as the impact of recession persists on the labour market. Economic activity in Russia recovered further, supported by strengthening global demand, firming up of oil prices and accommodative monetary policy. Although South Africa has emerged out of recession in Q2, the economy faces economic and political challenges.

The latest assessment by the WTO indicates a significant improvement in global trade in 2017, backed by a resurgence of Asian trade flows and rising imports by North America. Crude oil prices hit a two-year high in September on account of the combined effect of a pick-up in demand, tightening supplies due to production cuts by the OPEC and declining crude oil inventories in the US. Bullion prices touched a year’s high in early September on account of safe-haven demand due to geo-political tensions. Weak non-oil commodity prices and low wage growth kept inflation pressures low in most AEs and subdued in several EMEs, largely reflecting country-specific factors.

Global financial markets have been driven mainly by the changing course of monetary policy in AEs, generally improving economic prospects and oscillating geo-political factors. Equity markets in most AEs have continued to rise. In EMEs, equities generally gained on improved global risk appetite, supported by upbeat economic data and expectations of a slower pace of monetary tightening in major AEs. While bond yields in major AEs moved sideways, they showed wider variation in EMEs. The euro surged to a two and a half year high against the US dollar towards end-August on positive economic data. Most AE and EME currencies showed divergent movements.

In India GVA growth slowed significantly in Q1 of 2017-18, cushioned partly by the extensive front-loading of expenditure by the central government. GVA growth in agriculture and allied activities slackened in the usual first quarter moderation. Industrial sector GVA growth fell sequentially as well as on a y-o-y basis. The manufacturing sector – the dominant component of industrial GVA – grew by 1.2 per cent, the lowest in the last 20 quarters. The mining sector contracted, services sector performance, however, improved markedly, construction, as well as, financial, real estate & professional services,  picked up pace. Of the constituents of aggregate demand, growth in private consumption expenditure was at a six-quarter low in Q1 of 2017-18. Gross fixed capital formation exhibited a modest recovery in Q1 in contrast to a contraction in the preceding quarter.

The uneven spatial distribution of the monsoon was reflected in the first advance estimates of kharif production, which were below the level of the previous year.

IIP recovered marginally in July 2017 from the contraction in June on the back of a recovery in mining, quarrying and electricity generation. However, manufacturing remained weak. In terms of the use-based classification, contraction in capital goods, intermediate goods and consumer durables pulled down overall IIP growth. In August, however, the output of core industries posted robust growth on the back of an uptick in coal production and electricity generation. 

 Retail inflation, measured by year-on-year change in the CPI, edged up sequentially in July and August to reach a five month high. After a decline in prices in June, food inflation rebounded in the following two months, driven mainly by a sharp rise in vegetable prices. Cereals inflation remained benign, while deflation in pulses continued for the ninth successive month. Fuel group inflation remained broadly unchanged in August. Petroleum product prices tracked the hardening of international crude oil prices. CPI inflation excluding food and fuel also increased sharply in July and further in August, reversing from its trough in June.

A large liquidity overhang, fuelled mainly by the front-loading of government spend, which necessitated frequent recourse to ways and means advances and overdrafts over the greater part of this period, imparted a downside bias to overnight money market rates in H1 of 2017-18. Surplus liquidity in the system persisted through Q2 even as the build-up in government cash balances since mid-September 2017 due to advance tax outflows reduced the size of the surplus liquidity significantly in the second half of the month. Active liquidity operations narrowed the spread between the WACR and the policy rate from 31 bps in April to 13 bps in September. The RBI conducted OMO sales on six occasions during Q2 to absorb Rs. 600 billion of surplus liquidity on a durable basis. Net average absorption of liquidity under the LAF declined from Rs. 3 trillion in July to Rs. 1.6 trillion in the second half of September. The weighted average CMR, which on an average, traded below the repo rate by 18 bps during July, firmed up by 5 bps in September on account of higher demand for liquidity around mid-September in response to advance tax outflows.

Reflecting improving global demand, merchandise export growth picked up in August 2017 after decelerating in the preceding three months. Engineering goods, petroleum products and chemicals were the major contributors to export growth in August 2017; growth in exports of readymade garments and drugs & pharmaceuticals too returned to positive territory. Import growth remained in double-digits for the eighth successive month in August and was fairly broad-based. While the surge in imports of crude oil and coal largely reflected a rise in international prices, imports of machinery, machine tools, iron and steel also picked up. Gold import volume has declined sequentially since June. The sharper increase in imports relative to exports resulted in a widening of the CAD in Q1 of 2017-18, even as net services exports and remittances picked up. Net FDI at US$10.6 billion in April-July 2017 was 24% higher than during the same period of last year. While the debt segment of the domestic capital market attracted FPI of US$14.4 billion, there were significant outflows in the equity segment in August-September on account of geo-political uncertainties and expected normalisation of Fed asset purchases. India’s foreign exchange reserves were at US$399.7 billion on September 29, 2017.

Outlook

 The projection of real GVA growth for 2017-18 has been revised down to 6.7 per cent from the August 2017 projection of 7.3 per cent, with risks evenly balanced. The loss of momentum in Q1 of 2017-18 and the first advance estimates of kharif foodgrains production are early setbacks that impart a downside to the outlook. The implementation of the GST so far also appears to have had an adverse impact, rendering prospects for the manufacturing sector uncertain in the short term. This may further delay the revival of investment activity, which is already hampered by stressed balance sheets of banks and corporates.

Headline inflation was projected at 3 per cent in Q2 and 4.0-4.5 per cent in the second half of 2017-18. Actual inflation outcomes so far have been broadly in line with projections, though the extent of the rise in inflation excluding food and fuel has been somewhat higher than expected. Taking into account domestic and international factors, including food prices, price revisions pending the GST, the house rent allowance by the Centre and international crude prices, inflation is expected to rise from its current level and range between 4.2-4.6 per cent in the second half of this year.

Developmental and Regulatory Policies

The RBI also set out various developmental and regulatory policy measures for further improving monetary transmission; strengthening banking regulation and supervision; broadening and deepening financial markets; and, extending the reach of financial services by enhancing the efficacy of the payment and settlement systems:

Measures to Improve Monetary Policy Transmission: Arbitrariness in calculating the base rate/MCLR and spreads charged over them has undermined the integrity of the interest rate setting process. The base rate/MCLR regime is also not in sync with global practices on pricing of bank loans. A Study Group has, therefore, recommended a switchover to an external benchmark in a time-bound manner.

Banking Regulation and Supervision: As a part of the transition to a LCR of 100% by January 1, 2019, the SLR will be reduced by 50 bps, from 20.0% to 19.50% of banks’ NDTL, from the fortnight commencing October 14, 2017. The ceiling on SLR securities under ‘Held to Maturity’ (HTM) will also be reduced from 20.25% to 19.50% of banks’ NDTL in a phased manner, i.e., 20.00% by December 31, 2017 and 19.50% by March 31, 2018.

High-level Task Force on Public Credit Registry (PCR) will propose a state-of-the-art information system, allowing for existing systems to be strengthened and integrated, and suggest a modular, prioritized roadmap for developing a transparent, comprehensive and near-real-time PCR for India. 

It has been decided to require banks to make it mandatory for corporate borrowers having aggregate fund-based and non-fund based exposure of Rs. 50 million and above from any bank to obtain Legal Entity Identifier (LEI) registration and capture the same in the Central Repository of Information on Large Credits (CRILC). This will facilitate assessment of aggregate borrowing by corporate groups, and monitoring of the financial profile of an entity/group.

The regulatory norms have been eased in order to enable all co-operative banks to open current accounts and maintain CRR with the Reserve Bank. All the regional offices of the Reserve Bank have been advised to issue no objection certificates for opening current accounts for all licensed co-operative banks other than those under all-inclusive directions.

The P2P platform has been notified as an NBFC under section 45I (f) (iii) of the Reserve Bank of India Act, 1934 as per the gazette notification published on September 18, 2017.

 Banks to put in place explicit mechanisms for meeting the needs of senior citizens and differently abled persons for availing banking facilities in branches.

Financial Markets:  The Reserve Bank shall put in place a framework for authorisation of electronic trading platforms (ETP) for financial market instruments regulated by the Reserve Bank. 

A Foreign Exchange Trading Platform is proposed for improving the pricing outcome for the “retail user” (to be defined in terms of transaction size) under which client pricing is directly determined in the market by providing customers with access to an inter-bank electronic trading platform where bid/offers from clients and Authorised Dealer banks can be matched anonymously and automatically.

Non-resident importers and exporters (NRIE) entering into rupee invoiced trade transactions with residents will be permitted to hedge their INR exposures through their centralised treasury/group entities. This is expected to facilitate internationalisation of the rupee by encouraging rupee invoicing of trade transactions while also encouraging non-residents to hedge INR risks onshore.

A detailed review of current regulations on FPI debt investment shall be undertaken to facilitate the process of investment and hedging by FPIs, keeping in mind macro-prudential considerations. Regulatory changes to be finalised in consultation with the Government of India and the SEBI will be effective from April 2018.

Smoother settlement of short sale transactions is necessary for orderly functioning of the market. Towards this end, it has been decided that (i) a short seller need not borrow securities for ‘notional short sales’, wherein it is required to borrow the security even when the security is held in the held-for-trading/available-for-sale/held-to-maturity portfolios of banks; and, (ii) OTC G-sec transactions by FPIs may be contracted for settlement on a T+1 or T+2 basis. 

 In order to further develop liquidity in the State Development Loan (SDL) market, spread the issuance of SDLs, move towards market-based pricing that is sensitive to individual state’s fiscal risk metrics, and reduce uncertainties in announcement of auction results, the following measures are being proposed:

• Consolidation of state government debt will be undertaken to improve liquidity in SDLs through reissuances and buybacks, so as to even out redemption pressures and elongate residual maturity.
• SDL auctions will be conducted on a weekly basis and the auction results will be announced latest by 3.00 PM on the same day.
• High frequency data relating to finances of state governments available with the Reserve Bank will be disclosed on its website.

The Union Budget 2016-17 announced that the Reserve Bank will facilitate retail participation in the primary and secondary markets through stock exchanges. Accordingly, after consultation with the SEBI, it is proposed that:

• specified stock exchanges, in addition to scheduled banks and primary dealers, will be permitted to act as aggregators/facilitators for retail investor bids in the non-competitive segment for the auction of dated securities and treasury bills of the Government of India.

Payment and Settlement:  In line with the Vision for Payment and Settlement Systems in the country, a revised framework will pave the way for bringing inter-operability into usage of PPIs.

Highlights of RBI’s Third Bi-monthly Monetary Policy Statement, 2017-18:

Policy Measures

• The Monetary Policy Committee (MPC) decided to reduce the policy repo rate under the liquidity adjustment facility (LAF) from 6.25% to 6.00% with immediate effect.
• Consequently, the reverse repo rate under the LAF stands adjusted to 5.75%, and the marginal standing facility (MSF) rate and the Bank Rate to 6.25%.
• Inflation excluding food and fuel, which has hitherto been sticky, has fallen significantly over past three months. These factors along with the normal and well distributed rainfall and the smooth rollout of the GST opened up some space for Monetary Policy accommodation. Accordingly, the MPC decided by a vote of 4 to 2 to reduce the policy rate by 25 basis points.
• The decision of the MPC is consistent with a neutral stance of monetary policy in consonance with the objective of achieving the medium-term target for consumer price index (CPI) inflation of 4% within a band of +/- 2%, while supporting growth. 

 Assessment

Impulses of growth have spread across the global economy albeit still lacking the strength of a self-sustaining recovery. Among the AEs, the US has expanded at a faster pace in Q2 after a weak Q1, supported mostly by steadily improving labour market conditions. In the Euro area, the recovery has broadened across constituent economies on the back of falling unemployment and a pickup in private consumption.  In Japan, a modest but steady expansion has been taking hold, underpinned mostly by strengthening exports. Among EMEs, growth has regained some lost ground in China in Q2.  The Russian economy has emerged out of two years of recession. In Brazil, a fragile recovery remains vulnerable to political uncertainty and a still depressed labour market. South Africa is in a technical recession as economic activity in continues to be beset by structural and institutional bottlenecks. The modest firming up of global demand and stable commodity prices have supported global trade volumes, reflected in rising exports and imports in key economies. In the second half of July, crude prices have risen modestly out of bearish territory on account of inventory drawdown in the US, but the supply overhang persists. Chinese demand has fuelled a recent rally in metal prices. However, inflation is well below target in most AEs and is subdued across most EMEs.

International financial markets have been resilient to political uncertainties and volatility has declined. Equity markets in most AEs have registered gains, with indices crossing previous highs in the US. In EMEs, equities have gained on surging global risk appetite.  Bond yields in major AEs have hardened on expectations of monetary policy normalization, while in EMEs fixed-income markets have been generally insulated from the bond sell-off in AEs. In the currency markets, the US dollar weakened further and fell to a multi-month low in July. The euro, which has remained bullish, rallied further on upbeat economic data.  EME currencies largely remained stable and have traded with an appreciating bias.

In India a normal and well-distributed south-west monsoon for the second consecutive year has brightened the prospects of agricultural and allied activities and rural demand. Meanwhile, procurement operations in respect of rice and wheat during the rabi marketing season have been stepped up to record levels.

Industrial performance has weakened in April-May 2017, mainly reflecting a broad-based loss of momentum in manufacturing. The output of consumer non-durables accelerated and underlined the resilience of rural demand. It was overwhelmed, however, by contraction in consumer durables – indicative of still sluggish urban demand – and in capital goods, which points to continuing retrenchment of capital formation in the economy. The weakness in the capex cycle was also evident in the number of new investment announcements falling to a 12-year low in Q1, the lack of traction in the implementation of stalled projects, deceleration in the output of infrastructure goods, and the ongoing deleveraging in the corporate sector. The output of core industries was also dragged down by contraction in electricity, coal and fertiliser production in June, owing to excess inventory and tepid demand. The 78th round of the Reserve Bank’s industrial outlook survey revealed a waning of optimism in Q2 about demand conditions across parameters, and especially on capacity utilisation, profit margins and employment. The manufacturing PMI moderated sequentially to a four-month low in June and in July, the PMI declined into the contraction zone with a decrease in new orders and a deterioration in business conditions, reflecting inter alia the roll out of the GST.

In June, retail inflation measured by year-on-year changes in the CPI plunged to its lowest reading in the series based to 2011-12. This was mainly the outcome of large favourable base effects which are slated to dissipate and reverse from August. Prices of food and beverages, which went into deflation in May 2017 for the first time in the new CPI series, sank further in June as prices of pulses, vegetables, spices and eggs recorded year-on-year declines and inflation moderated across most other sub-groups. . Fuel inflation declined for the second month in succession as international prices of LPG fell and price increases moderated in other categories. Excluding food and fuel, CPI inflation moderated for the third month in succession in June, falling to 4%.

Surplus liquidity conditions persisted in the system, exacerbated by front-loading of budgetary spending by the Government. Surplus liquidity of Rs. 1 trillion was absorbed through issuance of treasury bills (TBs) under the MSS and Rs. 1.3 trillion through CMBs on a cumulative basis so far this financial year. Enduring surplus conditions warranted outright open market sales of Rs.100 billion each on two occasions in June and July. Apart from these operations, net average absorption of liquidity under the LAF was at Rs. 3.1 trillion in June and Rs. 3.0 trillion in July. Reflecting this active liquidity management, the weighted average CMR firmed up and traded about 17 bps below the repo rate on average during June and July.

Merchandise export growth weakened in May and June from the April peak as the value of shipments across commodity groups either slowed or declined. By contrast, import growth remained in double digits, primarily due to a surge in oil imports and stockpiling of gold imports ahead of the implementation of the GST. As import growth continued to outpace export growth, the trade deficit at US$40.1 billion in Q1 was more than double its level a year ago.

Net FDI doubled in April-May 2017 over its level a year ago, flowing mainly into manufacturing, retail and wholesale trade and business services. FPIs made net purchases of US$15.2 billion in domestic debt and equity markets so far (up to July 31), remaining bullish on the outlook for the Indian economy. The level of foreign exchange reserves was US$392.9 billion as on July 28, 2017.

Outlook

The projection of real GVA growth for 2017-18 has been retained at the June 2017 projection of 7.3 per cent, with risks evenly balanced. Business sentiment in the manufacturing sector reflects expectations of moderation of activity in Q2 of 2017-18 from the preceding quarter. Moreover, high levels of stress in twin balance sheets – banks and corporations – are likely to deter new investment. With the real estate sector coming under the regulatory umbrella, new project launches may involve extended gestations and, along with the anticipated consolidation in the sector, may restrain growth, with spillovers to construction and ancillary activities. Also, given the limits on raising market borrowings and taxes by States, farm loan waivers are likely to compel a cutback on capital expenditure, with adverse implications for the already damped capex cycle. At the same time, upsides to the baseline projections emanate from the rising probability of another good kharif harvest, the boost to rural demand from the higher budgetary allocation to housing in rural areas, the significant step-up in the budgetary allocation for roads and bridges, and the growth-enhancing effects of the GST, viz., the shifting of trade from unorganised to organised segments; the reduction of tax cascades; cost, efficiency and competitiveness gains; and synergies in domestic supply chains. External demand conditions are gradually improving and should support the domestic economy.

The second bi-monthly statement projected quarterly average headline inflation in the range of 2.0-3.5 per cent in the first half of the year and 3.5-4.5 per cent in the second half. The actual outcome for Q1 has tracked projections. Looking ahead, as base effects fade, the evolving momentum of inflation would be determined by (a) the impact on the CPI of the implementation of house rent allowances (HRA) under the 7th central pay commission (CPC); (b) the impact of the price revisions withheld ahead of the GST; and (c) the disentangling of the structural and transitory factors shaping food inflation. The inflation trajectory has been updated taking into account all these factors and incorporates the first round impact of the implementation of the HRA award by the Centre. Excluding the HRA impact, which will affect the CPI cumulatively, headline inflation would be a little above 4% by Q4, as against 4.5% inclusive of the HRA in the June statement. However, there are several factors contributing to uncertainty on both sides around this baseline inflation trajectory.

Developmental and Regulatory Policies

The RBI also set out measures to improve policy transmission and financial intermediation in the economy:

The experience with the MCLR system introduced in April 2016 for improving monetary policy transmission has not been entirely satisfactory, even though it has been an advance over the Base Rate system. Given a large part of the floating rate loan portfolio of banks is still anchored on the Base Rate, the RBI will be exploring various options in the near future to make the Base Rate more responsive to changes in cost of funds of banks.

Final guidelines set out for Tri-party Repo aimed to pave the way for a vibrant corporate bond borrowing and lending market, providing better liquidity and price discovery, reducing market cost of capital and allowing access to non-bank finance for a greater number of borrowers in the economy.

Task force to evaluate the existing public and private infrastructure for credit information, assess any data gaps, study the best international practices and provide a road map for the development of a comprehensive near real-time public credit registry for India.

Guidelines on Liquidity Coverage Ratio (LCR) have been revised such that reserves held by banks incorporated in India with a foreign central bank, in excess of the reserve requirement in the host country, should be treated as High Quality Liquid Assets (HQLAs), subject to certain conditions.

The circular to operationalize the scheme of simplified hedging facility has been finalized. The scheme aims to simplify the process for hedging exchange rate risk by reducing documentation requirements and avoiding prescriptive stipulations regarding products, purpose and hedging flexibility.

Separate limit of Interest Rate Futures (IRFs) for FPIs to be introduced to ensure FPIs’ access to futures remains uninterrupted during the phase when FPI limits on Government securities are under auction. It is proposed to allocate FPIs a separate limit of Rs. 5,000 crore for long position in IRFs. The limits prescribed for investment by FPIs in Government securities will then be exclusively available for acquiring such securities.