By Invitation. Good monsoon will help RBI ease rates

The recent earnings season shows signs of a nascent recovery in corporate performance. Companies in some sectors have reported healthy earnings improvement in Q4 FY2016 in nominal terms. There is also evidence of a pick-up in the infrastructure cycle, which is most visible in the roads sector. Recent developments related to the National Investment and Infrastructure Fund as well as investment by LIC in the railways are encouraging.

Despite being on the cusp of a domestic demand revival, the private sector’s confidence hasn’t strengthened enough to embark upon a widespread capacity expansion. ICRA’s expectation of an uptick of 50 basis points (bps) in the growth of India’s gross value added at basic prices in FY2017 draws from the anticipated pick-up in consumption after the implementation of the Seventh Pay Commission’s recommendations and the one-rank-one-pension scheme for the defence services. In addition, an above-normal monsoon may boost rural incomes and demand in H2 FY2017.

One of the factors that could hinder fresh investment is dumping of goods in sectors experiencing sluggish demand, globally. Moreover, the wealth effect is squeezing domestic consumption, given the weak confidence in the real estate sector, sluggish gold prices and no sustained revival in the stock markets. Additionally, a well-intentioned clampdown on the use of cash may be dampening demand in some sectors.

Furthermore, the cost of financing fresh investment has not eased as much as was hoped. The decline in inflation has created room for the RBI to undertake a 150-bps monetary easing since January 2015, the transmission of which to bank lending rates remains incomplete.

The impact of the implementation of the Marginal Cost of Funds-based Lending Rate regime by banks and downward reset of small savings rates by the Centre with effect from April 1, 2016, on the pace of monetary transmission has been weaker than expected. Significant pressure on banks’ asset quality and profitability metrics continue to constrain them from lowering lending rates. The newly approved bankruptcy law is a positive step that will help curtail the incidence of wilful defaults over time. Nevertheless, implementation will hold the key to the success of this law.

Moreover, the RBI’s recent discussion paper on the Framework for enhancing Credit Supply for Large Borrowers through Market Mechanism intends to limit overall banking sector exposure to a single corporate borrower.

The framework prescribes that 40-50 per cent of the incremental funds raised by large corporates should come from the non-banking channel from FY2018 onwards. Additionally, in March 2015, the RBI issued a discussion paper on exposure norms for single borrower as well as group of connected borrowers. These norms proposed to reduce the concentration risk for banks by limiting borrowings of a group of connected borrowers to 25 per cent of capital funds from the prevailing 55 per cent. Moreover, the definition of capital funds is proposed to be changed to include only Tier 1 capital of the bank from the current definition of Tier 1 capital plus Tier 2 capital. In ICRA’s view, the introduction of these two sets of norms would be credit-positive for banks.

Clearly, the writing on the wall is that companies need to diversify their funding, while banks need to limit their exposure to large corporates. In fact, most banks have already increased their focus on retail lending.

To develop the bond market as an alternative funding source for corporates, the RBI has proposed to permit investment by foreign portfolio investors in unlisted debt securities and securitised debt instruments. However, if domestic bond markets do not deepen for lower-rated issuers over the next three years, some of them may have to curtail their expansion plans or experience a rise in their cost of funding. Another avenue of fund-raising may be through Masala Bonds — rupee denominated borrowings raised in the overseas markets, which are yet to take off.

In the immediate term, the surprisingly sharp uptick in CPI inflation for April 2016 to 5.4 per cent and the warning by the India Meteorological Department of a delay in the monsoon’s onset over Kerala have ruled out further easing in the upcoming policy review. The focus has fittingly returned to whether the monsoon in 2016 is well-distributed, from the initial euphoria of an above-normal volume. Nevertheless, if favourable monsoon leads to a sustained decline in food inflation, we anticipate further repo rate cuts in H2 2016.

However, commodity prices have recently rallied despite sluggishness in global demand; a sustained rise could materially impact Indian inflation. A weaker rupee on growing expectations of rate hikes by the US Fed also poses inflationary risks, as does the much-awaited pick-up in domestic demand.

The writer is MD and CEO, ICRA