The biggest takeaway from the minutes of the Monetary Policy Committee (MPC) is the fear expressed by several members that India’s GDP growth may be gone for more than just a year.
This is the first time experts in official circles are acknowledging that the damage to the economy goes beyond the current year and can indeed mean the 7 percent average of the last two decades is gone for a few years.
Sample this: “The damage is so deep and extensive that India’s potential output has been pushed down, and it will take years to repair,“ writes Michael Patra MPC member and an RBI DG.
As he explains, “the destruction of economic activity by COVID-19 and ensuing lockdowns is much more deleterious in terms of loss of basic livelihood, economic security, health and confidence than the range of estimates/projections of GDP... suggest.”
While the blow to health and confidence is global, the other RBI DG and MPC member Janak Raj explains how severely India’s investment capability has been damaged.
Raj said there are three reasons investment demands will be hit.
One, given the collapse in demand, excess capacity is likely to be created in many sectors. "This, combined with huge uncertainty about future demand, both domestic and external, is likely to hamper new investments in the private sector."
Two, financing of investment activity – from own sources due to a decline in profitability or by borrowing due to weak balance sheets – will also be a challenge.
Three, Raj wrote that the focus of government spending, both by the Centre and the States, will also be on revenue expenditure than on capital expenditure.
"For all these reasons, investment activity, which contracted in last two quarters, is expected to be severely hit, going forward,” he said.
Janak Raj’s worry about a long-term investment drought gives reasons to believe that India’s potential to grow has been hit; and such potential can’t be built in a year.
The other RBI member in the MPC, governor Shaktikanta Das himself is more restrained, saying that the demand side will continue to weigh heavily on economic activity for "some time to come".
The RBI governor added that “overall, the GDP growth in 2020-21 is estimated to remain in negative territory; the pace of recovery will be contingent upon the containment of the pandemic and how quickly social distancing/lockdown measures are phased out."
None of these may be new to professional forecasters, but as the first official admission of damage to India’s longer-term potential, these minutes are important. They are in sharp contrast to the PM’s statement at the CII that “getting growth back wont be so tough”!
Incidentally, external member R Dholakia actually worried about even a negative nominal growth, not just real GDP contraction:
“Even the nominal GDP growth may slip into the negative zone. There are all symptoms of a recession – fall in aggregate demand, negative real growth and high unemployment”, he wrote.
The second major takeaway from the RBI members is their plea that the government capitalise the banks.
“Given the enormity of a collapse in demand, the need is to move ahead full throttle to ease financing conditions further so as to revive consumption and revitalize investment,” explains the governor.
”Since banks are the key players in financing consumption and investment, it is also imperative that they remain adequately capitalised," he argues.
Janak Raj echoes the governor's views: "For monetary policy actions to transmit fully to the credit market, it is important that banks remain well-capitalised. Only banks with strong balance sheets could be expected to support lending activity as and when credit demand picks up.”
How low can interest rates go
A third point that stood out is that the external members are conscious of their inflation mandate and this gives the impression there they don’t see too much space for rate cuts.
Even the usually dovish Dholakia says: "Although the real policy rate in most other comparator countries is zero or negative, in India it is not only positive but relatively very high at around 1.2 to 1.6 percent. I believe that the real policy rate needs to be kept positive but not so high under the present conditions."
Dholakia expects CPI to fall to around 3 percent by end-2020. Assuming he thinks 0.5% is the ideal real rate, then according to one of the MPC's most dovish members, the repo can at best be cut by another 50 bps down to 3.5 percent!
Chetan Ghate, of course, worried about the sharp spike in inflation expectations.
What MPC didn't discuss
Finally, no member raised or tackled the issue of the large government borrowing and hence direct monetization of deficit by the RBI.
Nor did anyone speak about the fragility of the financial sector. Perhaps these will come up in the next MPC, which may be the second last policy for the 3 external members. Their term expires in September.