Highlights of RBI’s Fifth Bi-monthly Monetary Policy Statement, 2018-19

Policy Measures

•   The Monetary Policy Committee (MPC) decided to keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 6.50%.
•    Consequently, the reverse repo rate under the LAF remains at 6.25%, and the marginal standing facility (MSF) rate and the Bank Rate at 6.75%.

       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 shown increasing signs of weakness on rising trade tensions. Among advanced economies (AEs), economic activity appears to be slowing in the US in Q4:2018, after a buoyant Q3. The Euro area growth lost pace in Q3, impacted by weaker trade growth and new vehicle emission standards. The Japanese economy contracted in Q3 on subdued external and domestic demand. Economic activity also decelerated in major emerging market economies (EMEs) in Q3. In China, growth slowed down on weak domestic demand. The ongoing trade tensions and the possible cooling of the housing market pose major risks to growth in China. The Russian economy lost some traction, pulled down largely by a weak agriculture harvest, though the growth was buttressed by strong performance of the energy sector. The Brazilian economy seems to be recovering gradually from the economic disruption in the first half of the year.

Crude oil prices have declined sharply, reflecting higher supplies and easing of geo-political tensions. The inflation scenario has remained broadly unchanged in the US and the Euro area. In many key EMEs, however, inflation has risen, though the recent retreat in energy prices, tightening of policy stances by central banks and stabilising of currencies may have a salutary impact, going forward.

 Global financial markets have been driven mainly by rising policy rates in the US, volatile crude oil prices and expectations of a slowdown compared with earlier projections. Among AEs, equity markets in the US witnessed a selloff on the weakening outlook for corporate earnings caused by rising borrowing costs, while the European stock markets declined on political uncertainties. The Japanese stock market also shed gains on global cues and the gradual strengthening of the yen. EM stock markets have corrected on shrinking global liquidity, weak economic data in some key EMEs, and lingering trade tensions. The 10-year yield in the US, which surged on robust economic data at the beginning of October, softened subsequently on the unchanged Fed stance. Among other AEs, bond yields in the Euro area and Japan softened on weak economic sentiment and idiosyncratic factors. In most EMEs, bond yields have softened in recent weeks on falling crude oil prices and steadying currencies. In currency markets, the US dollar, which was strengthening on a widening growth differential with its peers, eased in the second half of November. The euro has weakened on Brexit and budget concerns in Italy, while the yen appreciated on safe haven buying in November. EME currencies have been trading with an appreciating bias, supported by a sharp decline in crude oil prices and conservative domestic monetary policy stances.

In India GDP growth slowed down to 7.1 per cent year-on-year (y-o-y) in Q2:2018-19, after four consecutive quarters of acceleration, weighed down by moderation in private consumption and a large drag from net exports. Private consumption slowed down possibly on account of moderation in rural demand, subdued growth in kharif output, depressed prices of agricultural commodities and sluggish growth in rural wages. However, growth in government final consumption expenditure (GFCE) strengthened, buoyed by higher spending by the central government. Gross fixed capital formation (GFCF) expanded by double-digits for the third consecutive quarter, driven mainly by the public sector’s thrust on national highways and rural infrastructure, which was also reflected in robust growth in cement production and steel consumption. Growth of imports accelerated at a much faster pace than that of exports, resulting in net exports pulling down aggregate demand.

On the supply side, growth of gross value added (GVA) at basic prices decelerated to 6.9 per cent in Q2, reflecting moderation in agricultural and industrial activities. Slowdown in agricultural GVA was largely the outcome of tepid growth in kharif production. Within industry, growth in manufacturing decelerated due to lower profitability of manufacturing firms, pulled down largely by a rise in input costs, while that in mining and quarrying turned negative, caused by a contraction in output of crude oil and natural gas. Growth in electricity, gas, water supply and other utility services strengthened. Services sector growth remained unchanged at the previous quarter’s level. Of its constituents, growth in construction activity decelerated sequentially, but it was much higher on a y-o-y basis. Growth in public administration and defence services accelerated sharply.

The purchasing managers’ index (PMI) for manufacturing touched an eleven-month high of 54.0 in November, supported by an expansion in output, and domestic and export orders. According to the assessment of the Reserve Bank’s Industrial Outlook Survey (IOS), the overall business sentiment in Q3 remained stable, with sustained optimism about production and exports.

 Retail inflation, declined from 3.7 per cent in September to 3.3 per cent in October. A large fall in food prices pushed food group into deflation and more than offset the increase in inflation in items excluding food and fuel. Adjusting for the estimated impact of an increase in HRA for central government employees, headline inflation was 3.1 per cent in October. Within the food and beverages group, deflation in vegetables, pulses and sugar deepened in October. Inflation, however, showed an uptick in meat and fish, and non-alcoholic beverages. Inflation in the fuel and light group remained elevated, driven by LPG prices in October, tracking international petroleum product prices. However, electricity prices softened in October. Inflation in rural fuel items also moderated. CPI inflation excluding food and fuel accelerated to 6.1 per cent in October; adjusted for the estimated HRA impact, it was 5.9 per cent. Transport and communication registered a marked increase, pulled up by higher petroleum product prices, transportation fares and prices of automobiles. A broad-based increase was also observed in health, household goods and services, and personal care and effects. However, inflation moderated significantly in clothing and footwear, as also housing on waning of the HRA impact of central government employees.

Inflation expectations of households, measured by the November 2018 round of the Reserve Bank’s survey, softened by 40 basis points for the three-month ahead horizon over the last round reflecting decline in food and petroleum product prices, while they remained unchanged for the twelve-month ahead horizon. Producers’ assessment for input prices inflation eased marginally in Q3 as reported by manufacturing firms polled by the Reserve Bank’s IOS. Domestic farm and industrial input costs remained high. Rural wage growth remained muted in Q2, while staff cost growth in the manufacturing sector remained elevated.

Liquidity needs arising from the growth in currency and the Reserve Bank’s forex operations were met through a mixture of tools based on an assessment of the evolving liquidity conditions. The Reserve Bank injected durable liquidity amounting to Rs. 360 billion in October and Rs. 500 billion in November through open market purchase operations, bringing total durable liquidity injection to Rs. 1.36 trillion for 2018-19. Liquidity injected under the LAF, on an average daily net basis, was Rs. 560 billion in October, Rs. 806 billion in November. The WACR traded below the repo rate on an average by 5 basis points in October and 9 basis points in November. There was large currency expansion in October and especially during the festive season in November. Currency in circulation, however, contracted in each of the last three weeks in November. 

Merchandise exports rebounded in October 2018, after moderating in the previous month, driven mainly by petroleum products, engineering goods, chemicals, electronics, readymade garments, and gems and jewellery. Imports also grew at a faster pace in October relative to the previous month, contributed mainly by petroleum products and electronic goods. Consequently, the trade deficit widened in October, sequentially, as also in comparison with the level a year ago. Provisional data suggest a modest improvement in net exports of services in Q2:2018-19, which augurs well for the current account balance. On the financing side, net FDI flows moderated in April-September 2018. Portfolio flows turned positive in November on account of a sharp decline in oil prices, indications of a less hawkish stance by the US Fed and a softer US dollar. However, during the year, there were net portfolio outflows of US$14.8 billion (up to November 30). Non-resident deposits increased markedly in H1:2018-19 on a net basis over their level a year ago. India’s foreign exchange reserves were at US$393.7 billion on November 30, 2018.

Outlook

 GDP growth outlook for 2018-19 has been projected at 7.4 per cent (7.2-7.3 per cent in H2) as in the October policy, and for H1:2019-20 at 7.5 per cent, with risks somewhat to the downside. Although Q2 growth was lower than that projected in the October policy, GDP growth in H1 has been broadly along the line in the April policy when for the year as a whole GDP growth was projected at 7.4 per cent. Going forward, lower rabi sowing may adversely affect agriculture and hence rural demand. Financial market volatility, slowing global demand and rising trade tensions pose negative risk to exports. However, on the positive side, the decline in crude oil prices is expected to boost India’s growth prospects by improving corporate earnings and raising private consumption through higher disposable incomes. Increased capacity utilisation in the manufacturing sector also portends well for new capacity additions. There has been significant acceleration in investment activity and high frequency indicators suggest that it is likely to be sustained. Credit offtake from the banking sector has continued to strengthen even as global financial conditions have tightened. FDI flows could also increase with the improving prospects of the external sector. The demand outlook as reported by firms polled in the Reserve Bank’s IOS has improved in Q4. 

Headline inflation outlook is driven primarily by several factors. First, despite a significant scaling down of inflation projections in the October policy primarily due to moderation in food inflation, subsequent readings have continued to surprise on the downside with the food group slipping into deflation. The broad-based weakening of food prices imparts downward bias to the headline inflation trajectory, going forward. Secondly, in contrast to the food group, there has been a broad-based increase in inflation in non-food groups. Thirdly, international crude oil prices have declined sharply since the last policy; the price of Indian crude basket collapsed to below US$60 a barrel by end-November after touching US$85 a barrel in early October. However, selling prices, as reported by firms polled in the Reserve Bank’s latest IOS, are expected to edge up further in Q4 on the back of increased demand. Fourthly, global financial markets have continued to be volatile with EME currencies showing a somewhat appreciating bias in the last one month. Finally, the effect of the 7th Central Pay Commission’s HRA increase has continued to wane along expected lines. Taking all these factors into consideration and assuming a normal monsoon in 2019, inflation is projected at 2.7-3.2 per cent in H2:2018-19 and 3.8-4.2 per cent in H1:2019-20, with risks tilted to the upside.

Several uncertainties still cloud the inflation outlook. First, inflation projections incorporate benign food prices based on the realised outcomes of food inflation in recent months. The prices of several food items are at unusually low levels and there is a risk of sudden reversal, especially of volatile perishable items. Second, uncertainty continues about the exact impact of MSP on inflation, going forward. Third, the medium-term outlook for crude oil prices is still uncertain due to global demand conditions, geo-political tensions and decision of OPEC which could impinge on supplies. Fourth, global financial markets continue to be volatile. Fifth, though households’ near-term inflation expectations have moderated in the latest round of the Reserve Bank’s survey, one-year ahead expectations remain elevated and unchanged. Sixth, fiscal slippages, if any, at the centre/state levels, will influence the inflation outlook, heighten market volatility and crowd out private investment. Finally, the staggered impact of HRA revision by State Governments may push up headline inflation.

Developmental and Regulatory Policies

 External Benchmarking of New Floating Rate Loans by Banks

It is proposed that all new floating rate personal or retail loans (housing, auto, etc.) and floating rate loans to Micro and Small Enterprises extended by banks from April 1, 2019 shall be benchmarked to one of the following:

- Reserve Bank of India policy repo rate, or

- Government of India 91 days Treasury Bill yield produced by the Financial Benchmarks India Private Ltd (FBIL), or

- Government of India 182 days Treasury Bill yield produced by the FBIL, or

- Any other benchmark market interest rate produced by the FBIL.

The spread over the benchmark rate — to be decided wholly at banks’ discretion at the inception of the loan — should remain unchanged through the life of the loan, unless the borrower’s credit assessment undergoes a substantial change and as agreed upon in the loan contract. Banks are free to offer such external benchmark linked loans to other types of borrowers as well. In order to ensure transparency, standardisation, and ease of understanding of loan products by borrowers, a bank must adopt a uniform external benchmark within a loan category.

Aligning Statutory Liquidity Ratio with Liquidity Coverage Ratio

As per the existing roadmap, scheduled commercial banks have to reach the minimum Liquidity Coverage Ratio (LCR) of 100 per cent by January 1, 2019. Presently, Statutory Liquidity Ratio (SLR) is 19.5 per cent of Net Demand and Time Liabilities (NDTL). Further, the assets allowed to be reckoned as Level 1 High Quality Liquid Assets (HQLAs) for the purpose of computing the LCR of banks, inter alia, include (a) Government securities in excess of the minimum SLR requirement; and (b) within the mandatory SLR requirement, Government securities to the extent allowed by RBI under (i) Marginal Standing Facility (MSF) [presently 2 per cent of the bank's NDTL] and (ii) Facility to Avail Liquidity for Liquidity Coverage Ratio (FALLCR) [presently 13 per cent of the bank's NDTL]. In order to align the SLR with the LCR requirement, it is proposed to reduce the SLR by 25 basis points every calendar quarter until the SLR reaches 18 per cent of NDTL. 

Financial Markets

Access for Non-Residents to the Interest Rate Derivatives Market

The draft directions in this regard propose allowing non-residents to hedge their rupee interest rate risk flexibly using any available IRD instrument. Non-residents will also be permitted to participate in the Overnight Indexed Swap (OIS) market for non-hedging purposes, subject to a macro-prudential limit on exposure of all non-residents in terms of the interest rate risk undertaken.

 Measures to Improve Liquidity Management by Banks

 In order to enable banks to forecast their liquidity requirements with a greater degree of precision, it has been decided that the Reserve Bank will provide information on daily CRR balance of the banking system to market participants on the very next day. Accordingly, the daily Money Market Operations press release will contain the CRR figure for the previous day.

 Rationalisation of Borrowing and Lending Regulations under FEMA, 1999

As part of the ongoing efforts at rationalising multiple regulations framed over a period of time under FEMA, 1999, it is proposed to consolidate the regulations governing all types of borrowing and lending transactions between a person resident in India and a person resident outside India in both foreign currency and INR, in consultation with the Government. The proposed regulations, viz., Foreign Exchange Management (Borrowing or Lending) Regulations, 2018 shall subsume the existing ones and rationalise the extant framework for external commercial borrowings and Rupee denominated bonds with a view to improving the ease of doing business. 

Customer Education, Protection and Financial Inclusion

 Ombudsman Scheme for Digital Transactions

With the digital mode for financial transactions gaining traction in the country, there is an emerging need for a dedicated, cost-free and expeditious grievance redressal mechanism for strengthening consumer confidence in this channel. It has therefore been decided to implement an ‘Ombudsman Scheme for Digital Transactions’ covering services provided by entities falling under Reserve Bank’s regulatory jurisdiction.

        Framework for Limiting Customer Liability in respect of Unauthorised Electronic Payment Transactions

The Reserve Bank has issued instructions on limiting customer liability in respect of unauthorised electronic transactions involving banks and credit card issuing non-banking financial companies (NBFCs). As a measure of consumer protection, it has been decided to bring all customers up to the same level with regard to electronic transactions made by them and extend the benefit of limiting customer liability for unauthorised electronic transactions involving Prepaid Payment Instruments (PPIs) issued by other entities not covered by the extant guidelines.

        Expert Committee on Micro, Small and Medium Enterprises

An Expert Committee will be constituted by the Reserve Bank of India to identify causes and propose long-term solutions for the economic and financial sustainability of the MSME sector. 

Highlights of RBI’s Third Bi-monthly Monetary Policy Statement, 2018-19

Following are the Highlights of RBI’s Third Bi-monthly Monetary Policy Statement,     2018-19:

Policy Measures

• The Monetary Policy Committee (MPC) decided to increase the policy repo rate under the liquidity adjustment facility (LAF) by 25 basis points to 6.50%.
• Consequently, the reverse repo rate under the LAF stands adjusted to 6.25%, and the marginal standing facility (MSF) rate and the Bank Rate to 6.75%.
• 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 continued to maintain steam; however, global growth has become uneven and risks to the outlook have increased with rising trade tensions. Among AEs, the US economy rebounded strongly in Q2, after modest growth in Q1, on the back of rising personal consumption expenditures and exports. In the Euro Area, weak growth in Q1 continued in Q2 due to subdued consumer demand, weighed down by political uncertainty and a strong currency. In Japan, recent data on retail sales, consumer confidence and business sentiment point to moderation in growth. Economic activity in major EMEs has slowed somewhat on volatile and elevated oil prices, mounting trade tensions and tightening of financial conditions. The Chinese economy lost some pace in Q2, pulled down by efforts to contain debt. The Russian economy picked up in Q1; recent data on employment, industrial production and exports indicate that the economy has gained further momentum. South Africa’s economy contracted in Q1; though consumer sentiment has improved, high unemployment and weak exports pose challenges. In Brazil, economic activity suffered a setback in Q1 on nation-wide strikes; more recent data suggest that growth remained muted as industrial production contracted in May and the manufacturing PMI declined.

Global trade lost some traction due to intensification of trade wars and uncertainty stemming from Brexit negotiations. Crude oil prices, which remained volatile and elevated in May-June on a delicate demand-supply balance, eased modestly in the second half of July on higher supply from OPEC and non-OPEC producers. Base metal prices have fallen on the general risk-off sentiment triggered by fears of an intensification of trade wars. Gold prices have softened on a stronger dollar. Inflation remained firm in the US, reflecting higher oil prices and stronger aggregate demand. Inflation has edged up also in some other major advanced and emerging economies, driven, in part, by rising energy prices and pass-through effects from currency depreciations.

Global financial markets have continued to be driven mainly by monetary policy stances in major AEs and geopolitical tensions. Equity markets in AEs have declined on trade tensions and uncertainty relating to Brexit negotiations. Investors’ appetite for EME assets has waned on increases in interest rates by the US Fed. The 10-year sovereign yield in the US has moderated somewhat from its peak on May 17 on safe-haven demand, spurred by escalating trade conflicts. Yields have softened in other key AEs as well. In most EMEs, however, movements in yields have varied reflecting domestic macroeconomic fundamentals and tightening global liquidity. Capital flows to EMEs declined in anticipation of monetary policy tightening in AEs. In currency markets, the US dollar appreciated, supported by strong economic data. The euro strengthened in June on receding political uncertainty and taper talk by the central bank. However, the currency has traded soft thereafter on mixed economic data and the rising US dollar. EME currencies, in general, have depreciated against the US dollar over the last month.

In India IIP strengthened in April-May 2018 on a y-o-y basis. This was driven mainly by a significant turnaround in the production of capital goods and consumer durables. Growth in the infrastructure/construction sector accelerated sharply, reflecting the government’s thrust on national highways and rural housing, while the growth of consumer non-durables decelerated significantly. The output of eight core industries accelerated in June due to higher production in petroleum refinery products, steel, coal and cement. Capacity utilisation in the manufacturing sector remains robust. The assessment based on the Reserve Bank’s business expectations index (BEI) for Q1:2018-19 remained optimistic notwithstanding some softening in production, order books and exports. The July manufacturing PMI remained in expansion zone, although it eased from its level a month ago with slower growth in output, new orders and employment.

 Retail inflation, measured by year-on-year change in the CPI rose from 4.9 per cent in May to 5 per cent in June, driven by an uptick in inflation in fuel and in items other than food and fuel even as food inflation remained muted due to lower than usual seasonal uptick in prices of fruits and vegetables in summer months. Low inflation continued in cereals, meat, milk, oil, spices and non-alcoholic beverages, and pulses and sugar prices remained in deflation. Fuel and light group inflation rose sharply, pulled up by LPG and kerosene, while electricity inflation remained low. The pass-through of global crude oil prices impacted inflation in domestic petroleum products as well as transport services. Inflation also picked up modestly in respect of education and health. The June round of the Reserve Bank’s survey of households reported a further uptick of 20 basis points in inflation expectations for both three-month and one-year ahead horizons as compared with the last round. Manufacturing firms polled in the Reserve Bank’s industrial outlook survey reported higher input costs and selling prices in Q1:2018-19. The manufacturing PMI showed that input prices eased slightly in July, although they remained high. Input costs for companies polled in Services PMI in June also stayed elevated. Farm and non-farm input costs rose significantly. Notwithstanding some pick-up in February and March 2018, rural wage growth remained moderate, while wage growth in the organised sector remained firm.

The liquidity in the system remained generally in surplus mode during June-July 2018. In June, the Reserve Bank absorbed surplus liquidity of around Rs.140 billion on a daily net average basis under the LAF even as the system migrated from net surplus to a net deficit mode in the second half of the month due to advance tax outflows. Interest rates in the overnight call money market firmed up in June reflecting the increase in the repo rate on June 6, 2018. The weighted average call rate (WACR) traded, on an average, 12 basis points below the repo rate – the same as in May. Systemic liquidity moved back into surplus mode in early July with increased government spending but turned into deficit from July 10 onwards; on a daily net average basis, the Reserve Bank injected liquidity under the LAF of Rs.107 billion in July. The WACR in July, on an average, traded 9 basis points below the policy rate. Based on an assessment of prevailing liquidity conditions and of durable liquidity needs going forward, the Reserve Bank conducted two open OMO purchase auctions of Rs.100 billion each on June 21 and July 19, 2018.

Merchandise exports growth picked up in May and June 2018 on a y-o-y basis, aided by engineering goods, petroleum products, drugs and pharmaceuticals, and chemicals. During the same period, merchandise import growth also accelerated largely due to an increase in crude oil prices. Among non-oil imports, gold imports declined due to lower volume, while imports of machinery, coal, electronic goods, chemicals, and iron and steel increased sharply. Double-digit import growth in May and June pushed up the trade deficit. While net FDI inflows improved significantly in the first two months of 2018-19, with the tightening of liquidity conditions in AEs, growing geopolitical concerns and with the escalation of protectionist sentiment, net FPI outflows from the domestic capital market have continued, albeit at an increasingly slower rate. India’s foreign exchange reserves were at US$404.2 billion on July 27, 2018.

Outlook

 GDP growth outlook for 2018-19 is retained at 7.4 per cent as in the April policy. GDP growth is projected in the range of 7.5-7.6 per cent in H1 and 7.3-7.4 per cent in H2, with risks evenly balanced. Various indicators suggest that economic activity has continued to be strong. The progress of the monsoon so far and a sharper than the usual increase in MSPs of kharif crops are expected to boost rural demand by raising farmers’ income. Robust corporate earnings, especially of fast moving consumer goods (FMCG) companies, also reflect buoyant rural demand. Investment activity remains firm even as there has been some tightening of financing conditions in the recent period. Increased FDI flows in recent months and continued buoyant domestic capital market conditions bode well for investment activity. The Reserve Bank’s IOS indicates that activity in the manufacturing sector is expected to remain robust in Q2, though there may be some moderation in pace. Rising trade tensions may, however, have an adverse impact on India’s exports.

Headline inflation outlook is driven primarily by several factors. First, the central government has decided to fix the MSPs of at least 150 per cent of the cost of production for all kharif crops for the sowing season of 2018-19. This increase in MSPs, which is much larger than the average increase seen in the past few years, will have a direct impact on food inflation and second round effects on headline inflation. A part of the increase in MSPs based on historical trends was already included in the June baseline projections. However, there is a considerable uncertainty and the exact impact would depend on the nature and scale of the government’s procurement operations. Second, the overall performance of the monsoon so far augurs well for food inflation in the medium-term. Third, crude oil prices have moderated slightly, but remain at elevated levels. Fourth, the central government has reduced GST rates on several goods and services. This will have some direct moderating impact on inflation, provided there is a pass-through of reduced GST rates to retail consumers. Fifth, inflation in items excluding food and fuel has been broad-based and has risen significantly in recent months, reflecting greater pass-through of rising input costs and improving demand conditions. Finally, financial markets continue to be volatile. Based on an assessment of the above-mentioned factors, inflation is projected at 4.6 per cent in Q2 and 4.8 per cent in H2 of 2018-19, with risks evenly balanced. Excluding the HRA impact, CPI inflation is projected at 4.4 per cent in Q2 and 4.7-4.8 per cent in H2.

Developmental and Regulatory Policies

• Extension of MSF to Scheduled Primary (Urban) Cooperative Banks, and extension of LAF and MSF to Scheduled State Cooperative Banks, complying with the eligibility criteria prescribed for LAF / MSF, as part of the Reserve Bank’s continuous efforts in improving the transmission of monetary policy to money market rates.
• Investment in Non-SLR Securities by Primary (Urban) Cooperative Banks. In order to bring further efficiency in price discovery mechanism and as a step towards harmonization of regulations they will be permitted to undertake eligible transactions for acquisition / sale of non-SLR investment in secondary market with mutual funds, pension / provident funds, and insurance companies. This is in addition to undertaking eligible transactions with Scheduled Commercial Banks and Primary Dealers.    
• Co-origination of loans by Banks and Non-Banking Financial Companies (NBFCs) for lending to the priority sector to provide the much-needed competitive edge for credit to the priority sector. All SCBs (excluding Regional Rural Banks and Small Finance Banks) may co-originate loans with NBFCs - NBFC-ND-SIs, for the creation of eligible priority sector assets. The co-origination arrangement should entail joint contribution of credit by both lenders at the facility level. It should also involve sharing of risks and rewards between the banks and the NBFCs for ensuring appropriate alignment of respective business objectives, as per their mutual agreement.

Financial Markets

• Review of Foreign Exchange Derivative facilities for Residents (Regulation FEMA-25):  It is now proposed to undertake a comprehensive review of FEMA 25, in consultation with the Government of India, to, inter alia, reduce the administrative requirements for undertaking derivative transactions, allow dynamic hedging, and allow Indian multinationals to hedge the currency risks of their global subsidiaries from India.
• Comprehensive Review of Market Timings: It is necessary that timings across products and funding markets complement each other and avoid unanticipated frictions. It is, therefore, proposed, to set up an internal group to comprehensively review timings of various markets and the necessary payment infrastructure for supporting the recommended revisions to market timings. 
• Review of SGL/ CSGL Guidelines: In order to facilitate greater participation in the G-Secs markets and to provide market participants further operational ease in opening and operating of Subsidiary General Ledger (SGL) and Constituent Subsidiary General Ledger (CSGL) Accounts, it has been decided to review comprehensively the SGL/CSGL Guidelines. 

Highlights of RBI’s Sixth 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 gained further pace with growth impulses becoming more synchronised across regions. Among AEs, the Euro area expanded at a robust pace, supported by consumption and investment. The US economy lost some momentum with growth slowing down in Q4 of 2017 even as manufacturing activity touched a multi-month high in December. The Japanese economy continued to grow as manufacturing activity gathered pace in January on strong external demand. Economic activity accelerated in EMEs) in the final quarter of 2017. The Chinese economy grew above the official target, driven by strong domestic consumption and robust exports. However, some downside risks to growth remain, especially from easing fixed asset investment and surging debt levels. In Russia, strong private consumption, rising oil prices and high exports are supporting economic activity, although weak investment and economic sanctions are weighing on its growth prospects. In Brazil, data on household spending and unemployment were positive in Q4. However, recovery remains vulnerable to political uncertainty, which has dampened consumer confidence. South Africa continues to face challenges on both domestic and external fronts, including high unemployment and declining factory activity.

Global trade continued to expand, underpinned by strong investment and robust manufacturing activity. Crude oil prices touched a three-year high as production cuts by the OPEC coupled with falling inventories weighed on the global demand-supply balance. Bullion prices touched a multi-month high on a weak US dollar. Inflation remained contained in most AEs and was divergent in key EMEs due to country-specific factors.

Global financial markets have become volatile in recent days due to uncertainty over the pace of normalisation of the US Fed monetary policy. The volatility index (VIX) has climbed to its highest level since Brexit. Equity markets have witnessed a sharp correction, both in AEs and EMEs. Bond yields in the US have hardened sharply, adding to the upward pressures seen during January, with concomitant rise in bond yields in other AEs and EMEs. Forex markets have become volatile as well. Until this episode of recent volatility, global financial markets were buoyed by investor appetite for risk, corporate tax cuts by the US, and stable economic conditions. Equity markets had gained significantly in January, driven by robust Chinese growth, uptick in commodity prices, and positive corporate sentiment in general. In currency markets, the US dollar had touched a multi-month low on February 1 on fiscal risks and improving growth prospects in other AEs.

In India as per the first advance estimates released by the CSO is estimated to decelerate to 6.1 per cent in 2017-18 from 7.1 per cent in 2016-17 due mainly to slowdown in agriculture and allied activities, mining and quarrying, manufacturing, and public administration and defence services. Manufacturing output boosted the growth of IIP in November. After a period of prolonged weakness, cement production registered robust growth in November-December, which along with continuing healthy growth in steel production led to acceleration of infrastructure goods production in November. The manufacturing purchasing managers’ index (PMI) expanded for the sixth consecutive month in January led by new orders. Assessment of overall business sentiment in the Indian manufacturing sector improved in Q3 as reflected in the Reserve Bank’s Industrial Outlook Survey (IOS). However, core sector growth decelerated in December due to contraction/deceleration in production of coal, crude oil, steel and electricity. Acreage in the case of wheat, oilseeds and coarse cereals was lower than last year and there was a higher shortfall in area sown for rabi crops as of end-January.

 Retail inflation, measured by year-on-year change in the CPI, increased for the sixth consecutive month in December on account of a strong unfavourable base effect. After rising abruptly in November, food prices reversed partly in December, reflecting mainly the seasonal moderation, albeitmuted, in prices of vegetables along with continuing decline in prices of pulses. Cereals inflation moderated with prices remaining steady in December. However, inflation in some components of food – eggs; meat and fish; oils and fats; and milk – increased. Fuel and light group inflation, which showed a sharp increase in November, softened somewhat in December, driven by moderation in electricity, LPG and kerosene inflation.

CPI inflation excluding food and fuel, increased further in November and December, largely on account of increase in housing inflation following the implementation of higher HRA for government employees under the 7th CPC award. Inflation also picked up in health and personal care and effects. Reflecting incomplete pass-through to domestic petroleum product prices, inflation in transport and communication remained muted in December. Inflation also slowed down in clothing and footwear, household goods and services, recreation, and education. Organised sector wage growth remained firm, while the rural wage growth decelerated.

The liquidity in the system continues to be in surplus mode, but it is moving steadily towards neutrality. The weighted average call rate (WACR) traded 12 bps below the repo rate during December-January as against 15 bps below the repo rate in November. On some days in December and January, the system turned into deficit due to slow down in government spending and large tax collections, which necessitated injection of liquidity by the Reserve Bank. For December as a whole, however, the Reserve Bank absorbed Rs. 316 billion (on a net daily average basis). For January, on the whole, the Reserve Bank absorbed Rs. 353 billion.

Merchandise exports bounced back in November and December. While petroleum products, engineering goods and chemicals accounted for three-fourths of this growth, exports of readymade garments contracted. During the same period, merchandise import growth accelerated sequentially with over one-third of the growth emanating from petroleum (crude and products) due largely to high international prices. Gold imports increased – both in value and volume terms – in December, after declining in the preceding three months. Pearls and precious stones, electronic goods and coal were major contributors to non-oil non-gold import growth. With import growth exceeding export growth, the trade deficit for December was US$ 14.9 billion. Even though the current account deficit narrowed sharply in Q2 of 2017-18 on a sequential basis, it was higher than its level a year ago, mainly due to widening of the trade deficit. While net FDI inflows moderated in April-October 2017 from their level a year ago, net FPI inflows were buoyant in 2017-18 (up to February 1). India’s foreign exchange reserves were at US$ 421.9 billion on February 2, 2018.

Outlook

 GVA growth for 2017-18 is projected at 6.6 per cent. Beyond the current year, the growth outlook will be influenced by several factors. First, GST implementation is stabilising, which augurs well for economic activity. Second, there are early signs of revival in investment activity as reflected in improving credit offtake, large resource mobilisation from the primary capital market, and improving capital goods production and imports. Third, the process of recapitalisation of public sector banks has got underway. Large distressed borrowers are being referenced for resolution under the Insolvency and Bankruptcy Code (IBC). This should improve credit flows further and create demand for fresh investment. Fourth, although export growth is expected to improve further on account of improving global demand, elevated commodity prices, especially of oil, may act as a drag on aggregate demand. 

Headline inflation averaged 4.6 per cent in Q3, driven primarily by an unusual pick-up in food prices in November. Though prices eased in December, the winter seasonal food price moderation was less than usual. Domestic pump prices of petrol and diesel rose sharply in January, reflecting lagged pass-through of the past increases in international crude oil prices. Considering these factors, inflation is now estimated at 5.1 per cent in Q4, including the HRA impact.

Developmental and Regulatory Policies

• Relief for MSME Borrowers: (for which the aggregate exposure of banks and NBFCs does not exceed ₹ 250 million as on January 31, 2018), MSMEs who have registered under GST, be allowed by banks and NBFCs to pay the amounts overdue as on September 1, 2017 and payments due between September 1, 2017 and January 31, 2018, within 180 days from their original due date, as a measure to support their transition to a formalised business environment.
• Remove the currently applicable loan limits of Rs. 50 million and Rs. 100 million per borrower to Micro, Small and Medium Enterprises, (Services) respectively, for classification under priority sector.
• It has been decided that the sub-target of 8 percent of Adjusted Net Bank Credit (ANBC) or Credit Equivalent Amount of Off-Balance Sheet Exposure (CEOBE), whichever is higher, will be made applicable for lending to the small and marginal farmers for foreign banks with 20 branches and above from FY 2018-19. Further, the sub-target for bank lending to the Micro Enterprises in the country of 7.50 percent of ANBC or CEOBE, whichever is higher, will also be made applicable for foreign banks with 20 branches and above from FY 2018-19.
• It has been decided to harmonize the methodology of determining benchmark rates by linking the Base Rate to the MCLR with effect from April 1, 2018. 
• With a view to harmonizing regulations across different types of collateral and also to encourage wider participation, especially for corporate debt repos, the repo directions are proposed to be streamlined and simplified. 
• It is now proposed to allow non-residents hedging their INR currency risk arising out of their current and capital account transactions to dynamically hedge their currency and interest rate exposures onshore using any of the permitted instruments.
• It is now proposed to merge position limits across all foreign currency-INR pairs and provide a single limit of USD 100 million per user (both resident and non-resident) across all exchange traded currency derivatives, in all exchanges combined. 
• It is proposed that (i) FBIL would assume the responsibility for standardising the valuation of Government securities (issued by both the Centre and States) currently being done by FIMMDA; and, (ii) FBIL would also assume the responsibility for computation and dissemination of the daily “Reference Rate” for Spot USD/INR and other major currencies against the Rupee, which is currently being done by the Reserve Bank.
• With a view to providing customers of NBFCs with a cost-free and expeditious grievance redress mechanism, it has been decided to introduce an Ombudsman Scheme for NBFCs. The scheme will cover all deposit taking NBFCs and those with customer interface having asset-size of Rupees One Billion and above. 
• Standardize the note printing processes, procurement of raw materials, quality assurance processes, security, etc.
• With a view to promote a less cash economy it has been decided to discontinue the incentives for installation of Cash Recycler Machines (CRMs) and Automated Teller Machines (ATMs).

Highlights of the Union Budget for 2018-19

Introductory Remarks

Budget 2018-19 reflects the Government’s firm commitment to substantially boost investment in Agriculture, Social Sector, Digital Payments, Infrastructure and Employment Generation on the one hand and simultaneously stick to the path of fiscal rectitude by aiming for a reduction of fiscal deficit by 0.2% of GDP over RE 2017-18.

Fiscal situation

• Fiscal deficit target for 2018-19 at 3.3% of GDP to accommodate higher demand for expenditure against the earlier target of 3%. Revised deficit target for the year ending in March 2018 is 3.5% of GDP from the targeted 3.2%. Revenue deficit shot up to 2.6% of GDP in 2017-18 from the budget estimate of 1.9% of GDP (as receiving GST revenue for 11 months in 2017-18 led to a shortfall of Rs.50,000 crore).
• Aims to reduce its debt-to-GDP ratio to 48.8% in 2018-19, 46.7% in 2019-20 and 44.6% in 2020-21. Nominal GDP for BE 2018-2019 has been projected at Rs. 18722302 crore assuming 11.5% growth over the estimated GDP of Rs. 16784679 crore for 2017-18 (RE).
• Revenue receipts budgeted at Rs. 1725738 crores for 2018-19 against a BE of Rs. 1515771 and RE of Rs. 1505428 crore for 2017-18. Centre’s tax revenues at Rs. 1480649 crore in BE 2018-19 against a BE of Rs. 1227014 crore and RE of Rs.1269454 crore in 2017-18. Non- tax revenues at Rs. 245089 crore in BE 2018-19 against a BE of Rs. 288757 crore and RE of Rs. 235974 crore in 2017-18.
• Total expenditure is budgeted at Rs. 2442213 crore for 2018-19 as against a BE of Rs. 2146735 crore and RE of Rs. 2217750 crore in 2017-18.
• BE of Expenditure for 2018-19 show an increase of Rs. 2,24,463 crore over the RE 2017-18. Increases have occurred for higher —compensation to States and UTs for revenue loss on roll out of GST; payment of interest under Market loans; food subsidy under National Food Security Act; Defence, Civil and pensions payable to erstwhile employees of Department of Telecommunications, absorbed in Bharat Sanchar Nigam Limited; outlays provided for investment in Indian Railways, School Education and Literacy, Higher Education Financing Agency, Atomic Energy Industries and Construction of roads; capital expenditure of Defence Services; higher requirement by Central Armed Police Forces; provision made for Pradhan Mantri Swasthya Suraksha Yojana.
• Borrowings and Other Liabilities estimated at Rs. 624276 crore in BE of 2018-19 as against a BE of Rs. 546531 crore and RE of Rs. 594849 crore in 2017-18.
• Total resources going to States including the devolution of State’s share in taxes, Grants/Loans, and releases under Centrally Sponsored Schemes in BE (2018-19) is Rs.12,69,435 crore, with a jump of Rs. 1,53,558 crore over RE (2017-18) and Rs. 2,83,760 crore more than the Actuals (2016-17).

• Disinvestment target for this year set at ₹80,000 crore.

Tax proposals

Personal income tax

• No changes in personal income tax slabs.
• Salaried tax-payers to get a standard deduction of Rs. 40,000 in lieu of transport allowance and "other medical expenses".
• All senior citizens will now be able to claim benefit of a deduction of Rs. 50,000 for any medical insurance.
• For critical illnesses, the deduction has been increased to Rs. 1,00,000.
• Govt. will contribute 12% of the wages of new employees in EPF in all sectors for next 3 years. Women’s contribution to EPF reduced to 8% for first 3 years
  

• ₹2,000-crore fund for development of agri markets.
• Free power connections to 4 crore homes under Saubhagya Yojana. Rs. 16000 crore under this scheme
• Eight crore free gas connections for poor women through Ujjwala Yojana.
• Govt. to implement minimum support price for all crops; It is hiked to 1.5 times of production costs.
• New flagship National Health Protection Scheme, providing a health insurance cover of ₹5 lakh per family per year announced.
• Automatic revision of emoluments parliamentarians every five years, pegged to inflation.
• develop and upgrade existing 22,000 rural haats into Gramin Agricultural Markets (GrAMs). In these GrAMs, physical infrastructure will be strengthened using MGNREGA and other Government Schemes. These GrAMs, electronically linked to e-NAM and exempted from regulations of APMCs, will provide farmers facility to make direct sale to consumers and bulk purchasers.
• Organic farming in large clusters, preferably of 1000 hectares each, will be encouraged.
• Allocation of Ministry of Food Processing is being doubled from `715 crore in RE 2017-18 to `1400 crore in BE 2018-19.
• Rs. 500 crore ‘‘Operation Greens’’ to promote Farmer Producers Organizations (FPOs), agri-logistics, processing facilities and professional management.
• Export of agricommodities to be liberalized. state-of-the-art testing facilities in 42 Mega Food Parks to be set up.
• Volume of institutional credit for agriculture sector raised to Rs. 11 trillion for the year 2018-19 from Rs. 10 trllion in 2017-18.

BUDGET GLOSSARY

https://mofapp.nic.in/budgetmicrosite/images/union-budget-2018-brochure.pdf

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.