The Monetary Policy Committee (MPC) responded with alacrity as the Covid-19 crisis spread in India, cutting the policy repo rate by 115 bps in two tranches in March 2020 and May 2020. With this, the repo rate was brought down to 4.0 per cent, well below the floor of 4.75 per cent seen during the global financial crisis, reinforcing the MPC’s commitment to supporting the real sector.

As the Committee meets this week, its policy choices have become decidedly more complicated. The prolonged duration of the pandemic has worsened the outlook for economic activity. We expect the Indian economy to record a painful 9.5 per cent contraction in real GDP in FY21, with a year-on-year (y-o-y) de-growth for three consecutive quarters in Q1-Q3 FY21, and a marginal y-o-y rise in Q4 FY21.

Inflation readings

Simultaneously, the recent inflation figures have turned out to be rather unpalatable. The data released by the Central Statistics Office (CSO) for the headline CPI inflation for the lockdown months of April-May 2020 has created some controversy, given the method of imputation that has been adopted. Regardless, inflation has printed above the upper threshold of the MPC’s medium-term target of 2-6 per cent throughout Q1 FY21, and we project it to have risen in July 2020. Accordingly, many market participants have pencilled in a pause from the MPC in its August 2020 review.

However, we expect a downtrend in inflation readings to resume in August 2020. The CPI inflation is expected to soften appreciably to 2.7 per cent in H2 FY21 from 6.1 per cent in H1 FY21, benefitting partly from the favourable base effect for food items, as well as the expectation of muted demand for non-essential items.

Therefore, in our view, the MPC should look through the temporary above-target inflation readings, and front load rate cuts to signal continued support to the real economy and allow adequate time for transmission to take place.

The efficacy of rate cuts in the current scenario may well turn out to be a mere palliative to sentiment, and far from a trigger for fresh investment and consumption, but it is important nonetheless, given the testing times being faced by various economic agents.

The rate decision, the stance of monetary policy, and the underlying tone of the policy statement with respect to the how close we are to the end of the rate cut cycle, will crucially guide bond yields in the rest of this quarter, especially until the H2 borrowing calendar for government securities is released.

On the fiscal front, the news is sombre. In Q1 FY21, the fiscal deficit of the Government of India (GoI) widened by a significant 53.3 per cent from the level in Q1 FY20, and usurped 83.2 per cent of the budget estimate for the full year.

Taking into account our projections of the revenue shock facing the GoI (upward of ₹6 trillion), the fiscal support announced so far (around ₹2 trillion) and the expenditure management measures employed, we expect its fiscal deficit to breach ₹13 trillion in FY21, a sharp slippage from the budgeted level of ₹8 trillion.

G-Sec auctions

Moreover, our baseline forecast of the fiscal slippage (₹5 trillion) exceeds the upward revision in gross market borrowings announced thus far for FY21 (₹4.2 trillion). So far, the Central government has raised an additional ₹0.58 trillion above the announced levels of its weekly G-Sec auctions, through the exercise of green-shoe options. In particular, the benchmark G-Sec introduced in May 2020 (05.79 GS 2030) has already been replaced in a matter of less than a quarter, given its heavy issuance of ₹1.22 trillion in a matter of just three months.

According to provisional data from the Controller General of Accounts, while the inflows into savings deposits and certificates and public provident funds were subdued in the lockdown months, they have jumped in June 2020 as mobility improved in the unlock period. Nevertheless, the pace of growth of such inflows was muted on a y-o-y basis in Q1 FY21.

Overall, we continue to expect the GoI’s market borrowing programme for H2 FY21 to undergo an upward revision, which may push up yields in the absence of support from the Reserve Bank of India, such as secondary market G-Sec purchases.

Lastly, while the banking system remains awash in liquidity, there would be pockets of stress in the corporate and MSME sectors. Their actual liquidity situation will become clear only once the loan moratorium ends.

The writer is Principal Economist, ICRA

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