Monetary Policy Report - April 2021

Published under Section 45ZM of the Reserve Bank of India Act, 1934 Monetary Policy Report APRIL 2021 Reserve Bank of India MumbaiContents Chapter I: Macroeconomic Outlook 1 I.1 : Key Developments since the October 2020 MPR 1 I.2 : The Outlook for Inflation 4 I.3 : The Outlook for Growth 6 I.4 : Balance of Risks 11 I.5 : Conclusion 13 Box I.1: Quarterly Projection Model 2.0 7 Chapter II: Prices and Costs 14 II.1 : Consumer Prices 15 II.2 : Drivers of Inflation 16 II.3 : Costs 29 II.4 : Conclusion 31 Box: II.1: CPI Goods and Services: Do they Converge after Shocks? 26 Chapter III: Demand and Output 32 III.1: Aggregate Demand 32 III.2: Aggregate Supply 45 III.3: Conclusion 54 Box III.1: Investment and Financial Conditions 36 Chapter IV: Financial Markets and Liquidity Conditions 55 IV.1: Domestic Financial Markets 55 IV.2: Monetary Policy Transmission 68 IV.3: Liquidity Conditions and the Operating Procedure of Monetary Policy 71 IV.4: Conclusion 76 Box IV.1: Announcement Effect of Open Market Operations on Financial Markets 74 Chapter V: External Environment 77 V.1 : Global Economic Conditions 77 V.2 : Commodity Prices and Inflation 81 V.3 : Monetary Policy Stance 83 V.4 : Global Financial Markets 88 V.5 : Conclusion 92 Box V.1: Central Bank Actions to Mitigate Climate Change Risk: Cross-country Experience 85 Box V.2: Financial Markets and Real Economy Disconnect – Bubble or Retreat? 89 iABBREVIATIONS AEs - Advanced Economies CII - Confederation of Indian Industry AEs - Advance Estimates CLI - Composite Leading Indicator AL - Agricultural Labourers COVID-19 - Coronavirus Disease 2019 APMC - Agricultural Produce Market CP - Commercial Paper Committee CPC - Central Pay Commission ARCH - Autoregressive Conditional CPI - Consumer Price Index Heteroskedasticity CPI-AL - Consumer Price Index for AUD - Australian Dollar Agricultural Labourers BCB - Banco Central do Brasil CPI-IW - Consumer Price Index for Industrial BCD - Basic Customs Duty Workers BE - Budget Estimates CPI-RL - Consumer Price Index for Rural BEI - Business Expectations Index Labourers BG - Breusch-Godfrey CRR - Cash Reserve Ratio BI - Bank Indonesia CU - Capacity Utilisation BIS - Bank for International Settlements DCA - Department of Consumer Affairs BoC - Bank of Canada DFM - Dynamic Factor Model BoE - Bank of England DGCA - Directorate General of Civil Aviation BoJ - Bank of Japan DGCI&S - Directorate General of Commercial BoR - Bank of Russia Intelligence and Statistics bps - Basis Points EC - Error Correction BRICS - Brazil, Russia, India, China and ECB - European Central Bank South Africa ECLGS - Emergency Credit Line Guarantee CACP - Commission for Agricultural Costs Scheme and Prices EMEs - Emerging Market Economies CBs - Corporate Bonds eNAM - National Agriculture Market CCIL - Clearing Corporation of India Limited ENSO - El Niño - Southern Oscillation CD - Certificate of Deposit ES - Event Study CDS - Credit Default Swap ETFs - Exchange -Traded Funds CGA - Controller General of Accounts, EU - European Union Ministry of Finance EXIM - Export-Import Bank of India CI - Confidence Interval FAE - First Advance Estimates CiC - Currency in Circulation iiiiiiMonetary Policy Report April 2021 FAO - Food and Agriculture Organization H2 - Second Half of the Financial Year (October-March) FBIL - Financial Benchmarks India Pvt Ltd HKMA - Hong Kong Monetary Authority FCI - Financial Condition Index HRA - House Rent Allowance FD - Fiscal Deficit HTM - Held to Maturity FDI - Foreign Direct Investment IIP - Index of Industrial Production Fed - Federal Reserve IMF - International Monetary Fund FICCI - Federation of Indian Chambers of Commerce and Industry INR - Indian Rupee FIMMDA - Fixed Income Money Market and IOCL - Indian Oil Corporation Limited Derivatives Association of India IOS - Industrial Outlook Survey FIs - Financial Institutions IPCC - Intergovernmental Panel on Climate FIT - Flexible Inflation Targeting Change FOMC - Federal Open Market Committee IRFCL - International Reserves and Foreign Currency Liquidity FPAS - Forecast and Policy Analysis System ISM - Institute for Supply Management FPI - Foreign Portfolio Investment FRE - First Revised Estimates LAF - Liquidity Adjustment Facility F-TRAC - Financial Market Trade Reporting LM - Lagrange Multiplier and Confirmation System LPG - Liquified Petroleum Gas GDP - Gross Domestic Product LTROs - Long Term Repo Operations GEPUI - Global Economic Policy Uncertainty MCLR - Marginal Cost of Funds Based Index Lending Rate GFCE - Government Final Consumption MEP - Minimum Export Price Expenditure MFs - Mutual Funds GFCF - Gross Fixed Capital Formation MGNREGA - Mahatma Gandhi National Rural GFD - Gross Fiscal Deficit Employment Guarantee Act GNDI - Gross National Disposable Income MMRP - Modified Mixed Reference Period GoI - Government of India MOAFW - Ministry of Agriculture and Farmers’ GSDP - Gross State Domestic Product Welfare G-Sec - Government Securities m-o-m - Month-on-Month GST - Goods and Services Tax MOSPI - Ministry of Statistics and Programme Implementation GVA - Gross Value Added MPC - Monetary Policy Committee H1 - First Half of the Financial Year (April-September) MPR - Monetary Policy Report iivvAbbreviations MSCI - Morgan Stanley Capital International OMCs - Oil Marketing Companies MSF - Marginal Standing Facility OMOs - Open Market Operations MSMEs - Micro, Small and Medium OPEC - Organization of the Petroleum Enterprises Exporting Countries MSP - Minimum Support Price OT - Operation Twist NABARD - National Bank for Agriculture and OTC - Over-the-Counter Rural Development PADO - Public Administration, Defence and NBER - National Bureau of Economic Other services Research PBoC - People’s Bank of China NBFCs - Non-Banking Financial Companies PCE - Personal Consumption Expenditure NCAER - National Council of Applied PDS - Public Distribution System Economic Research PDs - Primary Dealers NDS - Negotiated Dealing System PEPP - Pandemic Emergency Purchase NDTL - Net Demand and Time Liabilities Programme NEER - Nominal Effective Exchange Rate PFCE - Private Final Consumption Expenditure NGFS - Network of Central Banks and Supervisors for Greening the PLI - Production Linked Incentive Financial System PMI - Purchasing Managers’ Index NGNF - Non-Government Non-Financial POL - Petroleum, Oil and Lubricants NHB - National Housing Bank PSBs - Public Sector Banks NIMs - Net Interest Margins PSL - Priority Sector Lending NOAA - National Oceanic and Atmospheric PSU - Public Sector Undertaking Administration Q1 - First Quarter NPA - Non-Performing Asset Q2 - Second Quarter NSC - National Savings Certificate Q3 - Third Quarter NSDL - National Securities Depository Q4 - Fourth Quarter Limited q-o-q - Quarter-on-Quarter NSO - National Statistical Office QPM - Quarterly Projection Model NSSF - National Small Saving Fund RBA - Reserve Bank of Australia NSSO - National Sample Survey Office RBI - Reserve Bank of India OECD - Organisation for Economic Cooperation and Development RBNZ - Reserve Bank of New Zealand OIS - Overnight Index Swaps RD - Revenue Deficit vvMonetary Policy Report April 2021 RE - Revised Estimates US$ - US Dollar REER - Real Effective Exchange Rate VAR - Vector Autoregression RHS - Right Hand Side VAT - Value Added Tax RL - Rural Labourers VECM - Vector Error Correction Model RM - Reserve Money VRRR - Variable Rate Reverse Repo SAAR - Seasonally Adjusted Annualised Rate WAC - Weighted Average Coupon SAE - Second Advance Estimates WACR - Weighted Average Call Money Rate SARB - South African Reserve Bank WADR - Weighted Average Discount Rate SCBs - Scheduled Commercial Banks SDLs - State Development Loans WADTDR - Weighted Average Domestic Term Deposit Rate SEBI - Securities and Exchange Board of India WALR - Weighted Average Lending Rate SIAM - Society of Indian Automobile WAR - Weighted Average Rate Manufacturers WCFI&ES - Working - Class Family Income & SIDBI - Small Industries Development Bank Expenditure Survey of India WEO - World Economic Outlook SLF - Special Liquidity Facility WMA - Ways and Means Advances SLR - Statutory Liquidity Ratio SOI - Southern Oscillation Index WPI - Wholesale Price Index T-Bill - Treasury Bill WTI - West Texas Intermediate TLTRO - Targeted Long-Term Repo Operation WTO - World Trade Organization UK - United Kingdom y-o-y - Year-on-Year US - United States YTD - Year to Date vviiI. Macroeconomic Outlook The rebound from the COVID-19 induced slump has been sharper than anticipated and economic activity is expected to rebound strongly in 2021-22. Headline consumer price index (CPI) inflation receded into the tolerance band beginning December 2020. Core inflation pressures remain elevated, reflecting pass-through from higher crude oil and non-oil commodity prices, high fuel and other taxes post-COVID and increased operating costs. The evolving COVID-19 trajectory and progress on vaccination remain the key drivers of economic activity and inflation, globally and in India. Section 45-ZA of the RBI Act, 1934 requires that the momentum in Q4:2020, driven by multiple vaccine Central Government shall, in consultation with the approvals, the launch of inoculation drives in many Reserve Bank of India (RBI), determine the inflation countries and the extension of monetary and fiscal target in terms of consumer price index (CPI), once stimuli. On the other hand, new mutants of the in every five years. Accordingly, in a notification on COVID-19 virus, second/third waves of infections, March 31, 2021, the Central Government, in renewed lockdowns in many countries and uneven consultation with the RBI, retained the inflation target access to vaccines across countries continue to weigh at 4 per cent (with the upper tolerance level of 6 per on the outlook. The resurgence of commodity price inflation, supported by abundant global liquidity, has cent and the lower tolerance level of 2 per cent) for fuelled reflation trade in global financial markets. the 5-year period April 1, 2021 to March 31, 2026. Despite the promise of continued accommodative The experience with successfully maintaining price monetary policies by central banks, bond yields have stability and the gains in credibility for monetary firmed up from very low levels, spurred by inflation policy since the institution of the inflation targeting concerns and expectations of stronger growth. Amidst framework in 2016 would be reinforced by the stretched valuations, equity prices have become retention of the target and the tolerance band.1 The sensitive to the hardening of yields. In turn, exchange experience during the COVID-19 period has testified rates have become volatile, with capital outflows from to the flexibility of the framework to respond to sharp emerging economies in early March interrupting their growth-inflation trade-offs and extreme supply-side earlier ebullience on risk-on sentiments. shocks. Crude oil prices jumped sharply on production cuts by I.1 Key Developments since the October 2020 MPR the Organization of the Petroleum Exporting Countries Since the release of the Monetary Policy Report (MPR) (OPEC) plus and on anticipation of stronger demand. in October 2020, domestic economic activity has Non-oil commodity prices have risen substantially turned out to be better than anticipated on the back across the board, putting upward pressures on of a turnaround in gross fixed capital formation and a inflation in commodity importing countries. Gold much shallower contraction in private consumption prices eased from the highs reached in August 2020 than in the preceding quarters of the financial year. on a stronger US dollar and expectations of economic The global economy is pulling out of the loss of recovery. While inflation is expected to remain 1 Report on Currency and Finance 2020-21: Reviewing the Monetary Policy Framework, Reserve Bank of India, February 2021. 1Monetary Policy Report April 2021 subdued in advanced economies (AEs) and most of during the current financial year and into the next the emerging market economies (EMEs) on account financial year – to revive growth on a durable basis of negative output gaps, the large fiscal and monetary and mitigate the impact of COVID-19 on the economy, stimuli and elevated commodity prices have raised while ensuring that inflation remained within the inflation concerns over longer horizons in advanced target going forward. economies and in the nearer-term in the case of EMEs. In the run up to the December 2020 meeting, CPI Turning to the domestic economy, the gross domestic inflation had increased to 7.6 per cent in October 2020 product (GDP) shrugged off the contractions of with food inflation surging to double digits across preceding quarters and moved into expansion zone protein-rich items, edible oils, vegetables and spices on in Q3:2020-21 (+ 0.4 per cent, year-on-year). High multiple supply shocks. Core inflation had remained frequency indicators point to the growth momentum sticky and was seen to firm up as economic activity gaining strength in Q4 although the surge in normalised and demand picked up. At the same time, COVID-19 infections in a few states in March 2021 with the signs of economic recovery being far from imparts uncertainty to the assessment. The outlook broad-based and still dependent on sustained policy for the agriculture sector remains bright, with higher support, the MPC decided to maintain status quo on rabi sowing, above normal north-east monsoon and the policy rate and continue with the accommodative adequate reservoir levels. Inflation receded into stance set out in the October resolution. the tolerance band beginning December 2020 after By the time the MPC met in February 2021, CPI breaching the upper threshold of 6 per cent for six inflation had declined to 4.6 per cent in December 2020 consecutive months (June-November 2020). The late on the back of a larger than anticipated deflation in winter easing of vegetable prices that caused this vegetable prices. The MPC noted the sharp correction softening has dissipated, however. In its February 2021 in food prices but was concerned that some pressures print, headline inflation firmed up again, with upside persisted, and core inflation remained elevated. As pressures getting generalised across constituents of the recovery was still to gather firm traction and core inflation. continued policy support remained crucial, the MPC Monetary Policy Committee: October 2020-March unanimously decided to keep the policy repo rate 2021 unchanged and maintain its accommodative stance. During October 2020-March 2021, the Monetary The MPC’s voting pattern reflects the individual Policy Committee (MPC) met thrice. In the October members’ assessments, expectations and policy 2020 meeting, the MPC noted that the revival of preferences (Table I.1). The MPC’s unanimous vote the economy from the unprecedented COVID-19 on the policy rate in all the three meetings during pandemic assumed the highest priority in the conduct October 2020-March 2021 was a reflection of the of monetary policy. High inflation was seen as easing unprecedented pandemic and an unambiguous with the unlocking of the economy, restoration of consensus on continued policy support. supply chains and normalisation of activity. Hence, Macroeconomic Outlook the MPC decided to look through the inflation spike and unanimously voted to keep the policy repo Chapters II and III analyse macroeconomic rate unchanged. It also voted to continue with the developments during October 2020-March 2021. accommodative stance as long as necessary – at least Turning to the outlook, the evolution of key 22Chapter I Macroeconomic Outlook Table I.1 Monetary Policy Committees and Table I.2: Baseline Assumptions for Projections Voting Patterns Indicator MPR October 2020 MPR April 2021 Country Policy Meetings: October 2020 - March 2021 Crude oil US$ 40.9 per barrel US$ 64.6 per barrel Total Meetings with Meetings without (Indian basket) during H2:2020-21 during 2021-22 Meetings Full Consensus Full Consensus Exchange rate ` 73.6/US$ ` 72.6/US$ Brazil 4 4 0 during H2:2020-21 during 2021-22 Chile 4 4 0 Monsoon 9 per cent above long Normal for 2021 Colombia 5 3 2 period average for Czech Republic 4 4 0 2020 Hungary 5 5 0 Global growth (-) 4.9 per cent in 2020 5.5 per cent in 2021 India 3 3 0 5.4 per cent in 2021 4.2 per cent in 2022 Israel 4 0 4 Fiscal deficit Given the Covid-19 To remain within BE Japan 4 0 4 (per cent of GDP) impact on activity, 2021-22 South Africa 3 1 2 revenues, and Centre: 6.8 Sweden 2 2 0 expenditures and Combined: 10.8 Thailand 4 4 0 factoring in the additional borrowings UK 4 4 0 announced, fiscal US 4 4 0 deficits are expected to be significantly Sources: Central bank websites. higher Domestic No major change No major change macroeconomic and financial variables over the macroeconomic/ structural past six months warrants revisions in the baseline policies during the forecast assumptions (Table I.2). period First, global crude oil prices have hardened notably Notes: 1. The Indian basket of crude oil represents a derived numeraire comprising sour grade (Oman and Dubai average) and sweet since November 2020 on the back of production cuts grade (Brent) crude oil. 2. The exchange rate path assumed here is for the purpose of by the OPEC and non-OPEC allies (OPEC plus) and generating the baseline projections and does not indicate any expected revival in demand with vaccine rollouts. ‘view’ on the level of the exchange rate. The Reserve Bank is guided by the objective of containing excess volatility in the Reflecting these developments as well as the attack foreign exchange market and not by any specific level of and/or band around the exchange rate. on Saudi Arabia’s oil facilities, Brent crude crossed 3. BE: Budget estimates. 4. Combined fiscal deficit refers to that of the Centre and States US$ 70 per barrel in early March. Prices, however, taken together. corrected to around US$ 65 in the second half of Sources: RBI estimates; Budget documents; and IMF. March over concerns of demand faltering on rising aversion and capital outflows. Subsequently, the INR COVID-19 infections and increase in crude stockpiles. appreciated, riding on the domestic recovery gaining Taking into account these developments, crude prices traction, decline in the number of new infections, (Indian basket) are assumed at US$ 64.6 per barrel for vaccine rollout, and the measures announced in the 2021-22 in the baseline, 58 per cent above the October Union Budget 2021-22 to revive the economy. The MPR baseline for 2020-21 (Chart I.1). INR depreciated sharply in late February on elevated Second, the nominal exchange rate (the Indian rupee global financial market volatility following the spike or INR vis-à-vis the US dollar) has moved in a range in sovereign bond yields in the US and other major of INR 72-75 per US dollar since October 2020. The AEs. Taking these developments into account, the INR remained under depreciating pressure till mid- exchange rate is assumed at INR 72.6 per US dollar for November 2020 due to COVID-related uncertainty, risk 2021-22 in the baseline. 33Monetary Policy Report April 2021 Chart I.1: Brent Prices Chart I.2: Global GDP Growth Source: Bloomberg. Source: IMF. Third, global economic activity has improved relative cereal prices. It rebounded to 5.0 per cent in February, to the outlook in October 2020 with vaccine rollouts however, driven primarily by base effects. Core and easing of lockdown restrictions, although it inflation pressures remained elevated, with inflation remains uneven across countries and sectors. The excluding food and fuel at 6.0 per cent in February International Monetary Fund (IMF) in its January 2021 reflecting pass-through to retail prices from higher World Economic Outlook (WEO) update projected the crude oil and non-oil commodity prices, high fuel and global economy to expand by 5.5 per cent in 2021 other taxes post-COVID and increased operating costs (Chart I.2); the outlook remains heavily contingent (Chapter II). upon the progress with COVID-19 containment Looking ahead, three months and one year ahead measures and the scale and speed of the vaccination median inflation expectations of urban households programme. The World Trade Organization’s (WTO) rose by 80 basis points (bps) and 10 bps, respectively trade barometers suggest a moderation in global in the March 2021 round of the Reserve Bank’s merchandise and services trade volumes from the survey2 in tandem with higher food and oil prices. The marked improvement in Q4:2020. proportion of respondents expecting the general price I.2 The Outlook for Inflation level to increase by more than the current rate also increased for both three months and one year ahead After breaching the upper tolerance threshold of 6.0 horizons vis-à-vis the previous round (Chart I.3). per cent for six consecutive months (June-November 2020), CPI inflation fell in December 2020 and eased Manufacturing firms polled in the January-March further in January 2021 to 4.1 per cent on the back of 2021 round of the Reserve Bank’s industrial outlook a sharp correction in vegetable prices and softening of survey3 expected further input cost pressures from 2 The Reserve Bank’s inflation expectations survey of households is conducted in 18 cities and the results of the March 2021 survey are based on responses from 5,955 households. 3 The results of the January-March 2021 round of the industrial outlook survey are based on responses from 967 companies. 44Chapter I Macroeconomic Outlook managers’ index (PMI) survey for the manufacturing Chart I.3: Inflation Expectations of Households sector also reported strong increase in input prices in March 2021 along with higher output prices; for the services sector, input cost inflation was at an eight- year high while selling prices remained stable in February, reflecting efforts to boost sales. Professional forecasters surveyed4 by the Reserve Bank in March 2021 expected CPI inflation to ease from 4.9-5.0 per cent in H1:2021-22 to 4.3 per cent in Q3 and revert to 5.0 per cent in Q4 (Chart I.5). Taking into account the initial conditions, signals from forward-looking surveys and estimates from structural and other time-series models, CPI inflation is projected to average 5.0 per cent in Q4:2020-21, 5.2 Source: Inflation Expectations Survey of Households, RBI. per cent in Q1:2021-22 and Q2, 4.4 per cent in Q3, and 5.1 per cent in Q4, with risks broadly balanced raw materials in Q1:2021-22; moreover, positive (Chart I.6). The 50 per cent and the 70 per cent sentiments on profit margins rose on the back of confidence intervals for headline inflation in higher selling prices, suggesting a return of pricing Q4:2021-22 are 3.3-6.9 per cent and 2.4-7.8 per cent, power (Chart I.4). The IHS Markit’s purchasing respectively. Chart I.4: Expectations about Cost of Raw Chart I.5: Inflation Expectations of Materials and Selling Prices Professional Forecasters Note: Net response is the difference between the respondents reporting optimism and those reporting pessimism. The range is -100 to 100. A positive/ negative value of net response is considered as optimistic/pessimistic from the viewpoint of respondent firms. Therefore, higher positive values of selling prices indicate increase in output prices while lower values for the cost of raw materials indicate higher input price pressures and vice versa. Source: Industrial Outlook Survey, RBI. Sources: Survey of Professional Forecasters, RBI and National Statistical Office. 4 31 panellists participated in the March 2021 round of the Reserve Bank’s survey of professional forecasters. 55Monetary Policy Report April 2021 keep inflation elevated. The downside risks are mostly Chart I.6: Projection of CPI Inflation (y-o-y) associated with a weaker than anticipated global and domestic demand in the case of another wave of infections and new mutants of the virus, fall in crude oil prices on weak demand and an early normalisation of supply chains. Prospects of a good rabi crop on top of a bumper kharif harvest in 2020-21 and effective supply management could keep food prices softer than in the baseline. I.3 The Outlook for Growth Note: The fan chart depicts uncertainty around the baseline projection path. The rebound from the COVID-19 induced slump has The baseline projections are conditioned upon the assumptions set out in Table I.2. The thick red shaded area represents 50 per cent confidence interval, been sharper than anticipated. Real GDP growth turned implying that there is 50 per cent probability that the actual outcome will be within the range given by the thick red shaded area. Likewise, for 70 per cent and positive in Q3:2020-21 and a further strengthening 90 per cent confidence intervals, there is 70 per cent and 90 per cent probability, respectively, that the actual outcomes will be in the range represented by the is expected to have occurred in Q4:2020-21. Going respective shaded areas. Source: RBI staff estimates. forward, rural demand is likely to remain resilient on good prospects for the agriculture sector. Urban For 2022-23, assuming a normalisation of supply demand and demand for contact-intensive services chains on the back of vaccine rollout, a normal is also expected to strengthen with the spread of monsoon and no major exogenous or policy shocks, vaccination. The fiscal stimulus under AtmaNirbhar structural model (Box I.1) estimates indicate that 2.0 and 3.0 schemes and increased capital outlays inflation will move in a range of 4.5-4.8 per cent. The and the investment-enhancing proposals in the 50 per cent and the 70 per cent confidence intervals Union Budget 2021-22 will likely accelerate public for Q4:2022-23 are 2.9-6.5 per cent and 1.9-7.5 per investment and crowd-in private investment. While cent, respectively. There are a number of upside and the domestic financial conditions are expected to downside risks to the baseline inflation forecasts. The remain supportive in view of the guidance from RBI major upside risks include supply chain disruptions that systemic liquidity would continue to remain persisting for a longer period, rise in global crude oil comfortable over the ensuing year, the risks of and other commodity prices beyond what is currently spillovers from volatility in global financial markets in the baseline, and stronger pass-through of input remain elevated. costs amidst improvement in demand conditions and return of pricing power. Persistent structural demand- Turning to the forward-looking surveys, consumer supply imbalances in key food items such as pulses, confidence5 for the year ahead dipped, although it was edible oils and fats, and eggs, meat and fish could also still in the optimistic zone, in the March 2021 round, 5 The survey is conducted by the Reserve Bank in 13 major cities and the March 2021 round is based on responses from 5,372 respondents. 66Chapter I Macroeconomic Outlook Box I.1: Quarterly Projection Model 2.0 The Quarterly Projection Model (QPM) in the RBI’s Forecast (e.g., balance-sheet effects, dynamic Dutch disease) due and Policy Analysis System (FPAS) is the workhorse model to sudden surges or reversals in capital flows (Ghosh et for generating medium term projections and undertaking al., 2016). policy scenario analysis, consistent with the central The model properties of these features can be best bank’s mandate under the flexible inflation targeting (FIT) represented through impulse response functions which framework (Benes et al., 2016). The QPM is a forward- trace out the impact on key macroeconomic variables looking, open economy, calibrated, new-Keynesian gap in response to shocks. First, an expansionary structural model, and incorporates specific characteristics of the fiscal shock contributes to demand pressures and creates Indian economy. a positive output gap. Increasing debt could contribute With a view to enriching the model’s analytics and to to depreciation of the currency through elevated country capture monetary-fiscal-external-real sector interactions risk premia. The positive output gap and currency more comprehensively, the model structure has been depreciation together lead to higher inflation, warranting expanded and the parameters of the QPM recalibrated, monetary policy action (Chart I.1.1a). On the other hand, taking into account pre-COVID period data (up to Q4:2019) if the fiscal deficit shock is cyclical, it has a modest impact and latest empirical findings. In terms of its structure, on inflation. Second, an increase in fuel taxes feeds into the augmented QPM model (QPM 2.0) incorporates: a) higher fuel prices and ex-food fuel inflation through fiscal-monetary dynamics, b) disaggregated fuel pricing the cost-push channel. Headline inflation goes up by 25 (oil price, exchange rate and fuel taxes) and c) balance of bps in response to a fuel tax increase of `10 per litre payments and exchange rate interactions. The fiscal block (Chart I.1.1b). Inflation expectations edge higher and in QPM 2.0 decomposes the primary deficit into structural remain entrenched, if tax reversals do not happen. (cyclically adjusted) and cyclical components, with shocks Demand conditions also remain subdued for a longer to the structural component impacting inflation through period. Finally, the impact of capital flows depends, inter aggregate demand and country risk premia. The monetary alia, on the RBI’s decision to intervene and sterilise. In policy stance affects the fiscal position through the case of a capital outflow shock of one percentage point interest rate channel (Escolano, 2010). The fuel block (of nominal GDP) and assuming the RBI intervenes incorporates India’s complex system of pricing – items like and sterilises 70 per cent of these capital outflows, petrol and diesel are priced on the basis of international the reserves will deplete by 0.7 percentage points oil prices, exchange rate and fuel taxes (excise duty and of nominal GDP. The exchange rate will depreciate, value added tax (VAT)); liquified petroleum gas (LPG) and inducing inflationary pressure (Chart I.1.1c). In the case kerosene prices are market determined but with lagged of no intervention, the exchange rate depreciation will pass-through; and prices of electricity are administered be relatively higher. by state governments. The cost-push implications are A historical decomposition of the shocks suggests that the also incorporated in the enhanced aggregate supply block. FIT framework helped in anchoring inflation expectations Finally, the balance of payments module incorporates during 2016-20 leading to lower headline as well as core determinants of current and capital accounts and their inflation. The disinflation during the post-FIT period was interaction with the exchange rate management, guided also supported by favourable supply shocks, both food by the objective of containing excess volatility in the and fuel, benign external factors and prudent fiscal policy foreign exchange market. This recognises the costs (Chart I.1.2). associated with spurts in volatility in the exchange rate (contd.) 77Monetary Policy Report April 2021 Chart I.1.1: Impulse Responses a: Response to Structural Deficit Shock b: Response to Fuel Tax Shock# c: Response to Capital Outflow Shock Structural Fiscal Deficit* Fiscal Deficit* Fuel Tax Petrol & Diesel Inflation Capital Outflow* Reserves* Public Debt* Output Gap Headline Inflation Core Inflation** Exchange Rate Headline Inflation Headline Inflation Policy Rate Output Gap Policy Rate Policy Rate Output Gap #: An increase of ` 10 per litre. *: Per cent of nominal GDP. **: CPI excluding food, fuel, petrol and diesel. Note: x-axes represent quarters and y-axes are in percentage points. Source: RBI staff estimates. Chart I.1.2: Historical Decomposition of Headline Inflation Source: RBI staff estimates. References: Ghosh, A. R., J. D. Ostry, and M. Chamon (2016), “Two Targets, Two Instruments: Monetary and Exchange Rate Benes, J., K. Clinton, A. George, P. Gupta, J. John, O. Policies in Emerging Market Economies”, Journal of Kamenik, D. Laxton, P. Mitra, G. Nadhanael, R. Portillo, H. International Money and Finance, 60, 172-196. Wang, and F. Zhang (2016), “Quarterly Projection Model Escolano, M. J. (2010), “A Practical Guide to Public Debt for India: Key Elements and Properties”, RBI Working Dynamics, Fiscal Sustainability, and Cyclical Adjustment Paper Series No. 8. of Budgetary Aggregates”, International Monetary Fund. 88Chapter I Macroeconomic Outlook Chart I.7: Consumer Confidence Chart I.8: Business Assessment and Expectations Source: Consumer Confidence Survey, RBI. Source: Industrial Outlook Survey, RBI. driven by lower expectations on the general economic base effects before tapering in subsequent quarters situation, the employment scenario and income (Chart I.9 and Table I.4). conditions (Chart I.7). Sentiments in the manufacturing sector for the quarter Table I.3: Business Expectations Surveys ahead strengthened further in the January-March Item NCAER FICCI Dun and CII 2021 round of the Reserve Bank’s industrial outlook Business Overall Bradstreet Business Confidence Business Composite Confidence survey, reflecting optimism on production, order Index Confidence Business Index books, capacity utilisation, employment conditions (February Index Optimism (March 2021) (February Index 2021) and the overall business situation (Chart I.8). 2021) (January- March Surveys by other agencies also indicate optimism on 2021) future business expectations (Table I.3). According to Current level of 84.8 74.2 79.9 68.7 the index the purchasing managers’ survey for March 2021, the Index as per 65.5 70.9 46.2 62.9 one year ahead business expectations of firms in the previous survey manufacturing sector exhibit confidence; optimism of % change (q-o-q) 29.6 4.7 72.9 9.2 sequential firms in the services sector strengthened to a one-year % change (y-o-y) -23.7 25.8 26.8 28.7 high in February. Notes: 1. NCAER: National Council of Applied Economic Research. Professional forecasters polled in the March 2021 2. FICCI: Federation of Indian Chambers of Commerce & Industry. round of the Reserve Bank’s survey expected a sharp 3. CII: Confederation of Indian Industry. Sources: NCAER, FICCI, CII and Dun & Bradstreet Information Services uptick in real GDP growth in Q1:2021-22, driven by India Pvt. Ltd. 99Monetary Policy Report April 2021 Chart I.9: Professional Forecasters’ Projection of Table I.4: Projections - Reserve Bank and Real GDP Growth Professional Forecasters (Per cent) 2020-21 2021-22 2022-23 Reserve Bank’s Baseline Projections Inflation, Q4 (y-o-y) 5.0 5.1 4.7 Real GDP growth -8.0 10.5 6.8 Median Projections of Professional Forecasters Inflation, Q4 (y-o-y) 4.9 5.0 Real GDP growth -7.5 11.0 Gross domestic saving (per cent of GNDI) 28.9 29.6 Gross capital formation (per cent of GDP) 27.7 30.1 Credit growth of scheduled commercial banks 6.4 8.0 Combined gross fiscal deficit (per cent of GDP) 14.0 10.5 Central government gross fiscal deficit 9.5 6.8 (per cent of GDP) Repo rate (end-period) 4.00 4.00 Yield on 91-days treasury bills (end-period) 3.3 3.9 Sources: Survey of Professional Forecasters, RBI and National Statistical Office. Yield on 10-year central government 6.2 6.5 securities (end-period) Overall balance of payments (US$ billion) 97.2 50.6 Overall, economic activity is gathering strength, Merchandise exports growth -10.3 15.0 supported by the recovery in both demand and Merchandise imports growth -19.0 24.1 Current account balance (per cent of GDP) 1.0 -0.8 supply channels, sustained rollout of the vaccination Note: GNDI: Gross National Disposable Income. programme, growth-enhancing proposals in the Sources: RBI staff estimates; and Survey of Professional Forecasters Union Budget and highly accommodative monetary (March 2021). conditions. Taking into account the baseline assumptions, the survey indicators, and model There are upside as well as downside risks to the forecasts, real GDP growth6 is projected to pick up baseline growth path. A faster decline in COVID-19 from (-) 8.0 per cent in 2020-21 to 10.5 per cent in infections helped by a rapid vaccination drive, large 2021-22 – with a quarterly path of 26.2 per cent in pent-up demand for contact-intensive services, and Q1, 8.3 per cent in Q2, 5.4 per cent in Q3, and 6.2 per stronger global demand provide an upside to the cent in Q4 – with risks evenly balanced (Chart I.10 and baseline growth path. The uncertainty associated with Table I.4). For 2022-23, assuming a normal monsoon, the spread of COVID-19, including new mutants of and no major exogenous or policy shocks, the the virus, deviation of the south-west monsoon from structural model estimates indicate real GDP growth the baseline assumption of a normal monsoon, and at 6.8 per cent, with quarterly growth rates in the elevated crude oil prices and global financial market range of 6.2-7.3 per cent. volatility pose downside risks. 6 The Central government in February 2021 decided to bring the off-budget part of food subsidies on-budget, which has resulted in GDP contraction (-8.0 per cent) being notably higher than that (-6.5 per cent) in gross value added (GVA) in 2020-21. This budgetary treatment would especially depress reported GDP growth for Q4:2020-21 (see Chapter III). 1100Chapter I Macroeconomic Outlook variants across the world and an unequal access to Chart I.10: Projection of Growth in Real GDP (y-o-y) vaccines across countries can result in a shallower and delayed global recovery. A surge in global bond yields – as experienced in February 2021 on reflation trade – could induce large global financial market volatility, disorderly adjustment in asset prices and disrupt global demand. In such a scenario, if global recovery is 100 bps below the baseline, domestic growth and inflation could be lower by around 40 bps and 30 bps, respectively, from the baseline trajectories. Conversely, success in containing the spread of new mutants, widespread and equitable distribution Note: The fan chart depicts uncertainty around the baseline projection of vaccines across the world, and additional policy path. The baseline projections are conditioned upon the assumptions set out in Table I.2. The thick green shaded area represents 50 per cent confidence stimulus could provide a boost to global economic interval, implying that there is 50 per cent probability that the actual outcome will be within the range given by the thick green shaded area. Likewise, for activity. In this scenario, assuming that global growth 70 per cent and 90 per cent confidence intervals, there is 70 per cent and 90 per cent probability, respectively, that the actual outcomes will be in the range surprises by 100 bps on the upside, domestic growth represented by the respective shaded areas. Source: RBI staff estimates. and inflation could edge higher by around 40 bps and 30 bps, respectively (Charts I.11a and I.12a). I.4 Balance of Risks (ii) International Crude Oil Prices The baseline projections of inflation and growth are International crude oil prices have risen sharply on conditional on the assumptions of key domestic and production cuts and hopes of demand revival. For international macroeconomic and financial conditions a net energy importer like India, the dynamics of described in the previous sections. The inherent international crude price movements have significant uncertainties associated with such assumptions have macroeconomic implications. A quicker containment exacerbated due to the COVID-19 pandemic and could of COVID-19 inducing higher global growth than the have a significant bearing on the inflation and growth baseline and a faster closing of the global output gap trajectories. This section explores plausible alternative along with sustained production cuts by the OPEC scenarios to assess the balance of risks around the plus could lead to a sharper increase in international baseline projections. crude oil prices. Assuming crude oil price to be 10 per (i) Global Growth Uncertainties cent above the baseline, domestic inflation and growth The COVID-19 pandemic induced the severest global could be higher by 30 bps and weaker by around 20 recession in decades in 2020. Global growth is expected bps, respectively, over the baseline. Conversely, crude to recover to 5.5 per cent in 2021, reflecting base oil prices could soften if the recovery is more subdued effects, the expected moderation in new infections, owing to a faster spread of virus mutations, the delays the rollout of the vaccination programme and large in vaccination or improved supplies of shale gas. As monetary and fiscal support. However, the uncertainty a result, if the price of the crude falls by 10 per cent about the pandemic’s spread and its containment relative to the baseline, inflation could ease by around continues to pose high risks to the global outlook on 30 bps with a boost of 20 bps to growth (Charts I.11a both sides. A faster spread of mutated coronavirus and I.12a). 1111Monetary Policy Report April 2021 Chart I.11: Impact of Risk Scenarios on the Baseline Inflation Path a: Crude Oil Prices and Global Demand Shocks b: Exchange Rate and Food Price Shocks Source: RBI staff estimates. (iii) Exchange Rate – could lead to a broader risk aversion to EME assets The INR has exhibited two-way movements over the and net capital outflows. In such a scenario, should past six months, reflecting both global and domestic the INR depreciate by 5 per cent from the baseline, factors. Looking ahead, heightened volatility in global inflation could move up by around 20 bps while GDP financial markets, especially a snapback in global growth could be higher by around 15 bps through sovereign bond yields – as observed in February 2021 increased net exports (Charts I.11b and I.12b). On Chart I.12: Impact of Risk Scenarios on the Baseline Growth Path a: Crude Oil Prices and Global Demand Shocks b: Exchange Rate and Food Price Shocks Source: RBI staff estimates. 1122Chapter I Macroeconomic Outlook the other hand, given India’s relatively better growth determining the food as well as headline inflation outlook and expectations of strong capital inflows, (Charts I.11b and I.12b). there could be INR appreciation. If the INR appreciates I.5 Conclusion by 5 per cent relative to the baseline, inflation and Domestic economic activity is widely expected to GDP growth could moderate by around 20 bps and 15 rebound strongly in 2021-22. Rapid vaccination bps, respectively, vis-à-vis the baseline. drive, large pent-up demand, investment enhancing measures by the government and better external (iv) Food Inflation demand provide an upside to the baseline growth Food inflation has softened since December 2020, path while surge in infections, new mutants, largely led by the sharp fall in prices of vegetables deviation of the south-west monsoon from the and moderation in prices of cereals. Going forward, baseline assumption of a normal monsoon, higher the bumper kharif harvest, record rabi sowing, crude oil and non-oil commodity prices and global further easing of supply chains and effective supply financial market volatility impart downside risks to management measures could moderate food inflation the baseline growth path. Lingering supply chain disruptions, rising global crude oil prices and stronger by 100 bps below the baseline. Conversely, the pass-through of input costs could push headline recent hardening of global food prices and domestic inflation above the baseline. There is also the demand-supply gaps in key food items like pulses, probability of softer international crude oil prices on edible oils and fats, and eggs, fish and meat could the back of a weaker than anticipated global demand, lead to persistent upward pressures of around 100 bountiful foodgrains production and effective supply bps on food inflation. Higher inflation expectations management coming together to ease inflation more could then add to sustained pressures on headline than anticipated. The evolving COVID-19 trajectory inflation. The baseline assumes a normal south-west and progress on vaccination remain the key drivers monsoon in 2021 and any deviations in the actual of economic activity and inflation, globally and in outturn on either side would be a critical factor in India. 1133II. Prices and Costs In 2020-21, inflation breached the upper tolerance band of 6 per cent for six consecutive months in the post-lockdown period (June-November 2020) due to a series of cost-push shocks – supply chain disruptions; weather shocks; higher crude oil and other commodity prices; and higher taxes. The sharp correction during December-January was reversed on adverse base effects in February. Core inflation remained sticky at elevated levels. Costs of farm and industrial inputs recovered with the gradual unlocking of the economy and rural wage growth moderated although it remained higher than in the pre-lockdown period. In the months following the publication of the October of 6.0 per cent in February 2021 under the combined 2020 MPR, inflationary pressures got accentuated effects of rising industrial raw material prices, record and headline inflation1 remained above the upper high petroleum product prices and the higher cost tolerance threshold. Core inflation also stayed sticky at of doing business in the post-lockdown period elevated levels. During December 2020-January 2021, (Chart II.1). however, there was a sharp correction and inflation The Reserve Bank of India (RBI) Act enjoins the RBI eased significantly, moving closer to the target, only to reverse to 5.0 per cent in February 2021, primarily due to set out deviations of actual inflation outcomes to adverse base effects. Core inflation (CPI inflation from projections, if any, and explain the underlying excluding food and fuel) surged to a 28-month high reasons thereof. The October 2020 MPR had projected Chart II.1: CPI Inflation (y-o-y) Note: The imputed CPI prints for April and May 2020 have been regarded as a break in the CPI series. Sources: National Statistical Office (NSO); and RBI staff estimates. 1 Headline inflation is measured by year-on-year changes in all-India consumer price index – combined (CPI-C). 1144Chapter II Prices and Costs moderation in CPI inflation from 6.8 per cent in monetary policies in the major advanced economies. Q2:2020-21 to 5.4 per cent in Q3 and 4.5 per cent in Cost-push pressures also impinged on core inflation Q4. In Q3, actual inflation was 100 basis points (bps) more than anticipated. In Q4 (January-February), the above projection (Chart II.2). A sharp, unanticipated correction in food prices resulted in actual inflation increase in food inflation – double-digit inflation in aligning with the projection (Chart II.2). eggs, meat and fish (due to fragmented supply chains), II.1 Consumer Prices pulses (tight demand supply balance), edible oils (high The sharp upward movement of inflation to a peak of international prices), and vegetables (unseasonal 7.6 per cent in October 2020 came about from a pick- rains) – led to this substantial overshoot. Retail price up in price momentum in food as well as in the core margins for food also increased, with the persistence category.2 Thereafter, strong favourable base effects of supply chain disruptions. International crude brought about a moderation in headline inflation to oil prices (Indian basket) jumped from the baseline 6.9 per cent in November 2020, more than offsetting assumption of US$ 40.9 per barrel for H2:2020-21 positive momentum in all these components. In to US$ 61.2 per barrel by February 2021. Gold prices December 2020, a negative momentum in headline remained elevated in Q3:2020-21 over COVID-19 inflation due to a sharp decline in food prices, along concerns, supported by highly accommodative with favourable base effects, resulted in headline inflation declining by 2.3 percentage points. In Chart II.2: CPI Inflation (y-o-y): January 2021, headline inflation moderated further Projection versus Actual due to a large negative momentum engendered by food prices. In February 2021, an adverse base effect of around 70 bps resulted in a substantial pick-up in inflation (Chart II.3). Reflecting broad-based price pressures, the distribution of CPI group/sub-group inflation in 2020-21 was centred at 4.9 per cent, higher than the sub-4 per cent levels seen in recent years (Chart II.4). With several sub-groups exhibiting double-digit inflation, the inflation distribution also exhibited a fat tail, pushing mean headline inflation *: Projection for entire Q4:2020-21 vis-a-vis actual average inflation during in excess of 6.0 per cent. The diffusion indices of price January-February 2021. Sources: NSO; and RBI staff estimates. changes in CPI items on a non-seasonally adjusted 2 A change in CPI year-on-year (y-o-y) inflation between any two months is the difference between the current month-on-month (m-o-m) change in the price index (momentum) and the m-o-m change in the price index 12 months earlier (base effect). For more details, see Box I.1 of the MPR, September 2014. 1155Monetary Policy Report April 2021 Chart II.3: CPI Inflation – Momentum and Base Effects a: CPI Headline b: CPI Food and Beverages c: CPI Fuel and Light d: CPI excluding Food and Fuel Sources: NSO; and RBI staff estimates. basis3 increased in January-February 2021, indicative be captured through vector autoregression (VAR) of price pressures across the CPI basket (Chart II.5).4 estimates and historical decomposition.5 The high inflation episode in Q3:2020-21 was predominantly II.2 Drivers of Inflation due to supply shocks. In Q4, supply side factors turned The relative role of various demand and supply benign pulling down headline inflation. On the other shocks impinging upon the inflation dynamics can hand, easy monetary conditions and the firming up 3 In view of the non-availability of CPI item level data for the period March-May 2020, the diffusion indices have been constructed with item level indices without seasonal adjustment. 4 The CPI diffusion index, a measure of dispersion of price changes, categorises items in the CPI basket according to whether their prices have risen, remained stagnant or fallen over the previous month. A reading above 50 for the diffusion index signals a broad expansion or generalisation of price increases and a reading below 50 signals broad-based price decline. 5 Historical decomposition estimates the contribution of each shock to the movements in inflation over the sample period (Q4:2010-11 to Q4:2020-21) based on a vector autoregression (VAR) with the following variables (represented as the vector Y) –crude oil prices; exchange rate (INR per US$), asset price t (BSE Sensex), CPI; the output gap; rural wages; the policy repo rate; and money supply (M3). All variables other than policy repo rate are growth rates. The VAR can be written in reduced form as: Y =c + A Y + e; where e represents a vector of shocks. Using Wold decomposition, Y can be represented t t-1 t t t as a function of its deterministic trend and sum of all the shocks e. This formulation facilitates decomposition of the deviation of inflation from its t deterministic trend into the sum of contributions from various shocks. 1166Chapter II Prices and Costs Chart II.4: Average CPI Inflation (y-o-y) Chart II.5: Diffusion Indices: CPI (Kernel Density Estimates) (M-o-M Non-Seasonally Adjusted) Sources: NSO; and RBI staff estimates. Sources: NSO; and RBI staff estimates. of asset and crude oil prices contributed positively items, the contribution of semi-perishable goods (non- to the deviation of inflation from trend levels in Q3 durable goods with a 30-day recall) remained elevated and Q4. Muted demand conditions and moderation (Chart II.6b). Imported components contributed 0.5 in rural wage growth pulled down inflation in Q3 and percentage points to headline inflation in February Q4, offsetting these effects (Chart II.6a). 2021, driven by gold, silver, edible oils and higher High volatility in perishable goods (non-durable domestic taxes on petroleum products (Chart II.6c). goods with a 7-day recall6) from supply shocks in Food Group both directions had a significant bearing on the Food inflation rose sharply to 10.1 per cent in inflation trajectory. With the surge in vegetable October 2020 and remained above 6 per cent for 14 prices, the contribution of perishables to overall consecutive months till November 2020. It moderated inflation increased to 55.3 per cent during September- quickly in the subsequent months to 2.7 per cent November 2020 from 46.8 per cent in June-August in January 2021 before picking up to 4.3 per cent in 2020. Subsequently, as vegetable prices corrected, February 2021. These large variations were primarily perishables’ contribution decreased sharply to 32.0 per cent during December 2020-January 2021. driven by movements in prices of vegetables In February 2021, following the lower rate of deflation (Chart II.7). The softening of inflation in respect of in the prices of vegetables, perishables’ share increased cereals and products, milk and sugar and confectionery to 38.6 per cent. Reflecting the increase in prices also aided the easing in food inflation. On the other of protein-based food, edible oils and other food hand, there were upward pressures from oils and fats, 6 The CPI weighting diagrams use the modified mixed reference period (MMRP) data based on the 2011-12 Consumer Expenditure Survey conducted by the National Sample Survey Office (NSSO). Under MMRP, data are collected on expenditure incurred for frequently purchased items – edible oil, eggs, fish, meat, vegetables, fruits, spices, beverages, processed foods, pan, tobacco and intoxicants – during the last seven days; for clothing, bedding, footwear, education, medical (institutional), durable goods, during the last 365 days; and for all other food, fuel and light, miscellaneous goods and services including non-institutional medical services, rents and taxes, data relate to the last 30 days. 1177Monetary Policy Report April 2021 Chart II.6: Drivers of CPI Inflation a: Decomposition of CPI Inflation* * Deviation from deterministic trend. Note: Estimated using a vector autoregression (see footnote 5 for details). Sources: NSO; RBI; Petroleum Planning & Analysis Cell (PPAC); BSE; Labour Bureau; and RBI staff estimates. b: Contribution of Goods and Services c: Contribution of Imported Inflation Note: Figures in parentheses indicate weights in CPI. Sources: NSO; and RBI staff estimates. non-alcoholic beverages, prepared meals and snacks In the case of cereals (weight of 9.7 per cent in the CPI and fruits. Despite a sizeable moderation, inflation in and 21.1 per cent in the food and beverages group), five out of twelve food sub-groups was still in double a bumper kharif rice production and record buffer digits in February 2021. Seven of the twelve sub- stocks – around 6.7 times the norms for rice and 2.1 groups recorded increases above the historical average times for wheat as on March 16, 2021 – led to easing (Chart II.8). Rural and urban food inflation exhibited in inflation to (-)0.3 per cent in February 2021 from 7.9 broadly similar movements, with no significant per cent in June 2020. Higher rabi sowing has kept the difference between month-over-month changes in price pressures subdued despite higher procurement prices of food and its sub-groups in rural and urban and exports of both rice and wheat. areas.7 7 Based on modified z-test (accounting for autocorrelation) on difference of rural and urban m-o-m changes of seasonally adjusted series. 1188Chapter II Prices and Costs Chart II.7: CPI Food Inflation a: Drivers of CPI Food Inflation b: Drivers of CPI Protein-based Food Inflation *: Includes meat & fish, egg, milk and pulses. **: Includes fruits, sugar, non-alcoholic beverages and prepared meals. Note: Figures in parentheses indicate weights in CPI - protein based food. Note: Figures in parentheses indicate weights in CPI food and beverages. Sources: NSO; and RBI staff estimates. Inflation in prices of vegetables (weight of 6.0 per cent potato prices (Chart II.9). Potato price inflation reached in the CPI and 13.2 per cent in the food and beverages a peak of 107.0 per cent in November 2020. Higher group) rose steeply to a peak of 22.1 per cent in imports and fresh arrivals of early rabi production October 2020 and then corrected rapidly to move in the market led to a sharp easing in prices during into deflation during December 2020-February 2021, December 2020-February 2021, with a deflation of (-) driven primarily by a large fall in onion, tomato and 21.3 per cent in February 2021. Chart II.8: CPI Food – Financial Year Price Build-up (February over March) Note: Figures in parentheses indicate weights in CPI - food and beverages. Sources: NSO; and RBI staff estimates. 1199Monetary Policy Report April 2021 and Maharashtra on the back of excess rainfall pushed Chart II.9: Drivers of Vegetable Inflation (y-o-y) inflation to a peak of 54.5 per cent in September 2020. Thereafter, with an increase in fresh arrivals, prices eased beginning October 2020. In protein-based food items, inflation in pulses (weight of 2.4 per cent in the CPI and 5.2 per cent in the food and beverages group) was in double digits throughout 2020-21. To improve domestic supplies, the government eased restrictions and issued licenses for imports, reduced import duties on masur, released 2 lakh tonnes of tur (arhar) from the buffer stock and extended the time limit for import of tur under the import quota of 4 lakh tonnes for 2020-21. Reflecting these measures, as well as the arrival of kharif pulses Note: Figures in parentheses indicate items weights in CPI-vegetables. Sources: NSO; and RBI staff estimates. and favourable base effects, pulses inflation moderated to 12.5 per cent in February 2021 from 18.3 per cent Inflation in onion prices, which was in negative in October 2020. The production of pulses at 244 territory during August-September 2020, witnessed lakh tonnes in 2020-21 (second advance estimates for substantial price pressures during September- 2020-21) is expected to augment the domestic November 2020 as excess rainfall in major producing availability and improve the stock-use ratio regions of Madhya Pradesh, Gujarat, Karnataka and (Chart II.12). Pulses inflation can thus be expected Maharashtra damaged the kharif crop and impacted to moderate in the coming months, given the past late kharif production, resulting in lower market relationship between production/stocks and prices8, arrivals. To contain the escalation in prices, the although pressures may persist in some items like tur Government imposed an export ban on onions in and urad. September 2020 (removed in January 2021), increased Among animal protein-rich items, inflation in egg, imports, released buffer stocks and imposed stock holding limits on wholesalers and retailers. These meat and fish also remained in double digits during steps, along with fresh arrivals, led to onion prices most of 2020-21. It eased during November 2020 moving into deflation during November 2020-January - February 2021, largely due to the fall in prices of 2021. Onion prices picked up again in February chicken from improved supplies and a decline in 2021, however, due to drop in arrivals on account of demand due to bird flu during January 2021. Prices unseasonal rainfall in January 2021 in Maharashtra. In of mutton and pork, however, remained high due to the case of the third key vegetable, i.e., tomatoes, low supply bottlenecks and higher demand for protein- arrivals from the key producing regions in Karnataka based food items. 8 The bumper harvests during 2016-17 and 2017-18 of 231 lakh tonnes and 254 lakh tonnes, respectively, and the consequent higher stock-use ratios coincided with record 29 consecutive months of deflation during December 2016 to April 2019. 2200Chapter II Prices and Costs Chart II.10: Pulses Inflation and Stock-Use Ratio: Monthly Balance Sheet Sources: NSO; Directorate General of Commercial Intelligence and Statistics (DGCIS); Commission of Agricultural Costs and Prices (CACP); Ministry of Agriculture; and RBI staff estimates. Prices of milk and products (weight of 6.6 per cent in the palm oil and soybean oil) resulted in oils and fats CPI and 14.4 per cent in the food and beverages group) inflation peaking at around 20 per cent in December remained muted in H2:2020-21, reflecting a quick 2020-February 2021. The government reduced the restoration of supply chains of the well-established basic customs duty (BCD) on crude palm oil from 37.5 system of cooperatives amidst lower demand from per cent to 27.5 per cent effective November 27, 2020 the bulk segment. Prices of sugar and confectionery and then revised it to 32.5 per cent [including the (weight of 1.4 per cent in the CPI and 3.0 per cent in Agricultural Infrastructure Development Cess (AIDC)] the food and beverages group) eased during September effective February 2, 2021. Mustard oil and refined oil 2020 - February 2021 on the back of expectations of a were the highest contributors to elevated edible oil inflation. bumper crop and higher domestic production even as international sugar prices increased due to concerns Retail Margins over lower global availability in 2020-21.9 Average retail price margins over wholesale prices Prices of oils and fats (weight of 3.6 per cent in the increased across all the major sub-groups (cereals, CPI and 7.8 per cent in the food and beverages group) vegetables, edible oils and pulses) during the post- remained one of the major pressure points throughout lockdown period, pulling up headline inflation. The the year. Higher demand for mustard oil coupled margins were higher in edible oils, vegetables and with elevated international prices10 (particularly pulses than in the other two sub-groups (Chart II.11).11 9 Domestic sugar mills produced 278 lakh tonnes of sugar during 2021 sugar season (till March 31, 2021) as compared with 233 lakh tonnes in the corresponding period of the previous year. 10 International edible oil prices firmed up due to labour shortages in palm oil plantations in Indonesia and Malaysia, drought in Argentina affecting soybean production, and increased Chinese demand. 11 The analysis is based on daily price data on wholesale and retail prices from the Department of Consumer Affairs (DCA) for four major sub-groups – cereals, vegetables, edible oils and pulses – for January 2012 to December 2020 (excluding data for January-February 2021 due to changes in price collection mechanism and item varieties by DCA). The overall period has been divided into three phases, viz., pre-lockdown (January 2012 to February 2020), lockdown (March 2020 to May 2020) and post-lockdown (June 20 to December 2020). Item level retail and wholesale prices are aggregated at respective sub-group using item level CPI weights. 2211Monetary Policy Report April 2021 Chart II.11: Retail Price Margins a: Cereals b: Pulses c: Vegetables d: Edible Oil Sources: Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public Distribution; and RBI staff estimates. CPI Fuel Group CPI excluding Food and Fuel Inflation in fuel prices initially moderated from 3.2 CPI inflation excluding food and fuel, or core per cent in August 2020 to 1.6 per cent in November inflation, remained sticky and hovered between 5.4 2020, due to a decline in LPG and PDS kerosene per cent and 6.0 per cent during September 2020 prices and favourable base effects. Fuel inflation then to February 2021. Excluding petrol, diesel, gold increased to 3.5 per cent in February 2021, led by and silver also, core inflation remained elevated prices of LPG, kerosene and dung cake (Chart II.12a). (between 4.5 per cent and 5.1 per cent) over this The movements in LPG inflation largely reflected the period (Chart II.13). While the price build-up in the lagged impact of international prices (Chart II.12b). core categories was similar to the historical average, PDS-kerosene prices were in deflation throughout considerable variation was observed across subgroups: 2020-21, as international prices to which they are transport and communication, pan, tobacco and linked have been below pre-COVID levels since intoxicants, personal care and effects, health and April 2020 (Chart II.12c). recreation and amusement exhibited substantially 2222Chapter II Prices and Costs Chart II.12: CPI Fuel Group Inflation a: Drivers (y-o-y) *: Includes diesel [excl. conveyance], coke, coal, charcoal and other fuels. Note: Figures in parentheses indicate weights in CPI- fuel and light. b: LPG: Domestic and International Prices c: Kerosene: Domestic and International Prices Notes: (1) The international price for LPG is based on spot prices for Saudi Butane and Propane, combined in the ratio of 60:40 respectively. These international product prices are indicative import prices. Further details are available at www.ppac.org.in. (2) The indicative international price for kerosene is the Singapore Jet Kero spot price. (3) The domestic prices of LPG and kerosene represent the average prices of four and three metros, respectively, as reported by Indian Oil Corporation Limited (IOCL). Sources: NSO; Bloomberg; IOCL; and RBI staff estimates. higher build-up than the long-term average whereas prices, along with the non-reversal of the substantial clothing and footwear, housing, household goods and post-lockdown hike in excise duties and value added services and education exhibited subdued build-ups taxes (VATs), resulted in domestic petrol and diesel (Chart II.14). pump prices reaching historical highs by February 2021 (Chart II.15b). In H2:2020-21, crude oil prices (Indian basket) jumped by nearly 50 per cent – from around US$ 41 The combined share of central excise and states’ value per barrel in September 2020 to US$ 61 per barrel added tax (VAT) in petrol prices has risen from `22 per in February 2021. This sharp rise in international litre (31 per cent) in mid-2014 and `38 per litre (54 per 2233Monetary Policy Report April 2021 Chart II.13: Exclusion based CPI Inflation (y-o-y) Chart II.14: CPI excluding Food and Fuel – Financial Year Price Buildup (February over March) Note: (1) Figures in parentheses indicate weights in CPI. (2) Derived as residual from headline CPI. Note: Figures in parentheses indicate weights in CPI excluding food and fuel. Sources: NSO; and RBI staff estimates. Sources: NSO; and RBI staff estimates. cent) in March 2020 to `53 per litre (61 per cent) in in sharp double digit deflation for most part of the February 2021 (Chart II.16a). While the WPI measures financial year, with February 2021 seeing a reading of basic prices less trade discounts, thereby leaving out only 0.2 per cent (Chart II.16b). indirect taxes, retail prices are inclusive of taxes. CPI Compared to pre-COVID levels, measures of core petrol and diesel inflation has been in double digits inflation remain elevated, indicative of significant since July 2020 and was at 20.7 per cent in February cost-push pressures across sectors in the post- 2021; in contrast, WPI petrol and diesel prices were lockdown period. Price inflation in the goods Chart II.15: Movements in International and Domestic Petroleum Product Prices a: Petrol – Domestic and International Prices b: Diesel – Domestic and International Prices Note: International petrol and diesel prices denote the spot price of Singapore gasoline and gasoil, respectively. Domestic petrol and diesel prices represent the average pump prices of four metros as reported by Indian Oil Corporation Limited (IOCL). Sources: Petroleum Planning and Analysis Cell (PPAC); Bloomberg; and RBI staff estimates. 2244Chapter II Prices and Costs Chart II.16: Petrol Price Build-up and Inflation Rates of Petroleum Products a: Petrol Price Build-up* b: Petrol and Diesel Inflation (y-o-y) *IOCL Delhi prices. Sources: PPAC; NSO; Ministry of Commerce and Industry; and RBI staff estimates. component, i.e., excluding food, fuel, petrol, diesel, per cent in August 2020, driven by health care goods gold and silver (with a weight of 20.7 per cent in – particularly medicines, clothing and footwear CPI) rose to 5.8 per cent in February 2021 from 4.7 goods and transportation goods like motor vehicles Chart II.17: Contribution to CPI Inflation excluding Food, Fuel, Petrol, Diesel, Gold and Silver a: Goods b: Services Note: Figures in parentheses indicate weights in CPI. Sources: NSO; and RBI staff estimates. 2255Monetary Policy Report April 2021 (Chart II.17a). Core services inflation (weight of 23.0 which primarily includes rental charges, at 3.2 per per cent in CPI) rose from 4.0 per cent in August 2020 cent during November 2020 - February 2021 was to 5.0 per cent in November 2020, primarily due to lower than the pre-COVID levels; however, it was the higher prices of recreation, education, transportation second largest contributor to core services inflation (Chart II.17b). and communications services. Subsequently, core services inflation moderated to 4.3 per cent in In sum, headline inflation dynamics in the post- January-February 2021 as inflation in prices of lockdown period were primarily driven by goods communication dropped sharply due to favourable inflation. Services inflation is the more durable base effects along with some moderation in education component of the CPI and drives goods inflation over and recreation services inflation. Housing inflation, time (Box II.1). Box II.1: CPI Goods and Services: Do they Converge after Shocks? Cross-country evidence suggests that services inflation, 2020. In February 2021, the gap narrowed to around 30 on average, exceeds goods inflation due to a variety of bps. In the past too, there have been episodes of goods factors such as lower productivity in non-tradable services and services inflation exhibiting divergent patterns, as (Balassa-Samuelson effect), higher mark-ups in services during September 2016 to September 2019. Movements in due to reduced competition and increased demand for CPI goods inflation excluding vegetables and gold and CPI services as per capita income rises (Ferrara 2019, Zaman services inflation (barring the period influenced by the statistical HRA12 impact), however, tend to show greater 2015). In the post-lockdown period, however, CPI goods co-movement (Chart II.1.1). inflation (with a weight of 76.6 per cent in the CPI basket) exceeded CPI services (weight of 23.4 per cent) inflation For India, the evidence suggests that prices of goods and substantially, with the gap increasing from 2.2 percentage services exhibit co-movement over time, i.e., the two points in June 2020 to 3.8 percentage points in September series are cointegrated (Table II.1.1). This is consistent Chart II.1.1: Goods and Services Inflation (y-o-y) a: Goods and Services Inflation Gap b: Adjusted Goods and Services Inflation Note: Figures in parentheses indicate weights in CPI. Sources: NSO; and RBI staff estimates. (Contd.) 12 In July 2017 house rent allowances (HRA) of central government employees were increased under the 7th Central Pay Commission awards. The impact of this lingered for more than two years as state governments also implemented changes for their employees in a staggered manner. 2266Chapter II Prices and Costs Table II.1.1: CPI Good and Services dynamics can be further explored through a Vector Error Correction Model (VECM). The VECM analysis indicates a Long-run cointegration estimates significant error correction (EC) term in CPI goods prices, …(1) while it was found to be insignificant in the case of CPI (23.98) *** services prices. This suggests that following a shock Note: Figures in parenthesis are t-statistics. Trace test and max- resulting in a divergence from the long run equilibrium, eigenvalue test indicates cointegrating relationship at 5 per cent level of it is goods prices that make the necessary adjustment to significance. *** denotes significance at 1 per cent level. restore equilibrium. Vector error correction estimates: In(CPI goods) In(CPI services) CPI goods prices are considerably influenced by the t t volatility induced by perishables such as vegetables and (–) 0.125 (+) 0.013 (ECM) t-1 (-3.04)*** ( 0.96) can result in divergences from CPI services prices over short periods. Services inflation, on the other hand, (+) 0.60 (+) 0.05 In(CPI goods) t-i (2.75)** (0.47) represents the relatively sticky component in the CPI (–) 0.59 (+) 0.75 basket and can spill over to goods inflation, resulting in In(CPI services) t-i (-1.72)* (6.74)*** generalised inflationary pressures. (+) 0.0051 (+) 0.001 c References: (3.25)*** (1.89)* Adj. R2 0.14 0.54 Ferrara, L. (2019), “What is Behind the Change in the Gap between Services Price Inflation and Goods Price Notes: Figures in parenthesis are t-statistics. *** denotes significance at 1 per cent level ** denotes significance at 5 per cent level and * denotes Inflation?”, ECB Economic Bulletin Boxes, 5. significant at 10 per cent level. The sample period for the analysis is January 2011-December 2019. CPI goods and CPI services are seasonally Peach, R.W., Rich, R., and Antoniades, A. (2004), “The adjusted CPI indices of goods and services, respectively. Historical and Recent Behavior of Goods and Services P-value for Breusch–Godfrey LM test for the null of no serial correlation Inflation”, Federal Reserve Bank of New York, Economic (up to 5 lags): 0.15. Policy Review, December. Sources: NSO; and RBI staff estimates. Zaman, S. (2015), “The Gap Between Services Inflation with the cross-country evidence (Peach, 2004). Given and Goods Inflation”, Economic Trends, Federal Reserve the evidence of long-run cointegration, the short-run Bank of Cleveland. In addition to exclusion-based measures, trimmed Other Measures of Inflation means of inflation provide a measure of underlying Inflation measured by sectoral CPIs for agricultural inflation dynamics and are computed by statistically labourers (CPI-AL) and rural labourers (CPI- eliminating items with extremely positive and RL) remained below headline CPI inflation in negative inflation. The trimmed mean indicators H2:2020-21. Lower inflation in food items along showed easing of inflation over the period under with their higher weight in CPI-AL and CPI-RL and review in view of the omission of a few large outliers – subdued inflation in fuel, and clothing and footwear such as vegetables, pulses, edible oils, transport fare, groups contributed to the relatively lower inflation and pan, tobacco and intoxicants – in either direction. prints for CPI-AL and CPI-RL. Inflation in terms of In contrast, exclusion-based measures, which capture CPI for industrial workers (CPI-IW) though their gap persistent trends in inflation by eliminating ex-ante narrowed. also remained below the headline CPI identified idiosyncratic and volatile components, during H2.13 The price build-up in CPI-IW for clothing, suggest stickiness in inflation (Charts II.13 and II.18). housing and miscellaneous groups was lower relative 13 The Labour Bureau revised the base year of CPI for industrial workers (CPI-IW) from 2001 to 2016 in September 2020, based on the Working-Class Family Income & Expenditure Survey (WCFI&ES). The series covers 88 centres (78 in the earlier series), uses geometric mean for aggregation of price quotations (instead of arithmetic mean in the earlier series), and covers a larger number of items (463 items as against 392). 2277Monetary Policy Report April 2021 WPI inflation also remained below CPI inflation Chart II.18: Trimmed Means of CPI Inflation in H2:2020-21, although it has quickly inched up (y-o-y) close to CPI inflation in recent months (Charts II. 19a). From its trough in May 2020, WPI inflation charted a V-shaped uptrend in view of a sharp rise in fuel and non-food commodity prices. In contrast, WPI food inflation decelerated continuously from September 2020 and fell into negative territory in January 2021 before moving up in February 2021 to 3.3 per cent. Average WPI food inflation during September 2020 to February 2021 at 3.7 per cent was way lower than average CPI food inflation at 6.6 per cent, with inflation across major food sub-groups, except vegetables, milk and products, oils and fats, Sources: NSO; and RBI staff estimates. recording lower prints in the WPI than in the CPI. The largest deviation between CPI and WPI emanated to the headline CPI; that of fuel, and pan, tobacco and from inflation in petroleum products, especially intoxicants groups was higher; and the fall in food in petrol and diesel, reflecting the wedge due to prices was muted.14 tax components. Similarly, tax implications were Chart II.19: Alternative Measures of Inflation a: Various Measures of Inflation (y-o-y) b: CPI-WPI Divergence : Select Commodities (Average during September 2020 - February 2021) Sources: NSO; Labour Bureau; Ministry of Commerce and Industry; and RBI staff estimates. 14 Inflation for major groups of CPI-IW cannot be worked out as the linking factor released by the Labour Bureau is only for headline index and not at the group level; therefore, the discussion is based on price build-ups. 2288Chapter II Prices and Costs visible in prices for pan, tobacco and intoxicants – Within farm sector inputs, fodder price inflation while CPI for these items remained in double digits remained elevated in double digits, during October (average 10.7 per cent), inflation in WPI beverages, 2020 to February 2021 due to the damage from excess and tobacco products averaged 0.2 and 2.5 per cent, rains during September-October 2020. Inflation in respectively, during September 2020 to February fertilisers remained muted in line with subdued 2021 (Chart II.19b). cost of raw materials such as natural gas. Prices of Inflation measured in terms of gross value added electricity – a key constituent of both industrial and (GVA) and gross domestic product (GDP) deflators farm inputs – remained in deflation on an average clocked a pick-up from Q1:2020-21 to Q3, broadly in during H2, barring a transient spike in November. alignment with WPI inflation. Inflation in prices of agricultural machinery and implements recorded a modest increase during II.3 Costs November 2020-February 2021. The measures of cost inflation – farm inputs and industrial raw materials derived from WPI – moved Nominal rural wages for both agricultural and non- higher with the gradual unlocking of the economy, agricultural labourers hardened during H1:2020-21, albeit with transient dips (Chart II.20). The firming up reflecting labour shortages during the lockdown of global crude oil prices during H2:2020-21 impacted period and the hike in wages by `20 under the the prices of inputs such as high-speed diesel, naptha, Mahatma Gandhi National Rural Employment aviation turbine fuel, and furnace oil. Minerals and Guarantee (MGNREGA) scheme effective April 1, 2020. non-food articles also generally rose during October As the unlock phase progressed and labour availability 2020-February 2021. Prices of fibres emerged out of improved, wage growth moderated in H2 although it deflation in January 2021 in line with a pick-up in raw remained higher than in the pre-lockdown period cotton and raw silk prices. Reflecting this, inflation in (Chart II.21). cotton yarn price registered sharp uptick. Growth in the value of production in Q3:2020- 21 for listed firms in the manufacturing and Chart II.20: Farm and Non-farm Input Cost Inflation (y-o-y) services sectors outpaced the rise in staff costs. As a result, unit labour costs (measured as a ratio of staff cost to value of production) decreased during Q3:2020-21, reverting towards pre-COVID levels. Unit labour costs moderated from 6.9 per cent in Q2:2020-21 to 6.4 per cent in Q3:2020-21 for firms in the manufacturing sector and from 31.4 per cent to 28.5 per cent respectively, for the services sector firms (Chart II.22). Manufacturing, services and infrastructure *: Comprise primary non-food articles, minerals, coal, aviation turbine fuel, high firms polled in Reserve Bank’s enterprise speed diesel, naphtha, bitumen, furnace oil, lube oil, petroleum coke, electricity, cotton yarn and paper and pulp from WPI. surveys15 reported an increase in salary outgo in $: Comprise high speed diesel, fodder, electricity, fertilisers, pesticides, and agricultural and forestry machinery from WPI. Q4:2020-21, with expectations of a further rise in Sources: Ministry of Commerce and Industry; and RBI staff estimates. Q1:2021-22 as the level of employment is likely to 15 Industrial Outlook Survey; and Services and Infrastructure Outlook Survey. 2299Monetary Policy Report April 2021 Chart II.21: Wage Growth and Inflation in Rural Areas (y-o-y) Sources: NSO; Labour Bureau; and RBI staff estimates. gradually edge up. Input costs were also expected to of 2021-22 with the pace of increase moderating a intensify further in Q1 and continue in Q2 and Q3 tad for the manufacturing sector. The surveyed firms reported passing through the costs to their selling prices in Q4:2020-21. Selling prices are expected to Chart II.22: Labour Cost in Manufacturing and Services: Staff Cost Per Unit Value of Production gain further traction in Q1:2021-22 and remain firm in Q2 and Q3 for all the three sectors (Chart II.23). Manufacturing firms polled for the purchasing managers’ index (PMI) reported an increase in input prices in Q3:2020-21, with a further firming up in Q4 from higher costs of chemicals, metals, minerals, cotton and plastic; higher cost pressures were passed through to the clients resulting in an increase in selling prices. PMI services firms also reported continued increase in input prices in Q3 and Q4, driven by fuel, with the sharpest increase reported in prices of consumer services. Despite an increase in input costs, services sector firms reported lower selling prices in Sources: Capitaline database; and RBI staff estimates. efforts to boost sales. 3300Chapter II Prices and Costs Chart II.23: Expectations of Cost Conditions (Net Response) a: Salary Outgo b: Cost of Inputs c: Selling Prices Note: ‘Net response’ is the difference between the percentage of respondents reporting increase in prices and those reporting decrease. Sources: Reserve Bank’s Industrial Outlook Survey; Services & Infrastructure Outlook Survey; and RBI staff estimates. II.4 Conclusion in trade and transport costs, taxi and auto fares, and In 2020-21, inflation breached the upper tolerance its second-round effects could push-up the prices of band of 6 per cent for six consecutive months in goods and services further in a broad-based manner, the post-lockdown period (June-November 2020) with firms regaining pricing power. Effective supply due to a series of cost-push shocks – supply chain measures and tax rationalisation are critical to help disruptions; weather shocks; higher crude oil and anchor inflation expectations. If inflation remains other commodity prices; and higher taxes. Inflationary close to the target on a durable basis, it can then pressures persisted despite a bumper kharif harvest. provide monetary policy the space to adequately The increase in petrol and diesel prices is showing up support the nascent recovery. 3311III. Demand and Output After the unprecedented contraction in Q1, real gross domestic product (GDP) recorded sequential upturn in Q2 and regained positive territory in Q3 with the ambit of the recovery broadening to encompass a wider spectrum of sectors, supported by a significant decline in COVID-19 infections. The recent increase in COVID infections, if not contained, could push back the normalisation process and impede the broader revival of economic activity. Economic activity in India in H2:2020-21 turned out (GVA) recorded positive growth in Q3 and is expected to be more resilient than anticipated in the October to be positive in Q4 also. 2020 MPR, supported by a significant decline in new III.1 Aggregate Demand COVID-19 infections from the mid-September 2020 Real GDP contracted by 8.0 per cent in 2020-21, peak and the rollout of the vaccination drive from mid- according to the National Statistical Office’s (NSO) January 2021. After the unprecedented contraction second advance estimates (SAE), although some slack in Q1, real gross domestic product (GDP) recorded can be attributed to on-budgeting of past subsidy sequential upturn in Q2 and regained positive territory payments in Q4 (Chart III.1a and Table III.1). in Q3 with the ambit of the recovery broadening to encompass a wider spectrum of sectors since then. The recovery in H2:2020-21 was on the back of revival On the supply side too, the sustained resilience of in government expenditure and fixed investment and agriculture and allied activities was complemented easing of the contraction in private consumption. by manufacturing and services sector activity gaining Quarter-on-quarter seasonally adjusted annualised some momentum. As a result, real gross value added (qoq-SAAR) growth rates, however, moderated in Q3 Chart III.1: GDP Growth and its Constituents a: Weighted Contribution of the Components t o b: GDP Growth and Momentum GDP Growth Note: 1. # - Implicit growth. 2. SAAR – Seasonally adjusted annualised rate. Sources: National Statistical Office (NSO) and RBI staff estimates. 32Chapter III Demand and Output Table III.1: Real GDP Growth (y-o-y, per cent) Item 2019-20 2020-21 Weighted 2019-20 2020-21 Contribution* 2019-20 2020-21 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4# Private final consumption expenditure 5.5 -9.0 3.1 -5.1 7.6 6.5 6.4 2.0 -26.3 -11.3 -2.4 3.1 Government final consumption expenditure 7.9 2.9 0.8 0.3 1.8 9.6 8.9 12.1 12.8 -24.0 -1.1 29.2 Gross fixed capital formation 5.4 -12.4 1.7 -4.0 13.3 3.9 2.4 2.5 -46.4 -6.8 2.6 2.8 Exports -3.3 -8.1 -0.7 -1.6 3.0 -1.3 -5.4 -8.8 -22.0 -2.1 -4.6 -3.7 Imports -0.8 -17.6 -0.2 -4.0 9.4 -1.7 -7.5 -2.7 -41.1 -18.2 -4.6 -4.3 GDP at market prices 4.0 -8.0 4.0 -8.0 5.4 4.6 3.3 3.0 -24.4 -7.3 0.4 -1.1 *: Component-wise contributions to growth do not add up to GDP growth because change in stocks, valuables and discrepancies are not included, #: Implicit growth. Source: National Statistical Office (NSO). and Q4 suggesting some flattening of momentum faster than anticipated reduction in new COVID-19 (Chart III.1b). infections in the country. The upside surprise in Q2 and Q3 largely stemmed from a better-than-expected GDP Projections versus Actual Outcomes performance in gross fixed capital formation. Data for The October 2020 Monetary Policy Report (MPR) Q4:2020-21 are expected on May 31, 2021. projected GDP growth at (-) 9.8 per cent for Q2:2020- III.1.1 Private Final Consumption Expenditure 21, (-) 5.6 per cent for Q3 and 0.5 per cent for Q4, with risks tilted to the downside. Actual outcomes in Private final consumption expenditure (PFCE) – the terms of the NSO’s SAE overshot these projections by mainstay of aggregate demand, severely dented during 250 and 600 basis points in Q2 and Q3, respectively the pandemic – revived in H2:2020-21 as spending (Chart III.2), which may be largely attributed to expanded from essential commodities and services towards discretionary items on the back of gradual relaxation of restrictions. The contraction in real PFCE Chart III.2: GDP Growth - Projections moderated to 2.4 per cent in Q3 from 11.3 per cent versus Actual in Q2. Spending on transport, hotels and restaurants, recreation and culture, which together contribute around 20 per cent to PFCE, also began improving in Q4. Several high frequency indicators of private consumption crossed pre-COVID levels, attesting to a broad-based momentum. Drilling down further reveals a divergence between urban and rural demand, with the former suffering the maximum damage and taking longer time to recover due to the loss of employment and heightened uncertainty. Some coincident and proximate high frequency indicators show that urban consumption started inching up from Q3:2020-21 and gained further strength in Q4 with the easing of restrictions. Passenger Sources: NSO and RBI staff estimates. vehicle sales remained robust since August and posted 33Monetary Policy Report April 2021 Chart III.3: Consumption Demand: High Frequency Indicators a: High Frequency Indicators - Urban Demand b: Household Credit Sources: Directorate General of Civil Aviation (DGCA), Society of Indian Automobile Manufacturers (SIAM); NSO; and RBI. double-digit growth in January and February 2021, remained in expansion zone since August 2020 (Chart partly reflecting shifting of preferences towards own III.4). The consumer non-durables output witnessed vehicles over public transportation in the wake of the expansion in December 2020, before contracting in pandemic. The production of consumer durables, that January 2021. had collapsed during H1, got revitalised and surpassed Unemployment rates in both rural and urban areas pre-COVID levels in December 2020 (Chart III.3a). recorded declines during H2 and supported private Credit card outstanding and other personal loans, consumption. The labour force participation rate however, remained subdued (Chart III.3b). Domestic improved considerably in H2 vis-à-vis H1 but remains air passenger traffic, is still tepid and around two- third of pre-COVID-19 levels, reflecting lackluster Chart III.4: Select Indicators - Rural Demand activity related to tourism and entertainment, and with business meetings increasingly preferring the virtual mode. Rural consumption recouped quickly and remained resilient on the back of record kharif production, sustained employment under the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA), and cash transfers under PM Kisan Samman Nidhi Yojana and other schemes. The households that sought employment under the MGNREGA scheme were 63 per cent higher in Q3:2020-21 and remained elevated in Q4. Indicators of rural demand – improved rabi acreage during 2020-21; higher production of fertilisers; and accelerated tractor sales during November-February – Sources: Tractor Manufactures Association; Society of Indian Automobile augur well for a brighter outlook. Motorcycle sales have Manufacturers (SIAM); and NSO. 34Chapter III Demand and Output Chart III.5: Evolving Employment Situation in India a: Number of Employed Workers-CMIE b: Naukri JobSpeak Hiring Index Consumer Pyramid c: Net Payroll Additions based on EPFO Records d: Unemployment and Labour Participation Rates Source: CMIE, EPFO and Naukari.com. below pre-COVID levels. Nonetheless, the available in Q4. For the full year 2020-21, GFCF is estimated data from different sources indicate that employment to have contracted by 12.4 per cent, given the sharp conditions have improved considerably in H2 downturn in H1. The share of GFCF in aggregate GDP (Chart III.5). inched up to 32.8 per cent in H2 from 28.5 per cent in H1 and 31.9 per cent in H2:2019-20. Real estate III.1.2 Gross Fixed Capital Formation and construction activity gained some momentum The upturn in fixed investment gained traction during from Q3 – particularly in rural and semi-urban areas H2:2020-21, although it continues to be weighed down and affordable segments in urban areas – benefitting by surplus capacity and uncertainty surrounding from lower mortgage rates, favourable pricing and a the outlook. Congenial financial conditions are slash in stamp duty across several states. Among its expected to continue supporting the recovery in fixed proximate coincident indicators, steel consumption investment (Box III.1). Gross fixed capital formation rose at a robust pace in January and February 2021 (GFCF) expanded by 2.6 per cent on year-on-year on top of double-digit growth in the preceding two basis in Q3 and is estimated to rise by 2.8 per cent months. Investment in machinery and equipment is 35Monetary Policy Report April 2021 Box III.1: Investment and Financial Conditions Domestic financial conditions eased considerably with the Chart III.1.2: FCI and GFCF Growth onset of the pandemic as reflected in large drops in interest rates/spreads across the spectrum and ample surplus liquidity in the system on the back of conventional and unconventional policy measures by the Reserve Bank. The availability and cost of finance are amongst the important drivers of investment. A financial condition index (FCI) that is a summary indicator of financial conditions, helps to gauge their impact on investment activity. Following Kongsamut et. al. (2017), a FCI for India is constructed with variables drawn from equity, debt, money and forex markets. Using data from Q1:2002 to Q1:2020, the FCI includes the following five standardised variables – government securities (G-Sec) 10-year benchmark yield, Source: RBI staff estimates. corporate AAA bond spread over G-Sec yield, Nifty-50 return, repo rate and net foreign portfolio inflows – based exhibit broadly similar directional changes (Chart III.1.2). on a preliminary analysis of their correlation and impact The FCIs capture the tightening of financial conditions on investment. during the global financial crisis in 2008 and later in Dynamic factor model (DFM)1 and vector auto regression 2012-13 (associated with the period of high inflation (VAR)2 approaches are used to construct FCIs (FCI1 and and monetary tightening) as well as the recent easing of FCI2, respectively) for a robust analysis. Negative values financial conditions after the pandemic. In terms of the of FCIs denote easier financial conditions while positive DFM-based FCI, financial conditions at present are at their values indicate tighter financial conditions. Both the FCIs easiest since 2003. Both the measures of FCIs are negatively correlated (statistically significant) with growth in gross fixed Chart III.1.1: GFCF Trend and Cycle capital formation (GFCF) and the correlation is higher for lagged FCI, i.e., the easing of financial conditions is associated with a subsequent rise in investment growth (Table III.I.1). Granger causality tests confirm that the Table III.I.1: Correlation Coefficient of FCIs with Investment Growth (y-o-y) FCI1 FCI2 Lag 0 -0.26* -0.52* Lag 1 -0.43* -0.57* Lag 2 -0.57* -0.59* Lag 3 -0.61* -0.52* Lag 4 -0.54* -0.38* * indicates significant at 1% level Source: RBI staff estimates. (Contd.) 1 DFM is applied as dimension reduction technique using factor analyser module of Python. Bartlett’s test of sphericity indicates that the dataset is not an identity matrix; Kaiser-Meyer-Olkin (KMO) measure of sampling adequacy is found to be greater than 0.6. The maximum likelihood (ML) method is used to fit factors to the observed data with visual scree plot analysis to decide on using 2 factors. 2 The VAR model is run on the same set of variables and the weights are derived from impulse response functions as cumulative impact on investment in 8 subsequent quarters to construct FCI2. 36Chapter III Demand and Output Table III.I.2: Granger Causality Test Hypothesis FCI1 (DFM) FCI2 (VAR) F-statistic Prob F-statistic Prob FCI does not Granger cause investment growth 2.04 0.14 3.76*** 0.03 FCI (-1) does not Granger cause investment growth 1.54 0.22 1.08 0.34 FCI (-2) does not Granger cause investment growth 2.45*** 0.09 2.33 0.11 FCI (-3) does not Granger cause investment growth 0.37 0.69 0.29 0.75 FCI (-4) does not Granger cause investment growth 0.02 0.98 0.39 0.68 ***indicates significant at 10% level. Source: RBI staff estimates. financial conditions have a statistical significant impact conditions in supporting investment activity is also on investment growth (Table.I.2). The role of financial corroborated by regression analysis with controls for expected economic activity (Table III.I.3). Table III.I.3: Regression Estimates References: Dependent Variable: Investment Growth Hatzius, J., Hooper, P., Mishkin, F., Schoenholtz, K., Coefficient t-Statistic Watson, M. (2010), ‘Financial Conditions Indexes: A Fresh Investment growth (-1) 0.54 4.67* FCI1(-2) -3.05 -2.98* Look after the Financial Crisis’, NBER Working Papers, No. GDP growth(+2) 0.58 2.69* 16150. Constant 0.27 0.14 R2 0.59 Kongsamut, P., C. Mumssen, A. Paret, T. Tressel (2017), Prob (J-statistic) 0.79 Q-statistic (upto 4 lags) (p-value) 0.23 ‘Incorporating Macro-Financial Linkages into Forecasts *: Significant at 1 per cent level. Using Financial Conditions Indices: The Case of France’ The equation is estimated through generalised method of moments approach with IMF Working Paper No. 17/269. the following instruments: lags of the endogenous variables as well as lag of world GDP growth, Brent crude prices and annual deviation rainfall in India from its long Gulati, S., Ghosh, B., Deepmala and Kumar, S. (2021), period average. ‘Investment and Financial Conditions’, Mimeo. Source: RBI staff estimates. also recovering as reflected by imports of capital goods (Chart III.6a). The production of capital goods attained remaining in the positive zone since December 2020 positive territory in December 2020 but shrank in Chart III.6: Investment Demand a: Indicators of Investment Demand b: Capacity Utilisation in Manufacturing Sources: DGCI&S; NSO; and RBI. 37Monetary Policy Report April 2021 January 2021. The capacity utilisation (CU) in the Chart III.7: Interest Coverage Ratio manufacturing sector improved to 66.6 per cent in Q3 from the previous quarter (Chart III.6b). Seasonally adjusted CU also increased to 65.2 per cent in Q3 from 64.4 per cent in the previous quarter. Half-yearly unaudited financial statements of listed non-government non-financial (NGNF) companies indicate that companies reduced their assets and used funds to reduce liabilities and build-up cash holdings – the former signifying deleveraging while the latter is indicative of precautionary saving in uncertain times. The debt to equity ratio of these firms dropped by 4.4 percentage points to 39.7 per cent in Note: Data for Q3:2020-21 are based on results of 1,685 listed private H1:2020-21, although it was still higher than its manufacturing companies and 678 listed private non-financial services companies. level in the previous two years. Investment by these Source: RBI staff estimates. companies remained subdued (Table III.2). At the same time, the interest coverage ratio of listed non- utilisation under the government’s Emergency Credit financial private companies increased in Q3, indicating Line Guarantee Scheme (ECLGS) to meet working improved debt servicing capacity of these companies capital requirements. As on February 28, 2021, the (Chart III.7). The deleveraging and improved debt utilisation under ECLGS stood at 82 per cent. The service capacity along with congenial financial PLI, covering 13 sectors with a commitment of the conditions, recovery in capacity utilisation, government support amounting to nearly `1.97 lakh resuscitation of private consumption and the crore, has begun attracting investment, including expanded scope of the Production-Linked Incentive FDI, in the manufacturing sector. The significantly (PLI) Scheme offer a conducive environment for higher allocation for capital expenditure in the capex spending by non-financial private companies. Union Budget 2021-22 is expected to crowd in private Bank lending to micro, small and medium enterprises investment, and hence, augurs well for the revival of (MSMEs) segment has improved with increased the private sector investment cycle. At the same time, possible stress in the balance sheet of banks – once Table III.2: Listed Private Manufacturing Companies special dispensations related to moratorium, asset (Per cent) classification and restructuring wane – could weigh Period Debt to Debt to Cash to Fixed Assets on the investment outlook. Capital infusion and Equity Assets Total Assets (y-o-y growth) Ratio Ratio Ratio efficient and effective handling of loan delinquencies H2:2017-18 36.9 19.3 2.9 should be accorded priority, so that impediment to H1:2018-19 37.9 19.5 2.6 H2:2018-19 37.7 19.8 3.0 4.6 credit availability does not undermine revival in the H1:2019-20 34.7 18.6 3.1 7.8 investment cycle. H2:2019-20 44.1 21.9 3.8 8.2 H1:2020-21 39.7 21.0 4.7 2.1 As per the first revised estimates for 2019-20, the gross Note: Based on data of 1,249 common listed private manufacturing domestic saving rate increased to 31.4 per cent of GDP companies. Source: RBI staff estimates. from 30.6 per cent a year ago. Net household financial 38Chapter III Demand and Output Chart III.8: Saving Investment Gap Table III.3: Key Fiscal Indicators – Central Government Finances Indicator Per cent to GDP 2019-20 2020-21 2021-22 (RE) (BE) 1. Revenue receipts 8.3 8.0 8.0 a. Tax revenue (Net) 6.7 6.9 6.9 b. Non-Tax revenue 1.6 1.1 1.1 2. Non-debt capital receipts 0.3 0.2 0.8 3. Revenue expenditure 11.6 15.5 13.1 a. Interest payments 3.0 3.6 3.6 b. Major subsidies 1.1 3.1 1.5 4. Revenue expenditure excluding 7.3 8.6 7.8 interest payments and subsidies 5. Capital expenditure 1.7 2.3 2.5 6. Capital outlay 1.5 1.7 2.3 7. Total expenditure 13.2 17.7 15.6 8. Gross fiscal deficit 4.6 9.5 6.8 Sources: NSO; and RBI staff estimates. 9. Revenue deficit 3.3 7.5 5.1 10. Primary deficit 1.6 5.9 3.1 Sources: Union Budget 2021-22 and RBI staff estimates. saving – a major source of funds for the economy – increased to 8.0 per cent of GDP in 2019-20 from 7.2 in H2. Excluding government expenditure, the per cent in the preceding year. While the public sector economy would have recorded a contraction of 9.3 per cent in 2020-21. In 2021-22, the growth in revenue was reliant on household surpluses for financing expenditure excluding interest and subsidy payments its deficit, the private sector depended primarily on has been budgeted at 4.8 per cent, considerably on internal resources for financing its investment needs the lower side as compared with 13.1 per cent in (Chart III.8). According to preliminary estimates, the 2020-21 (RE), indicating lower support to aggregate household financial savings rate spiked to 21.0 per demand (Table III.3). cent of GDP in Q1:2020-21 as consumption waned amidst lockdowns and nearly normalised back to 10.4 During 2020-21, the fiscal position of the central per cent in Q2 as consumption recovered reinforced government remained under stress due to revenue by pent-up demand3. shortfalls and increase in COVID-19-related discretionary spending. Revenue collections gathered III.1.3 Government Expenditure pace in H2, however, on the back of the pick-up in The contraction in Government Final Consumption economic activity. The centre’s net tax revenue Expenditure (GFCE) narrowed sharply from 24.0 per increased by 9.1 per cent during April-February cent during Q2 to 1.1 per cent in Q3. GFCE support to 2020-21 and stood at 90.4 per cent of revised estimates aggregate demand revived in Q4 (the implicit growth (RE) for the full year (Chart III.9). Except excise and in the SAE of NSO is 29.2 per cent). Overall, the fiscal customs duties, tax collections witnessed declines support to aggregate demand remained substantial across the board. 3 Hansda, Sanjay Kumar, Anupam Prakash, Anand Prakash Ekka and Ishu Thakur (2021), “Q2:2020-21 Estimates of Household Financial Savings and Household Debt-GDP Ratio”, RBI Bulletin, March. 39Monetary Policy Report April 2021 Chart III.9: Tax Collections a: Direct Taxes b: Indirect Taxes Source: Controller General of Accounts, Ministry of Finance. Total GST collections were severely hit by the Total tax revenue is budgeted to be higher in 2021-22 lockdown during H1:2020-21 but crossed the than in the previous year (Table III.4). previous year’s level from September 2020 onwards The revenue expenditure for the full year 2020-21 was (Chart III.10). In March 2021, GST collections were revised upward by 14.5 per cent from the BE, mainly recorded at `1.24 lakh crore. Direct tax collections due to spending on major subsides. Outgoes on food during April-February 2020-21 were 81.6 per cent of subsidy in RE were over three and half times of the BE RE, down by 9.9 per cent over the previous year’s level. (2.2 per cent of GDP) because of distribution of free foodgrains to over 80 crore people and on-budgeting of Chart III.10: GST Collections past subsidy payments to the Food Corporation of India Table III.4: Central Government Tax Collections Indicator Per cent to GDP 2019-20 2020-21 2021-22 (RE) (BE) 1. Direct tax 5.1 4.6 5.0 (i) Corporation 2.7 2.3 2.5 (ii) Income 2.4 2.3 2.5 2. Indirect tax 4.6 5.1 5.0 (i) GST 2.9 2.6 2.8 (ii) Customs 0.5 0.6 0.6 (iii) Excise 1.2 1.8 1.5 3. Gross tax revenue (1+2) 9.7 9.7 9.9 4. Net tax revenue 6.6 6.9 6.9 Source: CGA. Note: BE: Budget Estimates. RE: Revised Estimates. Source: Union Budget, 2021-22. 40Chapter III Demand and Output Chart III.11: Growth in Revenue and Capital Chart III.12: Revenue Expenditure and Expenditure during 2020-21 Capital Outlay #: Implicit Source: RBI staff estimates. Source: RBI staff estimates. (FCI) in the form of National Small Saving Fund (NSSF) allocation for capital expenditure has been budgeted loans. The revenue expenditure, excluding interest higher by 26.2 per cent, while revenue expenditure is and subsidy payments, is estimated to step-up by 33.6 budgeted to fall by 2.7 per cent in 2021-22. The capital per cent in Q4 (Chart III.11). The capital expenditure of outlay (i.e., capital expenditure excluding loans and the central government also inched up by 6.6 per cent advances) is budgeted to edge up to 2.3 per cent of in RE 2020-21 from BE on the back of higher spending GDP in 2021-22 (BE) from 1.7 per cent in 2020-21(RE) on central sector schemes, railways, defence, transfers (Chart III.12). The Union Budget 2021-22 expected the to the States, health and MSMEs. Higher capital fiscal deficit (FD) to decline to 6.8 per cent of GDP and expenditure in RE that is attributed to discretionary to 4.5 per cent by 2025-26. spending gave a thrust to fixed investment in the Based on data for 24 states for April-January 2020- economy. The increased government expenditure 21, states’ consolidated revenue receipts contracted reflects the fiscal policy push necessitated by the largely due to downturn in own tax revenue, central pandemic to save lives and livelihood and nurture tax transfer and own non-tax revenue. Consolidated the economic recovery. Reflecting decline in revenues revenue receipts, however, made a turnaround in and higher expenditures, the fiscal deficit (FD) and H2 (October-January 2020-21) due to revival in GST revenue deficit (RD) edged up considerably to 9.5 collections. Despite COVID-19 related spending, per cent and 7.5 per cent of GDP, respectively in states’ revenue expenditure (excluding interest 2020-21(RE). payments and subsidies) rose marginally during April- The Union Budget 2021-22 gave an impetus to growth January due to expenditure rationalisation. Capital through increased outlays for capital expenditure. expenditure after contracting in H1, posted a robust Although total expenditure is budgeted to grow growth in H2 (October-January 2020-21), reflecting a by only 1 per cent, the increased focus on capital qualitative improvement in expenditure composition. expenditure that has multiplier effects would boost For 2021-22, the consolidated GFD (for 12 states for overall investment and growth in the economy. The which data are available) is budgeted at 3.7 per cent of 41Monetary Policy Report April 2021 Table III.5: State Government Finances - Key Chart III.13: Funding of Centre's Fiscal Deficit Deficit Indicators (per cent of GSDP) Item 2019-20 2020-21 2020-21 2021-22 (BE) (RE) (BE) Revenue deficit 0.1 0.1 1.7 0.5 Primary deficit 0.7 1.1 2.4 1.8 Gross fiscal deficit 2.3 2.6 4.2 3.7 Notes: 1. Data pertain to 12 states out of 28 States and 3 Union Territories that have presented their Budgets for 2021-22. 2. GSDP is the sum of GSDP of the respective 12 states. Source: Budget Documents of State Governments. GSDP during 2021-22 as against 4.2 per cent in 2020- 21(RE) (Table III.5). The Reserve Bank of India completed the central government’s market borrowing programme for Sources: Government of India; and RBI staff estimates. 2020-21 successfully and in a non-disruptive manner (Table III.6). Despite a sharp increase in the quantum of the borrowings, ample surplus liquidity, regular open Eleven tranches of switch operations amounting market operations (OMO) including special OMOs, to `1.53 lakh crore were undertaken during 2020- regulatory measures and forward guidance enabled 21, aiming at managing rollover risk and enhancing the government to complete its borrowings at a 16- liquidity of government securities. year low weighted average cost – 5.79 per cent during The Union Budget 2021-22 has placed net market 2020-21 as compared with 6.84 per cent in 2019-20 borrowings through G-Sec at `9.2 lakh crore, lower – along with the highest weighted average maturity. than in 2020-21 (RE). Market borrowings are slated States’ gross borrowings of `7.98 lakh crore, also to finance 61 per cent of the centre’s fiscal deficit significantly higher than normal, were completed at a in 2021-22(BE), higher than 57 per cent in RE 2020- weighted average cost of 6.52 per cent during 2020-21. 21 (Chart III.13). Gross market borrowings of the central government through dated securities have Table III.6: Centre’s Borrowings been planned at `7.24 lakh crore in H1:2021-22 (60 (` Lakh Crore) per cent of the total budgeted amount for 2021-22). Item 2019-20 2020-21 2021-22 The ways and means advances (WMA) limit for the (RE) (BE) I Net borrowings (G-Sec) 4.7 10.5 9.2 central government has been fixed at `1.20 lakh Repayments 2.4 2.3 2.9 crore for H1:2021-22 to enable seamless bridging Gross borrowings (G-Sec) 7.1 12.8 12.1 II T-Bills/Cash management bills (Net) 1.5 2.2 0.5 of intermittent mismatch between receipts and III Net market borrowings (I+II) 6.2 12.7 9.7 payments on account of leads and lags. IV Securities against small savings 2.4 4.8 3.9 V State provident fund 0.1 0.2 0.2 III.1.4 External Demand VI Other receipts 0.4 0.4 0.5 VII External debt 0.1 0.5 0 With the global economy gradually emerging from one VIII Total debt (III to VII) 9.3 18.7 14.4 of its deepest recessions, India’s exports surpassed IX Drawdown on cash balances 0.1 -0.2 0.7 X Total funding (VIII+IX) 9.4 18.5 15.1 the pre-pandemic level and entered the expansionary Sources: Government of India; and RBI staff estimates. zone from December 2020. Imports contraction 42Chapter III Demand and Output Chart III.14: India's Merchandise Trade Sources: Directorate General of Commercial Intelligence and Statistics (DGCI&S) and RBI staff estimates. became softer in H2:2020-21 and eventually turned in merchandise imports moderated to 4.7 per cent in positive from December 2020 after a gap of 9 months Q3:2020-21 from 52.9 per cent in Q1 (Chart III.15b). (Chart III.14). The positive contribution of net external In February 2021, merchandise imports rose by demand to y-o-y growth fell in Q3 with improvement 7.0 per cent, registering an expansion for the third in imports outpacing exports. The contribution of net consecutive month. The rebound in non-oil non-gold external demand to growth is estimated to improve imports has been broad-based, with major sectors in Q4. including electronic goods, machinery, chemicals, and pearls and precious stones reaching pre-COVID levels According to data released by the Directorate General in December 2020 (Chart III.15d). Gold imports rose of Commercial Intelligence and Statistics (DGCI&S), by 38.0 per cent in Q3 and 124 per cent in February the pace of contraction in India’s merchandise 2021. Overall, merchandise imports contracted by exports, which peaked in Q1:2020-21 due to the disruptions caused by the COVID-19, moderated 23.1 per cent in April-February 2020-21. With imports in Q2 and Q3 on the back of a gradual recovery in contracting faster than exports, the merchandise global demand conditions. Merchandise exports trade deficit nearly halved to US$ 84.6 billion in expanded for the third month in a row in February April-February 2020-21 from US$151.4 billion in the 2021 (Chart III.15 a). Non-oil exports rose by 3.1 per corresponding period a year ago. Going forward, cent in Q3 and 7.5 per cent during January-February India’s oil import bill may edge up due to the rise in 2021 (Chart III.15c). At the disaggregated level, international crude oil prices since November 2020 in drugs and pharmaceuticals, iron ore and agricultural the face of rebalancing of global oil supply-demand products pushed up non-oil export growth. Overall, conditions. during April-February 2020-21, merchandise exports Turning to the services sector, the initial setback contracted by 12.2 per cent. to the exports of services in Q1:2020-21 waned With the gradual opening up of the economy and gradually in view of the resilience of software exports revival of domestic demand, the pace of contraction (Chart III.16). While travel and transport sector and 43Monetary Policy Report April 2021 Chart III.15: Relative Contribution to Export and Import Growth a: Relative Contribution: Exports b: Relative Contribution: Imports c: Major Drivers of Exports in H2:2020-21*: d: Major Drivers of Imports in H2:2020-21*: Relative Contribution Relative Contribution Note: *:H2: October-February 2020-21. Sources: DGCI&S and RBI staff estimates. trade-related services were adversely impacted Chart III.16: Services Trade due to the global lockdown restrictions, domestic information technology (IT) companies benefitted from demand from international customers and increasingly adopted new models for IT and other work operations in the wake of the pandemic. Remittances recorded sequential improvement in Q2 and Q3 with the phased normalisation of global economic activity. While the current account surplus was 3.0 per cent of GDP in H1, the rising trade deficit pushed the current account back into deficit in Q3. Net capital flows remained robust in 2020-21 supported by foreign direct investment (FDI) and foreign portfolio investment (FPI) on growing Source: DGCI&S. optimism about India’s growth prospects. Driven 44Chapter III Demand and Output primarily by megadeals in the digital and retail Chart III.17: Net Foreign Direct and sectors, net FDI at US$ 44.3 billion during April- Portfolio Investment January 2020-21 was higher than US$ 36.3 billion a year ago. The sharp upturn in net purchases by portfolio investors in the equity segment during H2 resulted in net FPI inflows at US$ 37.1 billion during 2020-21 (up to March 30) as against an outflow of US$ 5.2 billion during the same period last year (Chart III.17). While the accommodative monetary policies of major central banks improved the appetite for risk among global portfolio investors, robust earnings reported by domestic corporate sector, positive sentiments on COVID vaccination and optimism on domestic growth also helped in attracting record FPI inflows. Despite purchases by *: Upto March 30, 2021 Sources: NSDL; and RBI. FPIs in the debt market in H2:2020-21, there was a cumulative net outflow at US$ 0.5 billion from III.2 Aggregate Supply this segment in 2020-21 (up to March 30). External commercial borrowings recorded net outflows during Gross value added (GVA) – the measure of aggregate April-January 2020 partly due to pre-payments. Net supply – contracted by 6.5 per cent in 2020-21 as per flows under non-resident deposits, however, surged the SAE released by the NSO. GVA posted a growth of during the period. As on March 26, 2021, India’s 1.8 per cent in H2:2020-21 in contrast to a downturn foreign exchange reserves amounted to US$ 579.3 of 14.9 per cent in H1:2020-21. The momentum in billion, covering 18.4 months of imports and 102.8 growth – Q-o-Q-SAAR – eased during Q3 and Q4 from per cent of external debt (chart III.17). Q2 (Chart III.18). Chart III.18: GVA Growth a: GVA Growth b: GVA Growth: excluding PADO #: Implied Sources: NSO; and RBI staff estimates. 45Monetary Policy Report April 2021 Table III.7: Sector-wise Growth in GVA (y-o-y, per cent) Sector 2019-20 2020-21 Weighted 2019-20 (FRE) 2020-21 (SAE) (FRE) (SAE) Contribution 2020-21 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Agriculture, forestry and fishing 4.3 3.0 0.4 3.3 3.5 3.4 6.8 3.3 3.0 3.9 1.9 Industry -2.0 -7.4 -1.6 1.0 -2.7 -3.0 -3.2 -31.1 -1.6 1.4 1.9 Mining and quarrying -2.5 -9.2 -0.2 -1.3 -5.2 -3.5 -0.9 -18.0 -7.6 -5.9 -5.5 Manufacturing -2.4 -8.4 -1.4 0.6 -3.0 -2.9 -4.2 -35.9 -1.5 1.6 2.3 Electricity, gas, water supply and other utilities 2.1 1.8 0.0 6.9 1.7 -3.1 2.6 -9.9 2.3 7.3 8.9 Services 6.4 -8.4 -5.3 6.8 7.3 5.8 5.6 -24.8 -10.9 0.0 2.9 Construction 1.0 -10.3 -0.8 3.7 1.0 -1.3 0.7 -49.4 -7.2 6.2 8.4 Trade, hotels, transport, communication 6.4 -18.0 -3.7 6.2 6.8 7.0 5.7 -47.6 -15.3 -7.7 -2.9 Financial, real estate and professional services 7.3 -1.4 -0.3 8.8 8.9 5.5 4.9 -5.4 -9.5 6.6 6.9 Public administration, defence and other services 8.3 -4.1 -0.5 5.6 8.8 8.9 9.6 -9.7 -9.3 -1.5 3.2 GVA at basic prices 4.1 -6.5 -6.5 5.0 4.6 3.4 3.7 -22.4 -7.3 1.0 2.5 FRE: First Revised Estimates; SAE: Second Advance Estimates; #: Implicit growth. Source: NSO. Agriculture and allied activities remained at a record level of 3,265.8 lakh tonnes during 2020- resilient during 2020-21, partially offsetting 21 – 1.8 per cent higher than the final estimates for the contraction in other components of GVA. 2019-20 – driven largely by production of aromatics Manufacturing activity entered expansion in Q3 but and medicinal crops, vegetables and fruits. dipped back into contraction in January 2021. The Allied activities consisting of livestock, forestry and services sector – battered by the pandemic – tenuously fishing – which constitute about 44 per cent of the regained momentum in H2, buoyed by optimism on the roll-out of vaccines (Table III.7). Table III.8: Agricultural Production in 2020-21 III.2.1 Agriculture (Second Advance Estimates) (in Lakh Tonnes) GVA in agriculture and allied activities expanded by 3.0 per cent in H2:2020-21, maintaining its pace of Crop 2019-20 2020-21 Variation in 2020-21 (Per cent) H1. Sufficient access to inputs, adequate and well- 2nd AE Final Target 2nd Over Over Over spread south-west and the north-east monsoon AE 2nd AE Final Target 2019-20 2019-20 rains, sufficient reservoir levels and improved soil Foodgrains 2919.5 2975.0 3010.0 3033.4 3.9 2.0 0.8 moisture pushed up rabi acreage by 2.9 per cent. The Kharif 1423.6 1438.1 1493.5 1479.5 3.9 2.9 -0.9 SAE for 2020-21 has placed kharif and rabi foodgrains Rabi 1496.0 1536.9 1516.5 1554.0 3.9 1.1 2.5 production higher by 2.9 and 1.1 per cent, respectively, Rice 1174.7 1188.7 1196.0 1203.2 2.4 1.2 0.6 over their levels a year ago (Table III.8). Foodgrains Wheat 1062.1 1078.6 1080.0 1092.4 2.9 1.3 1.1 Pulses 230.2 230.3 256.0 244.2 6.1 6.0 -4.6 production, including both the staple cereals, viz., Oilseeds 341.9 332.2 370.0 373.1 9.1 12.3 0.8 rice and wheat, touched another record for the fifth Sugarcane 3538.5 3705.0 3900.0 3976.6 12.4 7.3 2.0 consecutive year. Among the commercial crops, cotton Cotton # 348.9 360.7 360.0 365.4 4.7 1.3 1.5 Jute & 98.1 98.8 105.0 97.8 -0.3 -1.0 -6.9 and oilseeds (groundnut and ‘rapeseed and mustard’) Mesta ## achieved record production levels. All the crops, except #: lakh bales of 170 kgs. each. pulses and jute and mesta, achieved their target levels ##: lakh bales of 180 kgs. each. Source: Ministry of Agriculture and Farmers’ Welfare, Government of for 2020-21. Horticultural production was also placed India. 46Chapter III Demand and Output over and above the record procurement during the Chart III.19: Contribution of Crops and Allied Activities previous rabi season. Record procurement of cereals led to a significantly higher buffer stock of wheat and rice at 286.8 lakh tonnes (2.1 times the buffer norms) and 512.4 lakh tonnes (6.7 times the buffer norms), respectively, by mid-March 2020 notwithstanding 315 lakh tonnes of cereals distributed under the Pradhan Mantri Garib Kalyan Anna Yojana (Chart III.20). In terms of high frequency indicators, tractor sales posted strong growth in Q3 and January-February 2021, and two-wheeler sales remained buoyant (Table III.9). Farm exports remained strong during Q3 and Q4 (January-February), benefitting from a surge in global demand and higher international food prices. Sources: NSO; and RBI staff estimates. The Union Budget 2021-22 has announced measures sector – contributed about half of overall agricultural targeted at infrastructure development in agriculture, GVA growth in 2019-20 (Chart III.19). rural areas, and fisheries by enhancing credit flow The procurement of paddy during the kharif and improving supply chains for perishables while marketing season that started in September 2020 ensuring continuation of direct procurement of was higher by 14.0 per cent year-on-year till March cereals by the government. The extension of the 31, 2021. For upcoming rabi marketing season (April- agriculture infrastructure fund to Agricultural March), the government has set a target to procure Produce Market Committees (APMCs) and integration 407.0 lakh tonnes of wheat, which is 2.3 per cent of additional 1,000 APMC mandis with electronic- Chart III.20: Stock, Procurement and Offtake Position – Wheat and Rice a: Wheat b: Rice Source: Food Corporation of India, GoI. 47Monetary Policy Report April 2021 Table III.9: High Frequency Indicators for Rural Economy Per cent Items Growth Jul-20 Aug-20 Sep-20 Oct-20 Nov-20 Dec-20 Jan-21 Feb-21 Tractor sales y-o-y 38.5 74.7 28.3 7.7 51.3 43.1 46.7 31.1 Two-wheeler sales y-o-y -15.2 3.0 11.6 16.9 13.4 7.4 6.6 10.2 Fertilizer sales y-o-y 25.4 7.0 -2.6 17.7 3.7 -26.5 -22.3 NA Demand for employment (MGNREGA) y-o-y 66.3 60.4 63.3 81.0 43.1 47.2 30.0 20.3 Export - agri and allied sector y-o-y 15.3 14.1 31.5 34.2 12.5 12.9 21.5 27.1 Agriculture credit (Outstanding) y-o-y 5.4 4.9 5.9 7.4 8.5 9.4 9.9 10.2 Stocks-cereals (Ratio of actual stock to quarterly buffer norms) Rice 2.8 2.2 2.4 3.3 3.6 4.5 6.6 6.7 Wheat 2.0 1.7 2.1 2.0 1.8 1.7 2.3 2.1 Sources: Tractor Manufactures Association; SIAM; Ministry of Chemicals and Fertilzers; Ministry of Rural Development; CMIE; RBI; and Food Corporation of India. National Agriculture Market (e-NAM)4 is expected to The index of industrial production (IIP) emerged out enhance farmers access to markets and prices and of a prolonged contraction in September 2020 but it improve marketing efficiency in the agriculture sector. lost momentum again in November and January 2021 The proposal to expand “operation green” from 3 (Chart III.22a). The improvement in manufacturing (onions, tomatoes and potatoes) to 22 perishable activity in Q3 was driven by basic metals, chemical commodities is expected to improve supply chains, and chemical products, motor vehicles and electrical reduce price fluctuations and boost exports of equipment. 12 out of 23 industry groups entered perishable agricultural commodities. According to the positive territory in Q3 as compared to only 5 groups National Oceanic and Atmospheric Administration during Q2. In terms of the use-based classification, (NOAA) of the US, there is around 60 per cent chance the recovery in Q3 was led by consumer durables of a transition from La Niña to ENSO-Neutral during and infrastructure/construction goods on the back of the April-June 2021, indicative of a normal south west monsoon. Chart III.21: Weighted Contribution to Industrial GVA growth III.2.2 Industry Industrial sector GVA was driven by the manufacturing sector emerging out of contraction in Q3, although in Q4, there has been some setback due to sharp retrenchment of production of capital goods and consumer non-durables (Chart III.21). In contrast, the mining sector continued to languish, throttled by supply bottlenecks. Crude oil and natural gas production dropped due to lack of critical infrastructure and equipment, and operational difficulties amidst the pandemic. Natural gas production crossed the pre- COVID levels in January 2021 following the start of production in KG-D6 field, which bodes well for the #: Implicit. outlook. Source: NSO and RBI staff estimates. 4 National Agriculture Market (eNAM) is a pan-India electronic trading portal which networks the APMC mandis to create a unified national market for agricultural commodities. 48Chapter III Demand and Output Chart III.22: Index of Industrial Production (IIP) a: Exclusion-based IIP b: IIP Index: Seasonally Adjusted and Normailsed c: Sectoral Contribution to IIP Growth d: Use-based Contribution to IIP Growth Sources: NSO; and RBI staff estimates. increase in sales of automobiles and electronics, and some deceleration in February 2021. The thermal higher domestic demand from the auto and white sector contributed primarily to the upturn in electricity goods segment for steel (Chart III.22d). In capital generation in Q3 and January with a growth of 7.6 per goods sector, the moderation was offset by higher cent and 7.0 per cent, respectively, before easing to 1.9 output of agricultural tractors, harvesters, threshers, per cent in February 2021. The rate of contraction in nuclear power generation became more pronounced tyres and tubes. during January-February 2021, while generation In January 2021, the IIP contracted by 1.6 per cent, from renewable sources decelerated in January and pulled down by the downturn in manufacturing. contracted in February (Chart III.23a). Hydro power Mining activity contracted further in January 2021. generation continued to contract in Q3 and January- In terms of the use-based classification, capital goods February 2021. The deceleration in electricity demand production declined to a 5-month low while consumer in February was mainly due to a drop in consumption non-durables output fell to an 8-month low. in western and southern regions (Chart III.23b). Electricity generation improved in Q3 and January Nominal GVA of manufacturing companies posted 2021 reflecting buoyant demand although there was a notable improvement in Q3 on the back of strong 49Monetary Policy Report April 2021 Chart III.23: Electricity Demand and Consumption a: Electricity Generation and Demand Growth b: Electricty Consumption: Region-wise Source: Central Electricity Authority and Power System Operation Corporation Limited (POSOCO). growth in profits (Chart III.24). Profit before tax of Business sentiment improved in H2:2020-21, with manufacturing companies surged on an improvement the Reserve Bank’s business assessment index in net sales coupled with reduced interest expenses. rising to 113.1 in Q4:20-21 (the 93rd round of the Employee cost posted an uptick, however. industrial outlook survey) from 108.6 in Q3:2020-21. The business expectations index (BEI) also improved Chart III.24: Components of Manufacturing GVA further to 119.6 for Q1:2021-22 as compared to 114.1 for Q4:2020-21. The manufacturing purchasing managers’ index (PMI) at 55.4 in March 2021 indicated expansion for the eighth consecutive month, driven by upturn in new orders and production (Chart III.25a). Overall, manufacturing activity and electricity generation are gradually normalising and approaching their 2019-20 levels (Table III.10). III.2.3 Services The services sector stepped out of contraction Note: Data for Q3:2020-21 are based on results of 1,685 listed private in H2:2020-21 with the phased unlocking of the manufacturing companies. Source: RBI staff estimates. economy, and recorded a growth of 1.4 per cent. 50Chapter III Demand and Output Chart III.25: Purchasing Managers Index (PMI) a: PMI Manufacturing b: PMI Services Note: >50: Expansion, < 50: Contraction. Source: IHS Markit. The construction sector recuperated faster than (Chart III.26a). Indicators such as finished steel anticipated – entering positive territory in Q3 – consumption mirrored the recovery in construction and rose by 7.3 per cent in H2 due to demand from activity (Chart III.26b). Robust collection of the goods the residential sector and highway construction and services tax (GST) and issuances of e-way bills Table III.10: Industrial Sector Indicators: Progress towards Normalisation (Seasonally adjusted and normalised to 2019-2020 = 100) Indicators 2019-20 Q1:2020-21 Q2:2020-21 Q3:2020-21 Oct-20 Nov-20 Dec-20 Jan-21 Feb-21 I Index of Industrial Production 100 69 94 98 98 97 99 98 IIP: Manufacturing 100 64 93 99 99 97 100 97 IIP: Capital goods 100 40 85 95 89 94 94 IIP: Infrastructure & construction goods 100 56 96 102 102 101 102 99 IIP: Consumer durables goods 100 36 89 100 104 95 101 99 IIP: Consumer non-durables goods 100 86 102 101 104 99 100 94 II Eight Core Industries Index 100 79 94 97 95 98 100 100 101 ECI: Steel 100 56 97 101 99 100 103 100 99 ECI: Cement 100 63 87 94 95 94 96 97 103 Electricity demand 100 87 99 101 100 99 103 105 109 III Production of Automobiles Passenger vehicles 100 19 87 109 112 99 116 94 106 Two wheelers 100 24 91 110 117 105 109 105 109 Three wheelers 100 25 46 64 62 62 68 62 70 Production of tractors 100 60 122 150 144 140 167 173 177 Sources: CMIE, CEIC, NSO, SIAM, RBI staff estimates.  Below pre-Covid level Normalisation / recovery of activity  51Monetary Policy Report April 2021 Chart III.26: Service Sector a: Service Sector Components b: Construction Indicators Sources: NSO; Office of Economic Adviser, Joint Plant Committee, Department of Industrial Policy & Promotion, Ministry of Commerce & Industry. suggest a strong upturn in domestic trading activity. and international, boosted railway freight traffic The ongoing normalisation of trade, both domestic (Table III.11). Table III.11: Services Sector: Progress towards Normalisation (Seasonally adjusted and normalised to 2019-2020 = 100) Indicators 2019-20 Q1:2020-21 Q2:2020-21 Q3:2020-21 Oct-20 Nov-20 Dec-20 Jan-21 Feb-21 I Construction Steel consumption 100 50 93 110 103 113 113 110 109 Cement production 100 63 87 94 95 94 96 97 103 II Trade, Hotels, Transport, Communication and Services related to Broadcasting Commercial vehicle sales (Quarterly average)* 100 18 74 108 Domestic air passenger traffic 100 7 26 48 42 49 53 56 64 Domestic air cargo 100 27 69 88 85 88 90 89 96 International air cargo 100 46 78 84 84 83 86 86 92 Freight traffic 100 82 101 109 109 109 111 110 113 Port cargo 100 82 92 100 97 101 102 103 105 Toll collection: Volume* 100 101 202 265 252 257 285 307 327 Petroleum consumption 100 76 89 98 98 98 99 100 100 GST E-way bill* 100 49 99 118 122 110 123 120 122 GST revenue* 100 61 88 106 103 103 113 118 111 III Financial, Real Estate & Professional Services * Credit outstanding 100 104 104 106 105 106 108 108 108 Bank deposits 100 107 110 112 110 111 114 114 114 Life insurance first year premium 100 76 116 102 106 89 113 99 104 Non-life insurance premium 100 89 122 103 101 95 114 117 100 4 External Trade* Merchandise exports 100 66 95 97 96 90 104 104 106 Merchandise imports 100 52 74 92 85 84 108 106 103 Non-oil non-gold imports 100 60 82 100 97 93 110 102 92 Services exports 100 91 92 95 90 93 102 93 Services imports 100 83 85 89 81 86 98 86 * indicates data has not been seasonally adjusted. Sources: CMIE, CEIC, NSO, MOSPI, IRDAI, RBI staff estimates.  Below pre-Covid level Normalisation / recovery of activity  52Chapter III Demand and Output as travellers are increasingly shedding their Chart III.27: Nominal Sales Growth: Industrial and Services Sectors inhibitions. The services PMI exhibited expansion during H2 and at 55.3 in February, it was above its long period average on the back of new work and business activity gaining hold (Chart III.25b). In H2, public administration, defence and other services (PADO) expanded marginally from the contraction in H1, driven by government revenue expenditure on public administration. Other services in PADO – private education; health; personal services; and cultural and recreational activities – continued to be tepid. Growth in central government revenue expenditure, excluding interest payments and Note: Data for Q3:2020-21 are based on results of 1,685 listed private manufacturing companies and 678 listed private non-financial services subsidies, recovered in Q3 and strengthened further companies. Source: RBI staff estimates. in Q4. GVA in financial, real estate and professional services rebounded and expanded by 6.8 per cent in IT companies continued to record steady growth H2, reflecting the strong performance of information (Chart III.27). Growing demand for core transformation technology and financial companies. Accelerated services5 and strong revenue conversion from earlier growth in aggregate deposits and the improvement deals, coupled with low travel cost, supported IT in bank credit extended support to financial services companies during Q3. Sales of non-IT services during H2. companies remained in contraction zone in Q3, albeit The real estate sector gained steam from Q3, with some moderation. particularly in rural and semi-urban areas and Commercial vehicle sales – an indicator of affordable segments in urban areas, on the back of transportation services – posted a sequential lower mortgage rates, favourable pricing and slash in improvement in Q3:2020-21, with the pace of stamp duty across several states. In residential real contraction moderating to 1.2 per cent from 20.1 per estate, new launches registered y-o-y growth for the cent in Q2. Other indicators of transportation services first time in eight quarters during Q3:2020-21 while – toll collections; rail freight traffic; and cargo handled the inventory overhang moderated to an average of 55 by major ports – displayed expansion. Air passengers months in Q3 from 73 months in Q2 (Chart III.28a). and cargo traffic – both domestic and international – Growth in the RBI’s all-India housing price index remained in contractionary zone, despite some pick- remained unchanged in Q3 from the previous quarter up. Domestic flights are witnessing some momentum (Chart III.28b). 5 Cloud services, analytics and insights, cognitive business operations, internet of things (IoT) and quality engineering and transformation platform services led growth in the quarter. 53Monetary Policy Report April 2021 Chart III.28: Housing Sector- Launches, Sales and Prices a: Housing Activity in India b: Housing Price Index of RBI Sources: PropTiger and RBI staff estimates. III.3 Conclusion to enhance India’s manufacturing capabilities and bolster exports. Despite gaining some traction, the Economic activity in India is gathering pace on contact-intensive services sector may take some improving business sentiment. Rural demand is time to reach pre-COVID levels. The recent increase leading the expansion, and there is growing evidence in COVID infections, if not contained, could push of catch-up in urban demand. The fiscal stimulus under AatmaNirbhar 2.0 and 3.0, coupled with back the normalisation process and impede the increased allocation for capital expenditure under broader revival of economic activity. The sharp rise the Union Budget 2021-22, should accelerate public in global crude oil and commodity prices and global investment and crowd in private investment. The financial market volatility impart downside risks to production-linked incentives scheme is expected the recovery. 54IV. Financial Markets and Liquidity Conditions During H2:2020-21, domestic financial markets continued to post recovery in market activity amidst easy liquidity conditions. Nevertheless, concerns about a surge in infections in a few states, global bond sell-off, the large government borrowing, and uncertainty about the pace and scale of economic recovery kept market sentiments subdued. The pace of monetary transmission improved while bank credit growth registered an upturn. Going forward, the RBI’s market operations would ensure ample surplus liquidity in consonance with the accommodative policy stance to revive growth on a durable basis by mitigating the impact of COVID-19. Introduction The weighted average call rate (WACR) in the unsecured overnight money market eased and slipped In H2:2020-21, global financial markets remained below the reverse repo rate, beginning the second half largely buoyant, fuelled by optimism around a of October 2020 (Chart IV.1). The negative spread of speedy vaccine-led recovery. Growing inflation WACR relative to the reverse repo rate averaged 14 bps concerns over fiscal stimulus amidst extremely in H2. accommodative monetary policies rattled global bond markets in February 2021. Long-term sovereign bond In the overnight call money segment, the weighted yields jumped sharply in the US and induced bouts average rate (WAR) of traded deals generally remained of volatility across financial markets and regions of above the reverse repo rate while that of reported deals the world. The consequent yield curve steepening remained below1. The share of the reported deals in resulted in portfolio reallocation and corrections in equity prices. Despite the recent declines, stock Chart IV.1: Policy Corridor and WACR indices remain elevated on anticipation of stronger recovery. In the currency markets, the US dollar appreciated in the first quarter of 2021 driven by rising bond yields while EME currencies faced depreciation pressures from bouts of capital outflows. IV.1 Domestic Financial Markets During H2:2020-21, domestic financial markets continued to post recovery in market activity amidst easy liquidity conditions. Nevertheless, concerns about a surge in infections in a few states, global bond sell-off, the large government borrowing and uncertainty about the pace and scale of economic recovery kept market sentiments subdued. Source: Reserve Bank of India (RBI). IV.1.1 Money Market 1 ‘Traded deals’ are deals negotiated directly on the NDS-Call platform The money market remained largely stable during whereas ‘reported deals’ are over-the-counter (OTC) deals which are reported on the NDS-Call platform after the completion of negotiation of H2:2020-21, reflecting surplus liquidity conditions. deals. 55Monetary Policy Report April 2021 Chart IV.2: Share of Traded/Reported Chart IV.3: Share in Overnight Deals in Call Money Market Money Market Volumes Sources: Clearing Corporation of India Ltd. (CCIL); RBI. Sources: CCIL; RBI. the total volume of the call money segment increased (private sector) banks in both triparty and market repo to 54 per cent in H2:2020-21 from 46 per cent in H1, segments – the share of public sector banks increased thereby pulling down the WACR below the reverse from 14 per cent in October 2020 to 56 per cent in repo rate (Chart IV.2). The increased share of reported March 2021 in the triparty repo and from 10 per cent deals reflected the sharp increase in lending share of to 17 per cent in market repo segment over the same co-operative banks from 60 per cent in October to 79 period – as these segments provide access to funds per cent in November and the concomitant reduction from mutual funds. Moreover, the share of mutual in the borrowing share of public sector banks (PSBs) funds in triparty repo lending increased from 61 per from 26 per cent to 1.0 per cent during the same cent in October 2020 to 68 per cent in March 2021. period. The rates in the secured overnight segments remained The share of the collateralised money market (triparty consistently below the WACR and the reverse repo repo and market repo) in the overnight money market rate (Chart IV.4), impelled by the surplus liquidity volume increased further to 97 per cent in H2: 2020- conditions, as alluded to earlier. 21 from 95 per cent in H2: 2019-20 (Chart IV.3). Within Following the reactivation of the 14-day variable the secured segment, the share of triparty repo in the rate reverse repo auctions in mid-January 2021 with overnight money market volume increased due to the resumption of normal liquidity management ramped-up lending by mutual funds in this segment. operations, money market rates and their spreads The combined volume in the overnight and term from the WACR firmed up somewhat from end- segments of the triparty repo market expanded sharply January 2021 (Table IV.1). during H2:2020-21 – daily average volume increased from `1.67 lakh crore in October 2020 to `2.67 lakh Interest rates on longer-term money market crore in March 2021. There was a sharp increase instruments like 91-day Treasury Bills (T-Bills) (decrease) in the share of borrowing by public sector rates and the 3-month certificates of deposit (CDs) 56Chapter IV Financial Markets and Liquidity Conditions Table IV.1: Policy Transmission in the Money Market (Basis points) Change in Rates Average Spread over WACR Repo Call Triparty Market 3-month 91-day 3-month Triparty Market 3-month 91-day 3-month (WACR) repo repo CD T-bill CP repo repo CD T-bill CP H1: 2020-21 -40 -87 265 211 -156 -97 -155 -59 -59 -2 -26 80 (Apr 03 – Sep 30, 2020) H2: 2020-21 0 -13 14 15 -11 0 -67 -14 -17 5 -2 46 (Oct 01-Mar 31, 2021) Jan 11*- Mar 31, 2021 0 12 13 18 25 24 22 -7 -17 13 7 65 Note: - (+): easing (hardening). *: Period after the announcement of resumption of normal liquidity operations by the RBI. Sources: RBI; CCIL:F-TRAC; CCIL; FBIL; and RBI staff estimates. to `9.54 lakh crore during H2:2020-21 from `10.04 Chart IV.4: Money Market Rates lakh crore during the corresponding period of 2019- 20 (Chart IV.5.a). CP rates generally traded above the reverse repo rate, with an average spread of 33 bps during H2:2020-21. A temporary rise in the weighted average discount rate (WADR) was observed in the last fortnight of January and March 2021 due to increased issuances by non-banking financial companies (NBFCs) (Chart IV.5.b). IV.1.2 Government Securities (G-sec) Market During H2: 2020-21, the 10-year G-sec yield firmed up by 30 bps, although it remained at decadal low levels. During Q3:2020-21, the yield softened by 15 bps from 6.04 per cent to 5.89 per cent, aided by policy Sources: RBI; CCIL: F-TRAC; CCIL: FBIL; and RBI staff estimates. measures viz., (i) introduction of on-tap TLTROs; (ii) extended dispensation of enhanced held to rates also traded below the reverse repo rate, on an average, by 16 bps and 9 bps, respectively. Interest maturity (HTM) limit for banks; (iii) open market rates on CDs and commercial papers (CPs), however, operation (OMO) purchase auctions; (iv) simultaneous inched up above the reverse repo rate in March purchase and sale of securities (special OMOs)2 ; and 2021. Reflecting the surplus system liquidity and (iv) the monetary policy committee’s (MPCs) forward weak credit demand, banks reduced their recourse guidance on maintaining accommodative monetary to CDs. As a result, fresh issuance of CDs declined policy stance as long as necessary to revive growth to `53,468 crore during H2:2020-21 (up to March 12, on a durable basis. The extent of softening, however, 2021) from `1.69 lakh crore in the corresponding was limited over concerns about large supply of bonds period of 2019-20. CP issuances declined moderately with the announcement of additional borrowing of 2 Commonly referred as Operation Twist (OT). 57Monetary Policy Report April 2021 Chart IV.5: Primary Issuances of Commercial Paper a: Systemic Liquidity, Issuances and WADR b: Institutional Break-up Sources: RBI; CCIL - F-TRAC; and RBI staff estimates. `1.1 lakh crore by the Central Government to fund Government borrowings of `12.05 lakh crore for the shortfall in GST compensation for states. 2021-22 and additional borrowing of `80,000 crore for 2020-21. Yields subsequently eased somewhat During Q4, yields remained range bound with an upward bias till the presentation of the Union on the back of (i) the OMO purchases for an Budget 2021-22 on February 1, 2021 (Chart IV.6). enhanced amount of `20,000 crore on February 10, Yields spiked following the announcement of 2021 at lower than the market’s expected cut-offs; Chart IV.6: 10-year Yield, Repo Rate and Liquidity Conditions Sources: RBI; and Financial Benchmark of India Pvt Ltd. (FBIL). 58Chapter IV Financial Markets and Liquidity Conditions (ii) extension of the dispensation of enhanced HTM Chart IV.7: FBIL -T-Bill Benchmark limit of 22 per cent of NDTL up to March 31, 2023; and (Yield to Maturity) (iii) forward guidance by the RBI on ensuring ample liquidity to foster congenial financing conditions. Yields firmed up from the second half of February in the wake of the sharp rise in US treasury yields and higher crude oil prices. The cancellation of the last scheduled G-sec auction for 2020-21 resulted in some moderation in yields towards end-March. Yields on treasury bills across maturities traded below the policy repo rate as systemic liquidity continued to remain in large surplus (Chart IV.7). The average level of the yield curve increased by 19 bps in H2:2020-21 and the slope steepened by 5 bps3 (Chart IV.8). The slope dynamics reflect larger rise in Sources: FBIL. long term yields compared with the short term, the latter driven by the large systemic liquidity surplus in was 53 bps during H2, same as in H1:2020-21 consonance with the accommodative monetary policy (Chart IV.9). The spread widened post the Union stance. Budget announcement of February 1, 2021 but State Development Loans narrowed substantially in end-March 2021 following The weighted average spread of cut-off yields on the cancellation of the last G-sec auction. The average SDLs over G-sec yields of corresponding maturities inter-state spread on securities of 10-year maturity Chart IV.8: G-Sec Yield Curve a: Shifts b: Changes in Level and Slope Sources: FBIL; and RBI staff estimates. 3 While the level is the average of par yields of all tenors up to 30-years published by FBIL, the slope (term spread) is the difference in par yields of 3-months and 30-years maturities. 59Monetary Policy Report April 2021 11.31 years as at end-March 2021 from 10.97 years as Chart IV.9: SDLs - Amount Raised and Spread over G-sec Yield at end-September 2020. The weighted average coupon (WAC) at 7.27 per cent was lower than 7.44 per cent over the same period. IV.1.3 Corporate Bond Market During H2:2020-21, corporate bond yields remained almost unchanged. Yields on AAA-rated 3-year bonds issued by NBFCs softened by 1 basis point to 5.54 per cent, while those on corporates and public-sector undertakings (PSUs), financial institutions (FIs) and banks hardened by 5 bps and 11 bps to 5.40 per cent and 5.20 per cent, respectively, at end-March 2021 (Chart IV.10a). The risk premium or spread on AAA- rated 3-year bonds (over 3-year G-sec) moderated Source: RBI. from 63 bps to 36 bps for NBFCs, 43 bps to 22 bps for corporates and 17 bps to 2 bps for PSUs, FIs and banks (fresh issuance) was 11 bps in H2 as compared with 9 (Chart IV.10b). bps in H1:2020-21. Resource mobilisation through issuances of corporate Switching of Securities bonds in the primary market at `3.06 lakh crore during In order to facilitate debt consolidation, the Reserve H2:2020-21 (up to February 2021) was marginally Bank conducted six switch operations on behalf of lower than `3.08 lakh crore during the corresponding the central government amounting to `77,371 crore period of the previous year (Chart IV.11a). Almost during H2:2020-21. The weighted average maturity the entire resource mobilisation in the corporate (WAM) of the outstanding stock of G-secs increased to bond market (97.3 per cent) was through the private Chart IV.10: Corporate Bond Yields and Spreads on AAA-rated 3-year Bonds a: Yields b: Spreads Source: Fixed Income Money Market and Derivatives Association of India (FIMMDA). 60Chapter IV Financial Markets and Liquidity Conditions Chart IV.11: Corporate Bond Market Activity a: Primary Market Issuances b: Secondary Market Turnover - Daily Average Source: SEBI. placement route. Outstanding investments by FPIs in corporates fell from 276 bps to 22 bps. The spreads on corporate bonds declined to `1.3 lakh crore at end- BBB- (BBB minus) bonds – the lowest rated investment March 2021 from `1.5 lakh crore at end-September grade corporate bonds – also moderated significantly by 2020. Consequently, foreign portfolio invenstors 171 bps over the same period (Table IV.2). The market (FPIs’) utilisation of the approved limit for investment perception of credit risk has also improved: State in corporate bonds declined to 23.1 per cent at end- Bank of India’s and ICICI Bank’s 3-year credit default March 2021 from 33.8 per cent at end-September 2020. swap (CDS) spreads reduced by 11 bps each during The daily average secondary market trading volume in H2:2020-21. the corporate bond market declined by 26.4 per cent IV.1.4 Equity Market to `6,084 crore during H2:2020-21 (up to February 2021) over the corresponding period of the previous Domestic equities scaled all-time highs in H2:2020-21 year (Chart IV.11b). on positive global cues, record FPI inflows, revival in Between March 26, 2020 and March 31, 2021, the spread economic activity, robust corporate earnings, roll-out of AAA-rated 3-year bonds (over 3-year G-sec) issued by of COVID-19 vaccine and announcement of a growth- Table IV.2: Financial Markets - Rates and Spread Interest Rates (per cent) Spread in bps (over corresponding risk-free rate) Instrument As on As on Variation As on As on Variation March 26, 2020 March 31, 2021 (in bps) March 26, 2020 March 31, 2021 (1) (2) (3) (4 = 3-2) (5) (6) (7 = 6-5) CP (3-month) 6.74 3.65 -309 170 38 -132 Corporate Bonds (i) AAA (1-yr) 7.76 4.15 -361 246 29 -217 (ii) AAA (3-yr) 8.47 5.40 -307 276 22 -254 (iii) AAA (5-yr) 7.84 6.14 -170 141 8 -133 (iv) AA (3-yr) 9.15 6.17 -298 344 99 -245 (v) BBB-minus (3-yr) 12.29 10.05 -224 658 487 -171 10-yr G-sec 6.22 6.17 -5 - - - Sources: CCIL: F-TRAC; FIMMDA; and Bloomberg. 61Monetary Policy Report April 2021 oriented Union Budget 2021-22. The BSE Sensex and accelerated roll-out of COVID-19 vaccines. The gained 30.1 per cent in H2:2020-21 to close at 49,509 benchmark index closed above 50000 for the first on March 31, 2021 (Chart IV.12a). time on February 3, 2021 and scaled an all-time high of 52154 on February 15, 2021 riding on the budget The Indian equity market remained upbeat in October euphoria. Markets, however, declined towards the 2020 following the phased unlocking of the economy, Q2 corporate earnings and a slew of liquidity and end of the month following a spike in US treasury regulatory measures by the RBI. Domestic equities, yields, rise in crude oil prices and fresh COVID-19 however, witnessed cautious trading towards the cases in a few Indian states. The equity market end of the month due to uncertainty surrounding resumed its upward trajectory in early March 2021 the outcome of the US presidential elections. In following robust GST collections, positive GDP data November, the BSE Sensex gained by 11.4 per cent, for Q3:2020-21 and improvement in manufacturing supported by FPI inflows, positive developments and services PMI for February 2021. Market on the vaccine and the Government’s approval of ebullience, however, sobered reflecting inflation a `1.5 lakh crore production-linked incentive (PLI) worries and a surge in infections in certain states. scheme for 10 manufacturing sectors. Equity markets During H2, FPIs were net buyers to the tune of `1.98 extended their gains in December 2020 amidst better- lakh crore while MFs were net sellers amounting than-expected GDP data for Q2:2020-21, expectations to `0.99 lakh crore in the Indian equity market of swifter global economic recovery after the US (Chart IV.12b). Resource mobilisation through public stimulus package and the announcement of Brexit and rights issues of equity increased to `1.04 lakh trade deal. Subsequently, the emergence of new crore during 2020-21 (up to February 2021) from strains of coronavirus in the UK and several other `66,324 crore in the corresponding period of the countries dampened sentiments and capped market previous year. rallies. Overall, the BSE Sensex increased by 25.4 per cent during Q3:2020-21. IV.1.5. Foreign Exchange Market In January 2021, domestic markets surged on the During H2:2020-21, the Indian rupee (INR) traded back of upbeat corporate results for Q3:2020-21 mostly with an appreciating bias against the US Chart IV.12: Stock Market Indices and Investment a: BSE Sensex and Dow Jones Industrial Average b: Net Investment in Equity by Institutional Investors Sources: Bloomberg; NSDL; and SEBI. 62Chapter IV Financial Markets and Liquidity Conditions 2020, the INR appreciated to `72.29 on February Chart IV.13: Movements of Indian Rupee and US Dollar Index 24, 2021 owing to sustained strong FPI inflows but depreciated somewhat thereafter due to elevated global financial market volatility on the back of rising US yields, firming global crude prices and moderation in FPI inflows. Strong FPI flows to most EMEs, largely driven by ample global liquidity, have induced an appreciation of their currencies. The appreciation of INR was modest relative to its EME peers in H2 (Chart IV.14a). In terms of the real effective exchange rate (REER), the INR depreciated between September 2020 and February 2021 in contrast to major EMEs (Chart IV.14b). In terms of the 40-currency nominal effective exchange Sources: FBIL; and Thomson Reuters. rate (NEER), the INR depreciated by 0.2 per cent dollar on the back of growth revival and robust (at end-March 2021 over the average of September foreign investments amidst a weakening US dollar 2020), while it depreciated by 1.4 per cent in terms of (Chart IV.13). After some depreciation in November the 40-currency REER (Table IV.3). Chart IV.14: Cross-Currency Movements a: Movement of Major EME Currencies against US Dolla r b: Movement in REE R (end-March, 2021 over end-September 2020) (February 2021 over September 2020) Sources: RBI; FBIL; IMF; Bloomberg; Thomson Reuters; and Bank for International Settlements (BIS). 63Monetary Policy Report April 2021 Financial Barometer Table IV.3: Nominal and Real Effective Exchange Rate Indices (Trade-weighted) A cross-market financial barometer illustrates the (Base: 2015-16 = 100) recovery in financial markets from the height of Item Index: Appreciation (+) / the pandemic-induced disruptions.4 The barometer end-March 2021 Depreciation (-) (P) (Per cent) presents four different stages since the declaration of end-March 2021 over the pandemic. In response to the gradual unlocking September (average) 2020 40-currency REER 104.0 -1.4 of the economy and resumption of normal market 40-currency NEER 94.7 -0.2 activity, all nine indicators suggest improvement in 6-currency REER 102.3 -1.2 6-currency NEER 88.5 -0.9 financial market sentiments in March 2021 vis-à-vis `/US$ 73.5 0.0 the elevated stress levels of March and May 2020 P: Provisional. (Chart IV.15). Sources: RBI; and FBIL. Chart IV.15: Financial Market Barometer a: 24-Mar-20 b: 8-May-20 28-Oct-20 05-Mar-21 Sources: Bloomberg; CCIL: F-TRAC; FBIL; and RBI staff estimates. 4 The barometer consists of nine indicators across four markets (money, bonds, foreign exchange and equities) and compares the level of each indicator on a certain day with its pre-turmoil level (calibrated as zero on the scale) and with its level at a ‘peak’ in the turmoil (calibrated as 100). Negative column for an indicator indicate values lower than its pre-turmoil level. The pre-turmoil level for all indicators is taken as January 1, 2020, while the peak turmoil day is indicator specific and happens to concentrate around March 24, 2020 (the day of imposition of country-wide lockdown) and in some cases in May 2020 (see Chapter IV of Monetary Policy Report, October 2020). 64Chapter IV Financial Markets and Liquidity Conditions IV.1.6 Credit Market Chart IV.16: Non-food Credit Growth of SCBs Credit offtake improved in H2, with the momentum picking up beginning October and registering a positive growth (financial year basis) since November. Non-food credit by scheduled commercial banks (SCBs) rose by 6.4 per cent (y-o-y as on March 12) as compared with 6.1 per cent a year ago (Chart IV.16). Credit growth accelerated across all bank groups, especially public sector banks (PSBs) (Chart IV.17a). Of the incremental credit extended by SCBs on a y-o-y basis (March 12, 2021 over March 13, 2020), 53.8 per cent was provided by PSBs, 45.7 per cent by private sector banks and 0.5 per cent by foreign banks (Chart IV.17b). Source: RBI Among major sectors5, credit to agriculture grew by 10.2 per cent (y-o-y) in February 2021 – the highest since April 2017 (Chart IV.18a). Credit growth to the taken by the Government of India and the RBI for services sector also remained strong. Credit to the enhancing credit flows to the MSME sector. In terms industrial sector, however, contracted marginally by of the contribution of different sectors in incremental 0.2 per cent, mainly due to a decline in credit to large credit, personal loans accounted for the largest share industries (which account for more than 80 per cent (41.7 per cent), followed by the services sector (39.0 of credit to the industrial sector). On the positive per cent) (Chart IV.18b). In the overall non-food credit side, credit to medium industries registered a robust growth of February 2021, the relative contributions growth of 21.0 per cent, reflecting the measures of personal loans and credit to the services sector Chart IV.17: Credit Flow across Bank-Groups a: Growth b: Share Source: RBI 5 Data on sectoral credit relate to select banks accounting for around 90 per cent of the total non-food credit. 65Monetary Policy Report April 2021 Chart IV.18: Sectoral Deployment of Credit a: Growth (y-o-y) b: Share in Incremental Non-food Credit c: Non-food Credit Growth - Contribution of Major Sub-Sectors Source: RBI. were 2.7 percentage points and 2.5 percentage points, to February 2021) mainly due to robust credit offtake in respectively (Chart IV.18c). transport operators and trade segments (Chart IV.19a). Within industry, credit to mining and quarrying, On a financial year basis (up to February 2021), credit food processing, beverages and tobacco, textile, gems growth to the services sector accelerated at a modest and jewellery, vehicle, vehicle parts and transport pace (Chart IV.19b). Personal loans segment, which has equipment registered accelerated growth (on a y-o-y generally performed well in recent years, decelerated basis) in February 2021. Credit growth to petroleum, during H2 so far primarily due to a sharp slowdown in growth of housing loans, its largest component (Chart coal products and nuclear fuels and cement and IV.19c). Amongst other constituents of personal loans, cement products, however, decelerated, while that consumer durable loans and credit card outstanding to chemicals and chemical products, basic metal witnessed tepid growth while loans against gold and and metal products, construction, all engineering jewellery picked up significantly (Chart IV.19d). and infrastructure contracted. Unlike the sharp deceleration in credit to the industrial sector, that to The asset quality of SCBs improved during 2020-21 (up the services sector accelerated during H2:2020-21 (up to December), with the overall non-performing assets 66Chapter IV Financial Markets and Liquidity Conditions v Chart IV.19: Credit Growth in Select Sub-Sectors Services a: Outstanding (Y-o-Y) b: Financial Year (February over March) Personal Loans c: Outstanding (Y-o-Y) d: Financial Year (February over March) Source: RBI (NPA) ratio declining to 6.8 per cent in December COVID-19 pandemic (Chart IV.20a). The NPA ratios from 8.3 per cent in March 2020, reflecting mainly eased across all the major sectors over the same period the regulatory dispensations in response to the (Chart IV.20b). Chart IV.20: Stressed Assets and Non-Performing Assets of SCBs a: Overall Loan Portfolio of SCBs b: Sectoral Non-Performing Assets Source: RBI. 67Monetary Policy Report April 2021 Chart IV.21: Non-SLR Investment and Adjusted Non-Food Credit a: Non-SLR Investment b: Adjusted Non-Food Credit Source: RBI. Banks’ non-SLR investments, i.e., investments in CPs, of normalcy in financial markets; however, it remained bonds, debentures and shares of public and private elevated for private sector banks (Chart IV.23). corporates fell in H2:2020-21 (up to March 12) (Chart Spreads of WALRs on outstanding rupee loans and IV.21a). Adjusted non-food credit growth (i.e., non- fresh rupee loans over 1-year MCLR were the lowest food credit including non-SLR investments) increased in respect of housing loans, reflecting lower defaults to 6.0 per cent as on March 12, 2021 from 5.5 per cent and the availability of collateral (Chart IV.24). Other a year ago (Chart IV.21b). personal loans i.e. loans other than housing, vehicle With muted credit offtake, strong deposit growth and education loans are mostly unsecured and involve and increased government market borrowings, banks augmented their SLR investments. Excess SLR Chart IV.22: Excess SLR of Banks holdings increased to 11.4 per cent of net demand and time liabilities (NDTL) on February 26, 2021 from 8.2 per cent at end-March 2020 (Chart IV.22). IV.2 Monetary Policy Transmission Monetary transmission to deposit and lending rates of banks improved significantly during 2020-21, aided by large surplus liquidity, the implementation of the external benchmark system and subdued credit demand. The weighted average lending rate (WALR) on fresh rupee loans declined by 107 bps since March 2020 in response to the reduction of 115 bps in the policy repo rate (Table IV.4). The median spread charged by public sector banks Source: RBI. returned to pre-COVID levels with the gradual return 68Chapter IV Financial Markets and Liquidity Conditions Table IV.4: Transmission from the Repo Rate to Chart IV.23: Median Spread - WALR Banks’ Deposit and Lending Rates (Fresh loans) over 1-Year MCLR (Basis points) Period Repo Term Deposit Lending Rates Rate Rates Median WADTDR 1 - Year WALR - WALR Term Median Outstand- - Fresh Deposit MCLR ing Rupee Rupee Rate Loans Loans February - -110 -9 -7 -30 2 -40 September 2019 (Pre-external benchmark) October -140 -175 -145 -120 -100 -138 2019 - March 2021* (Post-external benchmark) March 2020 - -115 -144 -106 -95 -82 -107 Note: PSB: Public sector banks; PVT: Private sector banks. March 2021* Source: RBI. February -250 -205 -152 -150 -98 -178 2019 - higher credit risk and hence, the spread was the March 2021* highest for this category. The lower WALRs on rupee October 2020 0 -6 -28 -13 -30 -10 -March 2021* export credit reflected the interest rate subvention *: Latest data on WADTDR and WALRs pertain to February 2021. provided by the government. WADTDR: Weighted Average Domestic Term Deposit Rate. MCLR: Marginal Cost of Funds-based Lending Rate. There has been a significant improvement in WALR: Weighted Average Lending Rate. Source: RBI. transmission to all new loans sanctioned since Chart IV.24: Sector-wise WALR Relative to 1-Year Median MCLR (February 2021)# #Pertain to domestic banks. Source: RBI. 69Monetary Policy Report April 2021 October 2019 in respect of the retail and MSE sectors Table IV.5: Loans linked to External Benchmark – where the new floating rate loans were mandatorily Median Spread over Policy Repo Rate linked to one of the prescribed external benchmarks.6 (February 2021) (Percentage points) The quantum of decline in WALRs on MSME loans, Personal Loans MSME housing loans, vehicle loans and other personal Loans Housing Vehicle Education Other loans exceeded the decline in WALR on aggregate Personal fresh rupee loans to all sectors (138 bps) during the Loans same period (Chart IV.25). Notably, the introduction Public Sector Banks (12) 3.6 4.8 4.5 6.8 6.1 Private Sector Banks (20) 6.7 7.2 7.4 7.8 7.0 of external benchmark linked loans has incentivised Domestic Banks (32) 4.4 5.0 4.8 7.0 6.5 banks to adjust their term as well as saving deposit Note: Figures in parentheses are number of banks. rates in line with the benchmark rates to protect Source: RBI. their net interest margins (NIMs), thus accelerating spread charged by public sector banks for different the pace of transmission to lending rates by bringing categories of loans was lower than those of private down the overall MCLR and, in turn, lending rates on sector banks. other sectors as well.7 The responsiveness of term deposit rates to policy rate In respect of fresh rupee loans linked to the policy changes has also improved in the past year, reflecting repo rate, the median spread charged by domestic the combined impact of surplus liquidity, the external banks was the highest in the case of other personal benchmark-based pricing of loans and weak credit loans, which are mostly unsecured as indicated earlier demand. The weighted average domestic term deposit (Table IV.5). Among the bank groups, the median rate (WADTDR) on outstanding rupee deposits declined by 152 bps during the ongoing easing cycle Chart IV.25: WALR on Personal Loans and (i.e., since February 2019), of which the decline of Loans to MSMEs - Variation 106 bps has occurred since March 2020. The median (October 2019 - February 2021) term deposit rate, which reflects the prevailing card rates, has registered a sizeable decline of 144 bps since March 2020 (Chart IV.26). Apart from the reduction in term deposit rates, banks have also lowered their saving deposit rates. These deposit rates of five major banks, which ranged 3.50- 4.00 per cent at the beginning of the current easing cycle (early February 2019) and 3.25-3.50 per cent immediately prior to the introduction of the external benchmark were placed at 2.70-3.00 per cent in March 2021. This adjustment in saving deposit rates is critical for transmission, given their large share (33.0 per cent Source: RBI. as on March 12, 2021) in aggregate deposits. 6 Loans to medium enterprises were also mandatorily linked to the external benchmark, effective April 1, 2020. 7 The reduction in term deposit rates applies only to fresh term deposits, while it is across the board in the case of saving deposits. The latter brings about an instantaneous reduction in the banks’ cost of funds, and in turn, in the MCLR and the lending rates on fresh rupee loans (provided the spread over the MCLR remains relatively stable). 70Chapter IV Financial Markets and Liquidity Conditions Chart IV.26: Median Term Deposit Rate Chart IV.27: Transmission across Bank Groups and Liquidity Conditions during Easing Cycle (February 2019 - February 2021) Source: RBI. Source: RBI. Amongst bank groups, the pass-through to deposit have a sizeable bearing on monetary transmission – and lending rates was the highest for foreign banks are linked to market yields on G-secs with a lag and (Chart IV.27). The deposit base of foreign banks is are fixed on a quarterly basis at a spread of 0-100 bps primarily made up of low cost and lower duration over and above G-sec yields of comparable maturities. wholesale deposits which adjust quickly to policy rate The interest rates on the various small savings changes, prompting faster transmission to lending instruments, after being lowered sharply during rates as well.8 Q1:2020-21 in alignment with the formula-based rates, While the decline in WADTDR on outstanding rupee were left unchanged during the remaining quarters of term deposits of private sector banks (170 bps) 2020-21 and Q1: 2021-22. The interest rates on small exceeded that of public sector banks (124 bps) in the savings for various instruments are 69-198 bps higher current easing cycle, the reduction in lending rates than the formula-based rates (Table IV.6). was higher for the latter group. Historically, WADTDR of private sector banks has been higher than those IV.3 Liquidity Conditions and the Operating offered by public sector banks. As credit demand Procedure of Monetary Policy slowed post COVID-19, private sector banks reduced The RBI Act 1934 requires the RBI to place the their term deposit rates sharply, and their WADTDR operating procedure relating to the implementation fell below the level of public sector banks (Chart IV.28). of monetary policy and changes thereto from time Administered interest rates on small savings to time, if any, in the public domain. In consonance instruments – which compete with bank deposits and with the accommodative stance of monetary policy, 8 More than 80 per cent of fresh deposits of 8 major foreign banks raised in February 2021 – accounting for 85 per cent of outstanding deposits of foreign banks - were wholesale deposits and almost 95 per cent of these deposits were of duration up to 180 days. The median term deposit rate (maturity up to 1 year) of foreign banks declined from 4.89 per cent in March 2020 to 2.79 per cent in February 2021. 71Monetary Policy Report April 2021 Chart IV.28: Weighted Average Domestic Term Deposit Rates (WADTDR) and Deposit Growth a: WADTDR on Outstanding Rupee Term Deposits b: Growth in Outstanding Term Deposits PSB: Public sector banks; PVT: Private sector banks. Source: RBI. liquidity measures during H2:2020-21 aimed at reiterating the availability of ample liquidity in reinforcing easy financial conditions to support the system. Overall, the total liquidity support the nascent economic recovery. Normal liquidity announced by the Reserve Bank since February 6, management operations – suspended in April 2020 2020 (up to March 31, 2021) amounted to `13.6 lakh in the face of COVID-related dislocations – were crore [6.7 (6.9) per cent of 2019-20 (2020-21) nominal resumed in January 2021 with the Reserve Bank GDP] (Table IV.7). Table IV.6: Interest Rates on Small Savings Instruments – Q1:2021-22 Small Savings Scheme Maturity Spread Average G-sec Formula based Government Difference (years) (Percentage Yield (%) of Rate of Interest Announced Rate (basis points) point) $ Corresponding (%) (applicable of Interest (%) in Maturity for Q1:2021-22) Q1:2021-22 (December 2020 -February 2021) (1) (2) (3) (4) (5) = (3) + (4) (6) (7) = (6) - (5) Savings Deposit - - - - 4.00 - Public Provident Fund 15 0.25 6.16 6.41 7.10 69 Term Deposits 1 Year 1 0 3.52 3.52 5.50 198 2 Year 2 0 4.02 4.02 5.50 148 3 Year 3 0 4.51 4.51 5.50 99 5 Year 5 0.25 5.51 5.76 6.70 94 Recurring Deposit Account 5 0 4.51 4.51 5.80 129 Monthly Income Scheme 5 0.25 5.49 5.74 6.60 86 Kisan Vikas Patra 124 Months# 0 6.16 6.16 6.90 74 NSC VIII issue 5 0.25 5.63 5.88 6.80 92 Senior Citizens Saving Scheme 5 1.00 5.51 6.51 7.40 89 Sukanya Samriddhi Account Scheme 21 0.75 6.16 6.91 7.60 69 $: Spreads for fixing small saving rates as per Government of India Press Release of February 2016. #: Current maturity is 124 months. Note: Compounding frequency varies across instruments. Sources: Government of India; and RBI staff estimates. 72Chapter IV Financial Markets and Liquidity Conditions (`0.89 lakh crore), including three OMOs in state Table IV.7: Liquidity Measures since February 6, 2020 (As on March 31, 2021) development loans (SDLs)9. Government spending (` crore) and the drawdown of excess cash reserve ratio (CRR) Measures Announced balances by banks also augmented system liquidity Amount (Chart IV.29a). Consequently, the surplus liquidity – LTRO 2,00,000 Variable rate repo 2,25,000 as reflected in average daily net absorptions under SLF for PDs 7,200 the liquidity adjustment facility (LAF) – soared to CRR cut 1,37,000 MSF (dip by 1% in SLR) 1,37,000 `5.33 lakh crore during the quarter. Banks returned TLTRO 1,00,000 TLTRO funds amounting to `0.37 lakh crore – 33.1 per TLTRO (2.0) 50,000 Net OMO purchases 1,50,000 cent of the total amount of `1.13 lakh crore availed Special liquidity facility for mutual funds 50,000 under the scheme. In Q4, surplus liquidity increased Refinance to NABARD, SIDBI, NHB and EXIM Bank 75,000 further to `5.9 lakh crore due to injection from forex Special liquidity scheme for NBFCs 30,000 56-day term repo 1,00,000 operations and net OMO purchases, despite leakage On Tap TLTRO 1,00,000 through CiC and reduced government spending. Total Total 13,61,200 OMO purchases during 2020-21 amounted to `3.13 As proportion of 2019-20 GDP (%) 6.7 lakh crore. Reserve money (RM) increased by 14.2 per As proportion of 2020-21 GDP (%) 6.9 Source: RBI. cent (y-o-y) during 2020-21 (up to March 26) driven by currency demand while money supply (M3) increased Drivers and Management of Liquidity by 12.6 per cent (y-o-y) (up to March 12). During Q3, the festival related expansion in currency in circulation (CiC) was the major source The surplus liquidity was mopped up through the of leakage of liquidity (`0.95 lakh crore), which was overnight fixed rate reverse repo under the LAF and more than offset by the infusion through net forex the reactivated 14-day variable rate reverse repos operations (`2.0 lakh crore) and OMO purchases (VRRR) (Chart IV.29b). Chart IV.29: Systemic Liquidity – Drivers and Management a: Drivers b: Management Source: RBI. 9 The Reserve Bank also conducted six auctions of simultaneous purchase and sale of securities under open market operations (special OMOs) during this period. 73Monetary Policy Report April 2021 Five 14-day VRRR auctions of `2 lakh crore each were Chart IV.30: Reverse Repo and Forex Purchases conducted in Q4, which were well received as reflected in the bid-cover ratio (bidding offers as a proportion of Resumption of variable the notified amount) of 1.3 or more in each auction. rate reverse repo The liquidity absorbed through the fixed rate reverse repo has steadily increased from a fortnightly average of `4.3 lakh crore during January 16-29, 2021 to `4.9 lakh crore during January 30 - March 31 (Chart IV.30). OMOs – both purchases and sales – are a key instrument to adjust the durable liquidity in the banking system in sync with the monetary policy stance. During 2020- 21, `1.00 lakh crore was infused through outright purchases from eight auction announcements (including three of state development loans). These announcements contributed to softening of yields Note: Net forex purchases are cumulative from October 2020. Source: RBI. (Box IV.1). Box IV.1: Announcement Effect of Open Market Operations on Financial Markets OMO auctions conducted by the central bank not only average, of (i) 2 bps on G-sec and corporate bonds; and impact government bond yields but also have a significant (ii) 1 bps on OIS, validating the presence of announcement effect on other financial instruments, given that these are effects (Table IV.1.1)12. priced off risk-free government bonds. The instantaneous The instantaneous announcement impact is announcement effect of OMOs is examined for the corroborated by regression analysis of the events (OMO benchmark 10-year government securities, AAA 5-year announcements) with appropriate controls viz., for intra- corporate bonds (CBs) and 5-year overnight index swaps day global factors through the global economic policy (OIS)10 using daily data on secondary market yields/ uncertainty index [GEPUI]13, the inter-day difference in rates spanning 10 years (January 2012 – January 2021) yields/rates on the announcement day as an indicator of in an event study (ES) framework (Hartley and Rebucci, 2020). During the sample period, there were 98 OMO Table IV.1.1: Closing and Opening Yields/Rates – announcements – 83 purchases and 15 sales. These Paired t-test announcements were made after the closure of market Variable Window Mean t-stat. p-value trading hours; therefore, the difference in yields between 10-Yr G-Sec Open (+1) - Close (0) -0.02** -2.39 0.01 the opening rate of the next trading day and the closing 5-Yr CBs Close (+1) - Close (0) -0.02** -2.02 0.02 rate of the OMO announcement day, controlled for other 5-Yr OIS Open (+1) - Close (0) -0.01** -2.35 0.01 factors, captures the announcement effect. Note: Close (0): Announcement day closing; Open (+1): Next day opening; Results from paired t-tests11 suggest negative and Close (+1): Next day closing. statistically significant softening in yields/rates, on an ** represents significance at 5 per cent. (contd.) 10 In OIS transactions, one of the counterparties swaps an overnight interest rate while the other swaps a fixed short-term rate. The spread between these two rates is an important indicator of financial market conditions – widening spreads signifying tight liquidity conditions. 11 The paired sample t-test determines whether the mean difference between two sets of observations in a large sample is zero. 12 Similar tests for OMO sales announcements suggest that there is no statistically significant difference in yields; hence the empirical exercise is confined to OMO purchases. 13 Baker, S. R. Bloom, N. and S. J. Davis (2016): Measuring Economic Policy Uncertainty, The Quarterly Journal of Economics, Vol 131:4, pp. 1593-1636. 74Chapter IV Financial Markets and Liquidity Conditions Table IV.1.2: Announcement Effect of OMOs Reg-1 Reg-2 Reg-3 G-sec CBs OIS G-sec CBs OIS G-sec CBs OIS Dependent Variable Independent Variables ΔY ΔY ΔY ΔY ΔY ΔY ΔY ΔY ΔY (open(+1)-close(0)) (close(+1)-close(0)) (open(+1)-close(0)) (open(+1)-close(0)) (close(+1)-close(0)) (open(+1)-close(0)) (open(+1)-close(0)) (close(+1)-close(0)) (open(+1)-close(0)) Constant (C) -0.03*** -0.03*** -0.02*** - - - - - - ΔY (close (0)-open (0)) 0.72*** - 0.06 0.73*** - 0.09 0.74*** - 0.09 ΔY (close (0)-close(-1)) - 0.25 - - 0.25 - - 0.24 - ΔLiquidity (close (+1)-close (0)) - -0.06 - - -0.05 - - -0.05 - GEPUI 0.0002*** 0.0001** 0.0001** 0.0001** 0.0001* 0.00005** 0.0002*** 0.0001 0.0000** Amount - - - -0.18*** -0.14* -0.10** -0.33*** -0.25** -0.11** Amount x Liquidity - - - - - - -0.07* -0.06** -0.001 Diagnostic (p - value) B-G LM Test 0.456 0.064 0.209 0.458 0.139 0.112 0.578 0.098 0.117 Arch-LM Test 0.856 0.099 0.839 0.933 0.135 0.946 0.953 0.151 0.947 Note: close (0): Announcement day closing; open (+1): Next day opening; close (+1): Next day closing; close(-1): Previous day closing; ***, ** and * represent significance at 1 per cent, 5 per cent and 10 per cent, respectively. Source: RBI staff estimates. the hysteresis phenomenon14 and changes in liquidity only in the G-sec segment, increased global uncertainty to account for intra-day liquidity effects on corporate marginally hardens yields/rates across markets bonds in the baseline regression (Reg-1). Apart from (statistically significant). Every `10,000 crore of OMO these variables, the size of the OMO auction is included auction announcement (equivalent to 0.1 per cent of in the second regression (Reg-2). Finally, for identifying NDTL, on an average) eases yields/rates by 1-2 bps (Reg-2). the impact of the prevailing liquidity conditions on the The interaction term in Reg-3 is found to be statistically announcement effect, an interaction term between significant in the G-sec and corporate bond segment, the size of the OMO purchase announcement and the suggesting that the prevailing liquidity situation also liquidity conditions on the announcement day is also matters – thus, the announcement effect is expected included in the third regression (Reg-3).15 The impact to be larger in deficit liquidity conditions. Overall, the of the OMO announcement is captured by the constant analysis indicates that the OMO announcements during term (C) in Reg-1 and by the coefficients on OMO auction 2020-21 have cumulatively eased G-sec and corporate amounts (as percentage of NDTL) in Reg-2 and Reg-3. All bond yields by about 20-25 bps each and the OIS rates the control variables are demeaned (by taking deviation by around 10 bps. Special OMOs (OTs), LTRO and TLTRO from the mean). auctions also had a significant impact on G-sec yields, thereby moderating the term spread (Talwar et. al, 2021). ΔY= C + α (ΔY ) + α Δ Liquidity + α GEPUI+ 0 -1 1 2 α Amount + α (Amt * Liquidity) +ε ...(1) References: 3 4 Reg-1: α and α = 0 Hartley, J. S. and A. Rebucci (2020), “An Event Study of 3, 4 Reg-2: C and α = 0 COVID-19 Central Bank Quantitative Easing in Advanced 4 Reg-3: C = 0 and Emerging Economies”, NBER Working Paper No. 27339, June. The estimates of Reg-1 indicate that, on an average, the OMO announcements soften G-sec, corporate bond Talwar, B. A., Kushawaha, K.M., and I. Bhattacharyya yields and OIS rates by 2-3 basis points (bps) each (Table (2021), “Unconventional Monetary Policy in Times of IV.I.2). While the hysteresis phenomenon is significant COVID-19”, RBI Bulletin, March, pp 41-56. 14 For corporate bonds, the daily difference in yields is used to capture the hysteresis effect. 15 Both the announced amount and the liquidity position (net LAF) are normalised by NDTL. 75Monetary Policy Report April 2021 Policy Measures asymmetric OT having a liquidity impact (purchase `20,000 crore; sales `15,000 crore) was conducted on To nurture the revival of activity in sectors that March 10, 2021 which elicited favourable response on have multiplier effects on growth, the Reserve the purchase leg with bid-cover ratio of 4. Bank announced “On-tap targeted long-term repo operations (TLTRO)” with tenors of up to three years As staff and IT resources were severely affected in for a total amount of up to `1 lakh crore at a floating financial markets with the onset of the COVID-19 rate linked to the policy repo rate in October 2020. pandemic, the RBI shortened trading hours for The liquidity availed by banks under the scheme is various markets regulated by it effective April 7, to be deployed in corporate bonds, commercial paper 2020. Subsequently, with the phased roll-back of the and non-convertible debentures issued by the entities lockdown and easing of restrictions on movement in five sectors16 over and above their investments of people and resumption of normal functioning of in these instruments as on September 30, 2020. offices, the RBI decided to restore trading hours in a Moreover, to enable banks to exploit the synergies phased manner beginning November 9, 2020. between central bank liquidity under on-tap TLTRO To meet any additional / unforeseen demand for scheme and the Emergency Credit Line Guarantee liquidity and to provide flexibility to the banking Scheme 2.0 (ECLGS 2.0) of the Central Government, system in year-end liquidity management, the the Reserve Bank expanded the scope of the on-tap Reserve Bank decided to conduct two fine-tuning TLTRO in December to all stressed sectors identified variable rate repo auctions of ` 0.25 lakh crore each by the Kamath Committee in addition to the five on March 26 and March 31, 2021 of 11 days and 5 days sectors announced earlier in October 2020. tenor, respectively. Furthermore, it was decided not to conduct the 14-day VRRR auction on March 26 to In February 2021, the RBI (i) allowed lending by ensure the availability of ample liquidity for managing banks to NBFCs under the TLTRO on-tap scheme for year-end requirements. incremental lending to specified stressed sectors; (ii) announced a gradual restoration of the cash reserve IV.4 Conclusion ratio (CRR) in two phases in a non-disruptive manner During H2, domestic financial markets and conditions to 3.5 per cent of NDTL effective March 27, 2021 and remained congenial, supported by ample surplus 4.0 per cent effective May 22, 2021; (iii) extended liquidity. Market activity continued to revive, building the facility for availing funds under the marginal on the recovery witnessed in the later part of H1 and standing facility (MSF) by dipping into the SLR up to steered by the forward guidance provided on liquidity 3.0 per cent of NDTL until September 30, 2021; and and the orderly evolution of the yield curve. The pace (iv) provided CRR exemption for credit flows to new of monetary transmission improved further and bank MSME borrowers on exposures up to `25 lakh per credit growth registered an upturn. Going forward, the borrower for credit extended up to October 1, 2021. RBI’s market operations would ensure ample surplus During H2:2020-21, thirteen auctions of OTs have been liquidity in consonance with the accommodative conducted. In March, the scale of OTs was increased policy stance to revive growth on a durable basis and to `15,000 crore (on March 4) and subsequently an mitigate the impact of COVID-19 on the economy. 16 Agriculture, agri-infrastructure, secured retail, micro, small and medium enterprises (MSMEs), and drugs, pharmaceuticals and healthcare. 76V. External Environment In Q1:2021 (January-March), the global economy gradually regained momentum. Rapid mutations of the virus, concerns over the effectiveness of available vaccines and limited access to vaccines in many countries keep the near- term outlook clouded and the recovery remains fragile, incomplete, uneven and divergent. Inflation risks are widely perceived to be rising in an environment of exceptional monetary and fiscal accommodation, leading to turbulence in global financial markets and capital outflows from emerging markets in the second half of Q1:2021. In Q1:2021 (January-March), the global economy exceptional monetary and fiscal accommodation, gradually regained momentum of recovery gathered leading to turbulence in global financial markets and in Q3:2020, which had encountered headwinds in capital outflows from emerging markets in the second Q4 as many advanced economies (AEs) and some half of Q1:2021. emerging market economies (EMEs) had to reimpose V.1 Global Economic Conditions restrictions/lockdowns in the wake of second/third Economic activity across major AEs and EMEs posted wave of infections coupled with the newer and a strong recovery in Q3:2020, following a record more virulent strains of the virus. Mass vaccination plunge in Q2 amidst widespread lockdowns. As stated drives are underway in several countries, but rapid earlier, activity stalled again in Q4 as countries battled mutations of the virus, concerns over the effectiveness new waves of infections and speedily communicable of available vaccines and limited access to vaccines in mutations of the virus. With inoculations underway, many countries keep the near-term outlook clouded high frequency indicators, however, point to some pick- and the recovery remains fragile, incomplete, uneven and divergent. up in Q1:2021. Nonetheless, activity remains below the pre-pandemic levels even as GDP contractions Prolonged monetary accommodation, easy financial ease across major economies. conditions and rounds of fiscal stimulus buoyed stock markets around the world, with strong rallies pushing The US economy contracted by 3.5 per cent in 2020, equity valuations to record levels in February 2021 to marking an abrupt halt to its expansion for more than a point of disconnect with the real economy. In the a decade (Table V.1). Notwithstanding steady decline bond market, short term yields remain anchored on in the unemployment rate from a record level of low policy rates, but longer-term yields have surged April 2020, labour market conditions remain weak since the second half of February 2021 across the world and fragile with employment well below the Federal on rising inflation expectations and apprehensions Reserve's (Fed's) goal of full employment. Incoming about possible reversal of monetary policy stances. In data for Q1:2021 suggest some stabilisation – retail turn, equity and currency markets have experienced sales picked up sharply in January before moderating bouts of volatility. Commodity prices continue to in February on severe winter weather, and the Institute spiral up under a combination of supply disruptions for Supply Management (ISM)’s manufacturing and revival of demand, translating into intensifying purchasing managers' index (PMI) in March posted input price pressures on account of severely stretched its strongest expansion since December 1983. US$1.9 supply chains. Consequently, inflation risks are trillion fiscal stimulus by the new administration has widely perceived to be rising in an environment of boosted prospects for the US economy. 7777Monetary Policy Report April 2021 consecutive month of decline in the composite PMI Table V.1: Real GDP Growth in February owing to subdued service sector activity. (Per cent) Country Q1- Q2- Q3- Q4- 2020 2021 2022 The Japanese economy expanded by 11.7 per cent 2020 2020 2020 2020 (E) (P) (P) (q-o-q, SAAR) in Q4, extending the third quarter’s Quarter-over-quarter, seasonally adjusted annualised rate (Q-o-q, SAAR) recovery from the worst recession witnessed in Canada -7.5 -38.5 40.6 9.6 - - - the first half of 2020. Resilient trade conditions Euro area -14.2 -38.8 59.9 -2.6 - - - as reflected in a strong pick-up in exports and Japan -2.2 -29.3 22.8 11.7 - - - high capital spending underpinned by significant South Korea -5.0 -12.0 8.8 5.0 - - - government support led to the GDP expansion. With UK -10.9 -57.9 87.1 5.2 - - - US -5.0 -31.4 33.4 4.3 - - - the third wave of COVID-19 infections and the re- imposition of the state of emergency in the Tokyo Year-on-year (Y-o-y) area, however, the momentum for recovery slowed Advanced Economies down in Q1, accompanied by large contractions in Canada -0.3 -12.7 -5.3 -3.2 -5.4 3.6 4.1 retail sales and industrial production in January Euro area -3.3 -14.6 -4.2 -4.9 -6.6 4.2 3.6 Japan -2.0 -10.3 -5.8 -1.4 -4.8 3.1 2.4 and February. The manufacturing PMI, on the other South Korea 1.4 -2.7 -1.1 -1.2 -1.0 3.1 2.9 hand, expanded in February 2021 for the first time UK -2.2 -21.4 -8.5 -7.3 -9.8 4.5 5.0 since April 2019, with March witnessing further US 0.3 -9.0 -2.8 -2.4 -3.5 5.1 2.5 expansion. Emerging Market Economies In the UK, GDP expanded in Q4, but it moderated Brazil -0.3 -10.9 -3.9 -1.1 -4.1 3.6 2.6 from the record pace registered in Q3, leading to an China -6.8 3.2 4.9 6.5 2.3 8.1 5.6 India 3.0 -24.4 -7.3 0.4 -8.0 11.5 6.8 overall contraction of 9.8 per cent in 2020. In early Indonesia 3.0 -5.3 -3.5 -2.2 -2.1 4.8 6.0 Q1:2021, infections reached new peaks, with newer Philippines -0.7 -16.9 -11.4 -8.3 -9.5 6.6 6.5 and more contagious variants pushing the economy Russia 1.4 -7.8 -3.5 -1.8 -3.0 3.0 3.9 into its third nationwide lockdown in January. South Africa 0.4 -17.8 -6.2 -4.1 -7.0 2.8 1.4 Thailand -2.1 -12.1 -6.4 -4.2 -6.1 2.7 4.6 Furthermore, the new trading arrangement with the European Union (EU) post-Brexit is likely to weigh on Memo: 2020 (E) 2021 (P) 2022 (P) activity in early 2021. World -3.5 5.5 4.2 Output The economic recovery continued in China for the World Trade -9.6 8.1 6.3 Volume third consecutive quarter in Q4, resulting in an overall annual increase of 2.3 per cent in 2020 and E: Estimate. P: Projection. -: Not applicable. Note: India's data correspond to fiscal year (April-March). making it the only major economy to register growth Sources: Bloomberg; Official statistical agency of each country and IMF WEO Update, January 2021. in a pandemic-ravaged year (Table V.2). China’s growth has been powered by strong and robust recovery in Euro area GDP declined by 6.6 per cent in 2020, with manufacturing and exports underpinned by policy Q4 reading reversing the strong rebound witnessed support measures. By contrast, the recovery in in Q3 as emergence of the second wave of the virus consumption activity remains relatively weak. The along with more virulent strains led to a re-clamping Chinese economy seems to have lost some steam of lockdowns across major constituent economies. in Q1 from COVID-19 flare-ups in January and This weakness continued into Q1:2021 with most the associated containment measures. The Caixin economies extending lockdown restrictions even as composite PMI – though in expansion – eased they continued with the slow pace of vaccination. to a ten-month low in February. Even the Caixin Consumer and business sentiments remain weak, manufacturing PMI for March turned out to be the with declining retail sales in January and the fourth lowest in the current 11-month period of expansion. 7788Chapter V External Environment Table V.2: Select Macroeconomic Indicators for BRICS Country 2020 (E) 2021 (P) Country 2020 (P) 2021 (P) Real GDP growth rate Brazil -4.1 3.6 General Govt. gross debt Brazil# 95.6 92.1 (per cent) Russia -3.0 3.0 (as per cent of GDP) Russia 21.0 20.7 India -8.0 11.5 India 85.5 83.1 China 2.3 8.1 China 65.2 69.4 South Africa -7.0 2.8 South Africa 77.7 84.9 Country 2020 2021(P) Country 2020 (P) 2021 (P) CPI inflation rate (per cent) Brazil 3.2 2.9 Current account balance Brazil 0.3 0.02 Russia 3.4 3.2 (as per cent of GDP) Russia 1.2 1.8 India 6.1@ 3.7 India 0.3 -0.9 China 2.5 2.7 China 1.3 0.7 South Africa 3.3 3.9 South Africa -1.6 -1.8 Country 2020 (P) 2021(P) Country 2020 2021(P) General Govt. net lending/ Brazil -16.8 -6.5 Forex reserves* Brazil 355.6 356.1 borrowing (as per cent of Russia -5.3 -2.6 (in US$ billion) Russia 596.1 586.3 GDP) India -13.1 -10.9 India 588.4 586.7 China -11.9 -11.8 China 3536.0 3528.8 South Africa -14.0 -11.1 South Africa 54.2 53.3 P: Projection. E: Estimate. *: Forex reserves for 2021 pertain to February 2021. #: Gross debt refers to the nonfinancial public sector, excluding Eletrobras and Petrobras, and includes sovereign debt held by the central bank. @: Average of the period from June 2020 to February 2021. Notes: India's data correspond to fiscal year (April-March). Sources: Bloomberg; Official statistical agency of each country; WEO October 2020 database and January 2021 Update; IMF Fiscal Monitor Update, January 2021; and IRFCL, IMF. The Brazilian economy contracted in Q4 on y-o-y basis a slow vaccine rollout and renewed load shedding. following declines in household and government These factors extended into Q1:2021. Across major consumption expenditure, while weak services and South-East Asian economies, GDP declined in external sector activity added further downward Q4:2020, with contraction varying in the range of pressures. The near-term growth outlook remains (-) 2.2 per cent to (-) 8.3 per cent (y-o-y) as the virus clouded with emergency transfer programs expected impeded economic activity. to unwind, while the more contagious COVID-19 P1 The global composite PMI moderated during variant continues to spread rapidly weighing heavily on economic activity with the composite PMI reflecting November-January within the expansion zone as contraction since January 2021. the resurgence of infections across major economies pulled down services activity, especially in the The Russian economy contracted in 2020, with a contact-intensive industries. There was some uptick modest recovery in H2 (July-December) preventing in February readings for both manufacturing and a deeper plunge. The South African economy services activity on the back of the strong performance rebounded sharply in Q3:2020 following a historic plunge in Q2, driven primarily by manufacturing, in the US (Chart V.1a). Composite leading indicators mining and trade activity. In Q4, the recovery slowed (CLIs) suggest growth is stabilising across major AEs down, with new waves of the deadly virus amidst and EMEs (Chart V.1b). 7799Monetary Policy Report April 2021 Chart V.1: Survey Indicators a: Composite PMI b: OECD CLIs Sources: Bloomberg; and OECD. Global trade recovered faster than expected from products have started showing signs of deceleration. the deep contraction witnessed in Q2:2020 on the The Baltic Dry Index, which measures shipping back of the robust trade performance of EMEs (Chart costs for a wide variety of bulk commodities such V.2a). The WTO’s Goods Trade Barometer rebounded as coal, iron ore, and grain, rose sharply in January in Q4:2020; however, this momentum is unlikely and February 2021 due to firming container shipping to be sustained in H1:2021 (January-June) as its key freight rates and an unfavourable base effect constituents such as export orders and automotive (Chart V.2b). Chart V.2: World Trade Volume a: World Trade Volume: Relative Contribution b: Movement in World Trade Volume and Baltic Index Sources: CPB Netherlands; and CEIC. 8800Chapter V External Environment V.2 Commodity Prices and Inflation cut production by an additional 1.0 million barrels per day during February-April added to bullish Global commodity prices have been rising since May, sentiments. Following an attack on Saudi Arabia’s oil after recovering from a plunge in the early part of 2020. facilities, Brent prices increased further, moving closer The Bloomberg commodity price index increased by to US$70 per barrel in mid-March. However, prices 17.8 per cent between September 2020 and March corrected thereafter, on near-term demand concerns 2021. The food price index of the Food and Agriculture amidst rising infections and build up in the US crude Organization (FAO) increased by 18.4 per cent between inventories. Despite the correction, Brent crude prices September 2020 and February 2021 – the index was increased by 21.9 per cent in Q1:2021 (Chart 3b). at its highest level in February 2021 since July 2014, with pressures being particularly high for vegetable oil Base metal prices, measured by the Bloomberg’s base prices due to tightening availability of supplies among metal spot index, increased by 28.4 per cent between major exporters. For meat, low demand for poultry September 2020 and March 2021, surpassing meat amidst avian influenza outbreaks has kept price pre-COVID levels on strong rallies witnessed in pressures somewhat muted (Chart V.3a). H2:2020. The upturn has been primarily driven Crude oil prices lost some steam in September- by strong restocking by China and positive October on waning demand prospects but have sentiments propelled by stimulus measures picked up since November on vaccine optimism and across major economies. The robust recovery in extension of production cuts by OPEC plus. The US manufacturing and industrial activity along with stimulus and Brexit agreement further boosted the persistent supply chain disruptions, shipping market sentiments. In February, prices surged to their difficulties and labour and container shortages have highest level since the pandemic amidst tightening boosted prices of industrial metals. In contrast, global supplies and falling crude inventories in the gold prices after wrapping up the year 2020 with a US and Europe. Saudi Arabia’s decision to voluntarily phenomenal gain of 25.1 per cent, lost sheen with Chart V.3: Commodity Prices a: FAO Food Price Indices b: Energy and Crude Oil Prices Sources: FAO; and World Bank. 8811Monetary Policy Report April 2021 Chart V.4: Metal Price Indices Source: Bloomberg. prices correcting by 10.0 per cent in Q1:2021. Rising Table V.3: Inflation Performance US bond yields, the strengthening US dollar and (Per cent) strong risk-on sentiments reduced the safe haven Country Inflation Q1:2020 Q2:2020 Q3:2020 Q4:2020 Q1:2021 Target appeal of the yellow metal (Chart V.4). Advanced Economies Canada 1.0-3.0 1.8 0.0 0.2 0.8 1.1 CPI inflation remains benign and below target in Euro area 2.0 1.1 0.2 0.0 -0.3 1.0 major AEs, while for major EMEs, barring China, Japan 2.0 0.5 0.1 0.2 -0.8 -0.5 UK 2.0 1.7 0.6 0.6 0.5 0.6 Thailand and Indonesia, CPI inflation has mostly US 2.0 1.7 0.6 1.2 1.2 1.5 picked up, even moving above targets in a few of them Emerging Market Economies (Table V.3). Brazil 3.75 ± 1.5 3.8 2.1 2.6 4.2 4.9 Russia 4.0 2.4 3.1 3.6 4.4 5.5 In the US, inflation based on the personal consumer India 4.0 ± 2.0 6.7 6.2* 6.9 6.4 4.5 China - 5.0 2.7 2.3 0.1 -0.3 expenditures (PCE) price index has risen since South Africa 3.0-6.0 4.4 2.4 3.1 3.2 3.1 December. However, average inflation remains well Indonesia 3.0 ± 1.0 2.9 2.3 1.4 1.6 1.5 Philippines 3.0 ± 1.0 2.7 2.3 2.5 3.1 4.5 below the Fed’s 2 per cent target as relatively soft Thailand 1.0-3.0 0.4 -2.7 -0.7 -0.4 -0.5 Turkey 5.0 12.1 11.7 11.8 13.5 15.6 aggregate demand and earlier declines in consumer *: Data refer to June 2020 only. energy prices contained price pressures. Inflation Notes: (1) Inflation for the US is in terms of personal consumption expectations have, however, shown some uptick in expenditure. (2) Quarterly inflation is the simple average of inflation in each the latest readings of survey-based measures. After month of the quarter. Q1:2021 is the average of the months for which data are available. being in deflation for the last five months of 2020, (3) The ECB aims at inflation rates of below, but close to 2%. The Euro area CPI inflation has moved back to the positive Fed adopted ‘flexible average inflation targeting’ in August 2020 wherein it would allow the inflation rate to go above the target zone since January 2021 on rising cost of services of 2 per cent rate for brief periods to make up for the shortfall from the target in earlier periods. Bank of Canada aims to keep and non-energy industrial goods with energy prices inflation at the 2 per cent mid-point of an inflation control rebounding in March. Nonetheless, inflation remains target range of 1-3 per cent. (4) Brazil’s inflation target for 2020 was 4.0 ± 1.5 per cent. low and below the ECB’s target owing to substantial Sources: Central bank websites; and Bloomberg. 8822Chapter V External Environment slack in product and labour markets. In Japan, CPI and utilities, and miscellaneous goods and services. In remained in deflation for the fifth consecutive month February, however, it eased marginally, moving below in February as COVID-19 weighed on demand; lower the central bank’s target range on softening health crude oil prices in the initial period and discounts and food prices. China, on the other hand, registered on travel within Japan through the ‘Go To Travel’ deflation since November, barring December. There campaign by the national government added to the has been a significant easing in consumer prices due to downside. In the UK, CPI inflation remains relatively lower pork prices on improved supply and favourable subdued over both direct and indirect COVID-induced base effects. Renewed lockdown restrictions due factors, particularly the reduction in value added tax to fresh outbreaks resulting in decreased travel and for certain services and lower energy prices. Despite consumer spending before the Chinese new year in some pick-up in December-January, it remains way February also kept the price pressures low (Chart V.5b). below the Bank of England’s (BoE's) target (Chart V.5a). V.3 Monetary Policy Stance In Russia, the inflation rate has overshot the target In order to mitigate the impact of the COVID-19 since November 2020, primarily attributed to the pandemic on their domestic economies, governments weakening ruble and firming global commodity prices, and central banks have provided unprecedented especially food prices, besides the lingering supply side and large fiscal and monetary stimuli since March disruptions inflicted by the pandemic. In Brazil too, CPI inflation has edged up, though it remains within 2020. The IMF estimates that the total fiscal support the central bank’s target range. The increase in global pledged in 2020 through additional spending, revenue commodity prices, the depreciating Brazilian real and foregone and liquidity support was about US$14 rapid recovery in domestic demand supported by trillion or 13.5 per cent of world GDP (Table V.4). emergency aid programs, led to the upward pressures Monetary policy turned even more accommodative in prices. CPI inflation in South Africa saw some with expansion of asset purchase programmes and uptick in January on higher prices for food, housing launch/extension of special liquidity programmes by Chart V.5: CPI Inflation (y-o-y) – Select Economies a: Advanced Economies b: Emerging Market Economies Source: Bloomberg. 8833Monetary Policy Report April 2021 limit for overnight reverse repo to US$80 billion from Table V.4: Fiscal Support in 2020 in Response to COVID-19 US$30 billion. (Amount in US$ billion; Per cent as proportion of GDP) The European Central Bank (ECB) in its December Country Amount Per cent 2020 meeting increased purchases under the Advanced Economies - 24.0 Pandemic Emergency Purchase Program (PEPP) by Canada 306 18.7 500 billion (approximately US$607 billion)1 to European Union 1,358 10.6 Japan 2,210 44.0 1.85 trillion (approximately US$2.25 trillion) and UK 877 32.4 extended the horizon for purchases by nine months to US 4,013 19.2 end-March 2022. Furthermore, it also extended the Emerging Market Economies - 6.1 Brazil 206 14.5 period for the more favourable terms of the third series Russia 63 4.4 of the targeted longer-term refinancing operations by 12 India 215 8.1 months to June 2022, besides other recalibrations. The China 904 6.0 South Africa 28 9.8 collateral easing measures were extended up to June Source: IMF Fiscal Monitor Update, January 2021. 2022. Four additional Pandemic Emergency Longer- Term Refinancing Operations would be conducted in central banks in most AEs and EMEs in Q4:2020. Rate 2021. The Eurosystem repo facility for central banks cuts continued in both Q4:2020 and Q1:2021, mainly and all temporary swap/repo lines with non-euro area by EMEs. A few major EMEs, however, raised rates in central banks were extended till March 2022. In March March in response to inflation concerns. 2021, the ECB said that purchases under the PEPP The Fed has maintained the target range for the federal would be at a significantly higher pace over the next funds rate at 0 to 0.25 per cent since March 2020. The quarter compared to the initial months of the year. Federal Open Market Committee (FOMC) has since The BoE has maintained a pause on the Bank Rate at December 2020 stated that monthly asset purchases its all-time low of 0.1 per cent since March 2020. In of at least US$80 billion of Treasury securities and its November 2020 meeting, the BoE increased the US$40 billion of agency mortgage-backed securities target stock of purchase of UK government bonds would continue till further progress has been made by an additional £150 billion (approximately US$197 towards the maximum employment and price stability billion). In March 2021, the UK government updated goals. The Fed also extended the temporary dollar the remit of BoE’s Monetary Policy Committee (MPC) liquidity swap lines and the temporary repurchase to reflect the “government’s economic strategy for agreement facility for foreign and international achieving strong, sustainable and balanced growth that monetary authorities up to September 2021. In is also environmentally sustainable and consistent March, the Fed extended the Paycheck Protection with the transition to a net zero economy.”2 Given the Program Liquidity facility by three months up to June implications of climate change for monetary policy 2021 to provide support for the flow of credit to small and financial stability, a number of central banks are businesses. The FOMC increased the per counterparty actively pursuing green goals (Box V.1). 1 The US$ approximations for all amounts mentioned in another currency in this Chapter are based on the exchange rate (Bloomberg) on the date of announcement of the particular measure. 2 https://www.bankofengland.co.uk/-/media/boe/files/letter/2021/march/2021-mpc-remit-letter.pdf?la=en&hash=C3A91905E1A58A3A98071B2DD41E65 FAFD1CF03E 8844Chapter V External Environment Box V.1: Central Bank Actions to Mitigate Climate Change Risk: Cross-country Experience In 2020, the average temperature of global land and ocean accurately, including exposure to “green swan”3 risks, surfaces was 1.17°C higher than the twentieth-century which are in nature of “climate black swan events”, i.e., average of 13.9°C, making it the second warmest year on extreme financially disruptive events that could be the record. The five warmest years since 1880 have been only next systemic financial crisis (Bolton et al. 2020). recently after 2015 (Chart V.1.1a). Global temperatures In 2017, eight central banks and supervisors established are expected to increase by another 1.5 degree between the Network of Central Banks and Supervisors for 2030 and 2052, and to continue upwards thereafter Greening the Financial System (NGFS) which had 89 [Intergovernmental Panel on Climate Change (IPCC), central banks and supervisors from around the world 2018]. The rise in global temperature is mainly attributed to an increase in greenhouse gas emissions. As a result, by March 2021. The NGFS recommended integration El Niño–Southern Oscillation changes in the global of climate-related factors into prudential supervision atmospheric circulation have been wild, influencing, and emphasised the importance of a robust and in turn, temperature and precipitation across the globe internationally consistent climate and environmental (Chart V.1.1b). disclosure framework. A recent survey of 26 central banks reveals that central banks consider climate change The higher global temperatures and the associated shifts in to be an emerging challenge both in terms of its potential weather patterns are key risks to the growth and inflation threat to the economy and impact on their operational outlook across AEs and EMEs through various channels. frameworks (NGFS, 2020). The prime motivation for While the most evident channel is agricultural output, others could be adverse effects on labour productivity, the central banks is to mitigate financial risks on their mortality rates and investment decisions (Acevedo et al., balance sheets due to exposures to climate change 2018; Batten, 2020). Thus, climate change poses severe related risks. Furthermore, central banks are in favour challenges to the central banks’ mandate of price and of formulating pro-active measures in moving towards a financial stability. Conventional models followed by low-carbon economy while ensuring smooth monetary the central banks cannot predict climate-related risks transmission over the long-term (Table V.1.1). Chart V.1.1: Evolving Climate Change Risk a: Global Surface Temperature Anomalies @ b: Southern Oscillation Index @: Deviations of average annual global surface temperatures (land and ocean) since 1880 from the long-term average (1901-2000). Note: The Southern Oscillation Index (SOI) measures large-scale fluctuations in air pressure occurring between the western and the eastern tropical Pacific during El Niño and La Niña episodes. In general, smoothed time series of the SOI correspond very well with changes in ocean temperatures across the eastern tropical Pacific. Prolonged periods of negative (positive) SOI values coincide with abnormally warm (cold) ocean waters across the eastern tropical Pacific typical of El Niño (La Niña) episodes. Sources: NOAA National Centers for Environmental Information, Climate at a Glance: Global Time Series, published March 2021, retrieved on March 31, 2021 from https://www.ncdc.noaa.gov/cag/; and https://www.cpc.ncep.noaa.gov/data/indices/soi. (Contd.) 3 The concept of “green swan” used by Bolton et al. (2020) was inspired by the famous concept of “black swan” developed by Taleb (2007) [Taleb, Nassim N. 2007. The Black Swan. New York: Penguin Random House]. Black swan events are rare and unexpected events with low probability but heavy impacts. Such events can only be explained after they happen. 8855Monetary Policy Report April 2021 Table V.1.1: Mitigating Climate Change Risk – Select Central Bank Initiatives Central Strategy Central Strategy Bank Bank Advanced Economies Bank of • Pilot project to help banks and insurance companies to Hong • Developed a common assessment framework to help banks to Canada develop climate change risk scenarios Kong assess their individual “greenness baseline” • A multi-year research plan focused on climate-related risks Monetary • Banks were advised to assess climate-related physical risk and and Canada-specific climate scenarios by staff members Authority transition risk associated with the projects and businesses they (HKMA) are funding • Assistance to the Government in implementation of green bond issuance programme Bank of • In March 2021, the Monetary Policy Committee's remit was Reserve • Supervisory engagement on the identification and management of England modified to include support to the Government's economic Bank climate risks among New Zealand’s financial institutions (BoE) strategy of transition to a net zero emissions economy o Zf e aN lae nw d • Better management of RBNZ balance sheet to mitigate climate • Became member of the government-regulator task force (RBNZ) change risk to examine the most effective way to approach climate related financial disclosures, including exploring the appropriateness of mandatory reporting European • Set up a climate change centre in January 2021 to bring Federal • The Federal Reserve supervisors expect banks to have systems in Central together the work on climate issues in different parts of Reserve place that appropriately identify, measure, control, and monitor all Bank (ECB) the ECB of their material risks, “which for many banks are likely to extend • Climate risk stress test exercise to assess the impact on the to climate risks.” European banking sector over a 30-year horizon • Formally joined the Network for Greening the Financial System in December 2020 Emerging Market Economies Banco • Capital requirements guidelines for banks for pricing-in environmental risks through which banks evaluate lending practices, stress-test against Central do the exposure to environmental risks and disclose their risk assessment methods and exposure to social and environmental damages Brasil People's • Issued green bond guidelines for building a green finance system in 2015 Bank of • Mandatory for financial institutions to disclose environment-related information to support and incentivise green investment China (PBoC) • Incentives included, among others, for re-lending operations by the PBoC, specialised green guarantee programs, interest subsides for green loan-supported projects, and the launch of a national-level green development fund Reserve • In 2015, included the small renewable energy sector under the Priority Sector Lending (PSL) scheme Bank of • Sensitising public, investors and banks regarding the need, opportunities, and challenges of green finance through its regular reports and other India communications Source: Websites of respective central banks. To sum up, changing weather patterns and increased Batten, S., R. Sowerbutts and M. Tanaka (2020), “Climate reliance on bioenergy could increase the volatility of food Change: Macroeconomic Impact and Implications and energy prices and hence impart substantial volatility for Monetary Policy”, in: Ecological, Societal, and to headline inflation, making it challenging for central Technological Risks and the Financial Sector, July 2020. banks to meet their inflation targets. Nowcasting and Bolton P., D. Morgan, da Silva. L. A. P., S. Frédéric and S. forecasting models of central banks need to be augmented Romain (2020), The Green Swan: Central Banking and to adequately account for weather effects. Financial Stability in the Age of Climate Change, Bank for International Settlements. References: IPCC (2018), Global Warming of 1.5oC. Available at: https:// www.ipcc.ch/sr15/ Acevedo, S., M. Mrkaic, N. Novta, E. Pugacheva and P. Topalova (2018), “The Effects of Weather Shocks on NGFS (2020), “Survey on Monetary Policy Operations and Economic Activity: What are the Channels of Impact?”, Climate Change: Key Lessons for Further Analyses”, NGFS IMF Working Paper, WP/18/144s. Technical Document, December. 8866Chapter V External Environment The Bank of Japan (BoJ) in December 2020 extended policy relating to sustainable house prices. In March, the duration of the special program to support the RBNZ withdrew a few temporary liquidity financing in response to COVID-19 by six months facilities, which were introduced in response to the to September 2021 and made adjustments to the COVID-19 pandemic, as they had low usage. programme. Following a review of the measures Amongst the major AE central banks, Australia and taken under “quantitative and qualitative monetary Iceland reduced policy rates in Q4:2020. In November, easing with yield curve control”, the BoJ announced the Reserve Bank of Australia (RBA) cuts its policy rate further effective and sustainable monetary easing in by 15 bps to a new low of 0.10 per cent and reduced March 2021: (i) establishment of an “Interest Scheme the target for 3-year government bond yields to the to Promote Lending” under which interest rates, same level. It also launched a quantitative easing linked to the short-term policy rate, would apply as programme of purchase of government bonds of 5-10 an incentive to financial institutions' current account years maturity worth AUD100 billion (approximately balances with the BoJ, corresponding to amount lent US$72 billion) to be carried out over six months. In by the institutions under eligible fund-provisioning February 2021, the RBA extended the asset purchase measures; (ii) the range of 10-year government bond programme that was to end by mid-April 2021 by six yield fluctuations would be +/- 25 basis points (bps) months with purchase of additional AUD100 billion from the target level; and (iii) the annual target for (approximately US$76 billion). In March, the RBA purchase of exchange-traded funds and Japan real indicated that it had adjusted bond purchases to estate investment trusts has been removed, while the enable smooth functioning of the market and would ceiling has been retained. do more, if required. The central bank of Iceland reduced its policy rate by 25 bps in November to 0.75 The Bank of Canada (BoC) has maintained a pause per cent (Chart V.6a). on the policy rate since reducing it to 0.25 per cent Given the conventional policy space, a few EMEs cut in March 2020. In October, the BoC announced it the policy rates further in 2021, while others started would gradually reduce quantum of weekly purchase reversing monetary stimulus. The People’s Bank of of government securities, while recalibrating its China has maintained the one-year Loan Prime Rate quantitative easing program towards longer-term at 3.85 per cent since April 2020, while the South bonds that have a more direct influence on borrowing African Reserve Bank has maintained its policy rate at rates. 3.5 per cent since July 2020. After maintaining a pause The Reserve Bank of New Zealand (RBNZ) has through Q4:2020, in January 2021, Banco Central do maintained its policy rate at the historic low of 0.25 Brasil (BCB) withdrew the forward guidance introduced per cent since March 2020. In November, the RBNZ in August 2020 when the underlying measures of announced additional stimulus in the form of a inflation were below the target. In its March meeting, “Funding for Lending Programme” aimed at reducing with inflation projected to be at the upper bound of banks’ funding costs. In February 2021, the RBNZ the target, the BCB raised the Selic rate by 75 bps to stated that it had completed the operational work to 2.75 per cent and indicated that a similar magnitude make its policy rate, the official cash rate, negative if hike will likely be effected in its next policy meeting. need arose for further monetary stimulus. The New The Bank of Russia, after maintaining a pause through Zealand government modified the MPC’s remit with Q4:2020, raised the policy rate by 25 bps to 4.5 per effect from March 1, 2021 to assess and outline, inter cent in March and indicated that it was a beginning of alia, the impact of its decisions on the government’s return to neutral monetary policy. 8877Monetary Policy Report April 2021 Chart V.6: Policy Rate Changes – Select Major Economies a: Advanced Economies b: Emerging Market Economies Source: Bloomberg. The central bank of Turkey followed up the rate hike Among AEs, US equity markets scaled new peaks every in September 2020 with an increase of 475 bps in month between November 2020 and March 2021. November and by another 200 bps each in December Apart from the earlier noted ultra-accommodative 2020 and March 2021 and indicated that the tight monetary policy and vaccine news, the US markets monetary policy stance would be maintained decisively were also boosted by the Presidential election results for an extended period until strong indicators pointed in early November and the additional fiscal stimulus to a permanent fall in inflation. Amongst other EME packages in December and March. In Q1:2021, there central banks, Bank Indonesia (BI) and Bangko Sentral were episodes of correction, mostly due to surge in ng Pilipinas cut their policy rates by 25 bps each in yields in the bond market. Q4: 2020 (November), while BI and Banco de México Among other major AEs also, November 2020 was one cut rates by 25 bps each in February during Q1:2021 of the best months on record in terms of gains. The (Chart V.6b). UK and the EU stock indices moved up, benefitting V.4 Global Financial Markets additionally from the trade agreement concluded The global financial markets remained buoyant, before the expiry of the transitional period following supported by highly accommodative monetary and Brexit. Towards end-January 2021, these indices fiscal policies and vaccine-led recovery optimism. Stock corrected due to the volatility brought on by US markets reached record highs in a few jurisdictions markets and again in the second half of February. In in February 2021, despite output being well-below March, the indices were up again to almost 13-month pre-pandemic path, raising concerns of a disconnect highs. The Nikkei crossed 30,000 in February 2021 between the markets and the real economy and risks for the first time since 1990. Stock markets in EMEs of future financial fragility (Box V.2). powered further ahead through Q4:2020 and up to 8888Chapter V External Environment Box V.2: Financial Markets and Real Economy Disconnect – Bubble or Retreat? Under the unprecedented and continuing monetary markets at the global level. The variables included in the accommodation by most central banks, financial empirical exercise are: MSCI world stock index (LWorld_ markets across the world have been exuberant. Equity stk), World GDP (LWorld_GDP), gold prices (LGold) and markets touched record highs, even as COVID-19 yield on 10-year US government securities (US_10yr)4. All pushed the global economy into its severest contraction the variables are integrated of order one, i.e., I(1), and the in decades. This is in sharp contrast to the typical co- Johansen-cointegration test reveals the presence of one movement between the equity markets and the real long-run cointegrating relationship5. The estimated long- economy, especially in severely stressed situations run equation from a vector error correction model (VECM) (Chart V.2.1). is as follows: The apparent disconnect between the real economy and LWorld_stk=5.34+1.98LWorld_GDP– 1.11LGold asset prices could be due to non-price factors (Claessens (9.99) (11.01) and Kose, 2017). A steep decline in risk premiums and - 0.12US_10yr ... ... ...(1) risk-free discount rates have driven up asset prices (Igan et al., 2020). Certain segments of the equity markets, (2.97) particularly small-cap, health and pharmaceuticals, Figures in parentheses are estimated t-values. All and technology notched higher gains than others. coefficients are statistically significant at 1 per cent level. Despite episodic corrections, the US S&P and the Indian BSE Sensex, inter alia, reached all-time highs in Q1:2021. The results suggest that higher real GDP growth boosts Though reflation trade, creeping bond yields and inflation equity prices, while higher interest rates and gold prices expectations led to a correction in the stock markets in are associated with corrections in equity prices. A higher the latter part of February, markets picked up again in level of GDP growth translates to higher corporate March with the US stimulus, mainly in AEs. earnings, which in turn results in higher equity returns (Gracia and Liu, 1999). Rise in yields and gold prices Against this backdrop, a preliminary examination has been undertaken to understand the drivers of stock presents portfolio diversification options, and are Chart V.2.1: Equity Markets and GDP – Growth Rates a: World b: AEs c: EMEs Sources: IMF; Bloomberg; and RBI staff estimates. (Contd.) 4 All data, barring LWorld_GDP, were sourced from Bloomberg. For LWorld_GDP, annual world GDP levels given by the IMF were interpolated to obtain quarterly series. The sample period is from Q1:2005 to Q4:2020. 5 To control for periods of excessive volatility and uncertainty in economic conditions, three dummies, viz., Dummy_COVID, Dummy_TT and Dummy_ GFC for COVID-19, taper tantrum and global financial crisis episodes, respectively, were included. 8899Monetary Policy Report April 2021 of the ΔLWorld_stk is statistically significant with the Table V.1.1: Short-run Estimates of Change in World Stock Prices correct negative sign implying that the stock prices adjust towards long-run relationship after a shock and Coefficient P-values that the estimated model is stable (Table V.1.1). In the ECT -0.238 0.026** case of a shock, gold prices are the quickest to adjust, 0.321 0.295 followed by stock prices. Summing up, unprecedented large scale monetary and 1.476 0.063* fiscal accommodation by most countries and vaccine optimism have contributed to a sharp rebound in stock -0.169 0.484 markets across the world. The empirical evidence still -0.137 0.019** supports the conventional wisdom that a long-run relationship holds between the financial markets and the Dummy_COVID 0.044 0.313 Dummy_GFC -0.064 0.013** real sector. Dummy_TT 0.042 0.272 References: Adjusted R2 0.47 Memo: VEC Residual Portmanteau Tests for Autocorrelations Claessens, S. and M. A. Kose, (2017), “Asset Prices and Lags Adj. Q-Stat. P-value Macroeconomic Outcomes: A Survey”, World Bank Group 4 33.765 0.209 Policy Research Working Paper 8259. Notes: 1. All variables are in log form, barring the 10-year yield, which Garcia, V.F. and L. Liu (1999), “Macroeconomic is in percentage points. The model was estimated with lag order of 3. 2. * and ** indicate statistical significance at 10 and 5 per cent level, Determinants of Stock Market Development”, Journal of respectively. Applied Economics, 2, pp.29–59. Source: RBI staff estimates. Igan, D., D. Kirti and M. S. Peria (2020), “The Disconnect inversely related to stock prices. The short-run dynamics between Financial Markets and the Real Economy”, IMF show that the coefficient of the error correction term Special Notes Series on COVID-19, August 26. mid Q1:2021, mirroring those in the US and other AEs expectations. In February, the large sell-offs saw longer and supported by burgeoning foreign portfolio flows term yields, especially of the 10-year and 30-year bonds (Chart V.7). With resumption of capital outflows since shoot up, leading to steepening of the yield curve. The the latter part of February, EME stock indices have 10-year yield at end-March 2021 was 106 bps higher shed gains. than its level at end-September 2020. Bond yields remained low in major AEs till end- There has also been a steepening of the yield curve 2020 driven by low or negative policy rates, forward in several other countries, both AEs and EMEs, guidance of low for longer, explicit yield curve control particularly since the second half of February. Low policies in a few countries and safe haven demand policy rates have kept the short-term yields low, while due to continued uncertainty with new rounds of longer maturities have been rising. This necessitated infections, fatalities and virus mutations. In the US, further bond purchases by countries like Australia however, bond yields have been inching up gradually which practice yield curve control. The rise in yields from Q3:2020 on expectations of reflation (Chart V.8a). led to portfolio reallocation resulting in correction in In January 2021, the 10-year yield rose above 1 per cent equity markets noted above. for the first time since March 2020 on expectations of further stimulus by the new US administration, better In currency markets, the US dollar weakened further economic recovery prospects and rising inflation in Q4:2020. In 2021, it has strengthened mainly due to 9900Chapter V External Environment Chart V.7: Equity Markets a: Equity Indices (MSCI) b: Change in Equity Indices Sources: Bloomberg; and RBI staff estimates. rising bond yields and expectations of higher inflation the emerging markets currencies to depreciate and higher interest rates. As regards emerging market (Chart V.8b). The MSCI Emerging Market Currency currencies, there has been resumption of capital Index, which increased by 5.3 per cent in Q4:2020, outflows in Q1:2021 from most regions, causing dipped by 1.1 per cent in Q1:2021. Chart V.8: Bond Yields and Currency Movements a: 10-year Sovereign Bond Yields in Select AEs b: Currency Indices Source: Bloomberg. 9911Monetary Policy Report April 2021 V.5 Conclusion inflation and consequent movements in the bond In 2021, real GDP is expected to register a strong markets lead to large valuation shifts in equity and rebound following the record contraction in the other financial markets, it could lead to extreme previous year. The actual outcome will depend on volatility in global financial markets which could how the race against the virus and its mutations is then spill over to emerging economies and impede won. Inflation concerns are creeping up at a time the nascent global recovery. Monetary authorities in when both monetary and fiscal policies are highly major advanced economies need to remain vigilant to accommodative, there are promises of continued these developments and be sensitive to the spillovers low rates for long and demand is recovering. If rising of their policies to the rest of the world. 9922