Currency withdrawal, TCS will revive uncertainty, not economy

Times of India May 24, 2023

On May 16 the government of India announced that it would impose a TCS (tax collected at source) of 20% on all international credit and debit card transactions made by Indians on their foreign travels from July 1, 2023 onwards. On May 19, the Reserve Bank of India announced that the 2000 rupee notes would be withdrawn from circulation though they would continue to be legal tender. The general consensus seems to be that both these are non-events. They will not impact many people and will not cause any real damage to the Indian economy. These predictions may well prove correct. But the interpretation misses the wood for the trees. We need to take a step back and understand that both announcements are problematic.

First, it is not clear why either of these announcements was necessary. The 2000 rupee note was introduced during the demonetisation episode of 2016 partly as a means to rapidly remonetise the economy till the time that currency notes of other denominations became available. As per the RBI’s recent notification, these notes have served their purpose, and are no longer commonly used for transactions. If this claim is correct, then why was there a need to withdraw them from circulation now instead of letting the notes become naturally redundant over time? The RBI could have simply instructed the banks to stop dispensing these notes.

Moreover, since the notes are not being demonetised and will continue to retain their value, the RBI could have also allowed users to exchange or deposit them over an unlimited period of time, instead of imposing a deadline of September 30, 2023 to do so. It is not clear why this deadline is necessary, nor is it clear why this announcement was sprung as a surprise instead of giving the users and the banks ample notice so that they could prepare for the change. Even if the 2000 rupee notes account for only 10.8% of the total notes in circulation, withdrawing them in this manner will cause inconvenience for many people, especially those in the cash-based informal sector that is still recovering from the devastating impact of the pandemic.

The rationale behind the imposition of TCS is even less clear. If the purpose is to collect information about a few people who are allegedly spending large amounts abroad using credit or debit cards thereby bypassing the foreign purchase limit of $2,50,000 permitted under the LRS (Liberalised Remittance Scheme), then this announcement is a disproportionate response because it will end up penalising every Indian who travels abroad to make perfectly legitimate international transactions. This is similar to the demonetisation episode when the entire country was inconvenienced in order to punish a few.

More fundamentally, the Indian economy has benefitted enormously from the liberalisation reforms of the early 1990s. During the last three decades, Indians have undertaken vast amounts of cross-border transactions. A significant percentage of Indians today live in a globalised world where they can easily travel to other countries for leisure or education or business purposes. We need to further encourage free flow of people and money across borders to be able to enjoy the fruits of globalisation. The ability to spend using credit or debit cards anywhere in the world is a critical element of this process. By making these purchases costlier, the recent TCS rule disrupts the financial freedom that a growing number of Indians have come to enjoy over the years, both at an individual level as well as from a business perspective.

Second, it seems ironic that these announcements were made when the country is trying to internationalise its currency, for example by using it to trade with other countries. An important pre-requisite for a currency to become international is people having confidence in it. Frequent withdrawal of currency notes without any prior warnings or increasing the cost of using the currency in other countries dent the credibility of the rupee and move India farther away from the goal of making it an international currency.

Finally, both these announcements come at a time when the Indian economy is struggling to find its feet. Forecasts by major organisations show that the economy is going to slow down in 2023-24. Much of the growth witnessed in the last year was due to the release of pent-up demand once the pandemic related mobility restrictions were fully removed. By now, that pent-up demand is exhausted. The two main engines of growth have also not been performing well. Non-oil goods exports contracted on a year on year basis in the quarter ending March 31, 2023, and private sector investment continues to be sluggish. At such a juncture, it is important for the government to create an environment in which the private sector feels confident to start investing again. Instead, the surprise withdrawal of the 2000 rupee notes bringing back memories of the 2016 demonetisation and the abrupt TCS announcement, undermine confidence in the policy framework. This kind of uncertainty discourages private investment even further.

In order to revive rapid economic growth, it is essential to ensure policy stability and predictability. The two announcements of last week are likely to create the opposite effect. This kind of sudden announcements act as a reminder that the government without any warning can introduce rules that may disrupt investment plans and hamper economic freedom. A proliferation of rules and regulations in this manner may seem non-events at first brush but cause long-term damage to the economy.

Is the RBI’s commitment to inflation targeting credible?

Is the RBI’s commitment to inflation targeting credible?, Ideas for India, May 24, 2023.

The post-pandemic credit landscape in India

The post-pandemic credit landscape in India, Ideas for India, May 8, 2023.

Don’t hit pause in the battle to contain inflation

Hindustan Times April 8, 2023

On April 6, the Reserve Bank of India (RBI) announced its first monetary policy decision of the financial year 2023-24. Going against widespread market expectations, it decided to hold the repo rate at 6.5%, pausing the rate hike cycle that began in May 2022. Unfortunately, the Monetary Policy Committee (MPC) statement does not fully explain why. All we can, therefore, do is speculate about the possible reasons behind this pause and discuss what MPC may need to do going forward.

Let's start by understanding what has changed since the last MPC meeting of February 8. There have been three main developments.

First, inflation pressures have arguably increased. Back in February, when MPC raised the repo (or policy) rate by 25 basis points, the latest data (for December 2022) showed that headline inflation had moderated to 5.7%, whereas going into the latest meeting headline, consumer price index (CPI) inflation had gone up to 6.4% in February 2023. In the run-up to both meetings, core inflation (non-food, non-fuel) remained elevated above 6%, the upper-limit of RBI’s tolerance band.

Second, the global economic environment has become significantly more uncertain compared to February, because of the turmoil in the financial markets in the US and European Union. With the collapse of a few mid-sized banks in the US and the forced take-over of the systemically important Credit Suisse by UBS, financial stability concerns resurfaced, which in turn, complicated the tasks of central bankers.

Third, the rupee-to-dollar exchange rate stabilised in recent weeks, after depreciating chronically in 2022, largely because markets now expect the US Federal Reserve to be less aggressive. The Fed has been tightening monetary policy since the start of 2022, increasing its policy rate from essentially zero to 5%, to rein in inflation which shot up to 9%, the highest in four decades. Arguably, this aggressive tightening triggered the financial instability in the US. The ensuing chaos prompted analysts to expect that the Fed will now slow down the pace of rate hikes in order to balance financial stability concerns with inflation control.

Which of these factors can help explain MPC's latest pause?

Clearly, it was not the first factor, given that inflation is still far from under control. RBI is legally mandated to bring headline CPI inflation down to 4%. Its inflation forecast for 2023-24 is 5.2%, implying that the central bank expects that inflation will remain well above target for the second consecutive year. What is more worrisome is that underlying (core) inflation is likely to be even higher, persistently hovering around 6% for several years now. The MPC statement recognises these problems, stressing the “importance of low and stable prices” and “not letting the guard down on price stability”, while pointing out that work needs to be done to “[anchor] inflation expectations” and “rein in generalisation of price pressures”. Yet, despite such a hawkish assessment, it did not vote in favour of a rate hike.

Why not? One possibility could be that the previous repo rate increases have not been fully passed on by banks to their lending and borrowing rates. So the central bank might have decided that the priority should now shift to ensuring that monetary transmission improves, either by tightening bank liquidity or exhorting banks to raise their rates. But there was no sign of any such initiative in the MPC statement.

So maybe the second factor, global uncertainty, played a key role? Perhaps RBI was worried that problems abroad could weigh on India’s growth? Apparently not. The central bank actually increased its 2023-24 GDP growth forecast, albeit marginally, to 6.5%, indicating that growth worries were likely not the major factor driving its decision.

Perhaps, then, exchange rate factors played the key role. It is certainly striking that RBI’s actions over the past year seem to have been mirroring those of the Fed. When the Fed was aggressively raising rates during 2022, RBI kept increasing its repo rate. And when the Fed decided in 2023 to slow down the pace of rate hikes, RBI responded by pausing. Hence, it is possible that there is some link between US and Indian monetary policy, perhaps motivated by a desire to protect the exchange rate by ensuring that rupee interest rates remain significantly higher than those in the US.

If indeed the pause was driven more by exchange rate factors than by domestic inflation – though RBI governor Shaktikanta Das said that monetary policy was driven by domestic factors, not international – then it needs some reflection. External considerations should not distract RBI from its primary objective of restoring price stability in the domestic economy. Traditionally, ensuring that the exchange rate remained stable against the US dollar could aid in this task, as US inflation used to be low. But times have changed. As long as inflation in developed economies remains elevated, India runs the risk of importing this high inflation.

Consequently, achieving the inflation target will require RBI to focus on exerting downward pressure on domestic inflation, especially now that high core inflation has become entrenched in the system. In particular, MPC needs to ensure that the real interest rate (the difference between the repo rate and core inflation) is firmly in positive territory if there is to be any chance of breaking the persistence of core inflation. Currently, the real rate is barely there.

Persistently high inflation hurts the poor the most. Volatile inflation can be inimical to growth, a troubling possibility given that India’s medium-term growth prospects look uncertain. Therefore, inflation control remains crucial to India’s future. Unfortunately the monetary policy decision did not throw much light on RBI’s plan to bring inflation down.

Should monetary policy be used to target financial stability?

Mint, April 2, 2023 (with Harsh Vardhan)

The recent financial market turmoil in the US triggered by the collapse of the Silicon Valley Bank has raised questions about the impact of the US Fed’s monetary policy on the stability of the banking system. More generally it has brought back to fore a fundamental question that central banks all over the world have been grappling with for a while now – should financial stability be given priority over inflation in the conduct of monetary policy? There is no easy answer to this as both problems are serious.

This issue is of crucial importance for India as well. It has been less than a decade since the Reserve Bank of India adopted inflation targeting as its monetary policy framework and under IT, the primary goal of monetary policy is achieving price stability. Expecting monetary policy to also keep an eye on financial stability, will distract attention from the central bank’s legally mandated objective, and may lead to destabilising outcomes for the economy in general.

There are some practical as well as conceptual problems in making financial stability an objective of monetary policy.

First of all, it is difficult to define financial stability. We can only see financial sector instability when it manifests for example through the failure of a systemically important bank, or the bursting of an asset price bubble, but before such an event occurs, we cannot precisely describe what is financial sector stability. Moreover, there are various institutions in the financial system involving a large number of participants that interact with each other thereby creating a complex, interconnected network. Within this system, sources of financial instability can be varied. We have seen financial instability occurring due to failures of banks, insurance companies, pension funds or mutual funds, and we have seen crises in the stock market and bond market. Ex-ante, it is often difficult to identify the specific part of this vast, complex network where a risk is building up.

Also, once instability occurs in any part of this network, given the interconnectedness, it can spread through the entire system leading to what is commonly known as contagion. It is difficult to predict whether an event of financial instability will indeed trigger a contagion, how rapidly the contagion will spread through the system or what impact it will have on different parts of the network.

Secondly, given that financial stability is difficult to define, it is also hard to measure. Often financial sector regulators use "stress tests" to assess the resilience of the system under various scenarios. Problem is that they only test for risks that they are worried about. There are many other risks beyond the obvious ones and typically those are the ones that get financial institutions into trouble, all the more making financial stability difficult to measure.

Monetary policy works best when it has clearly defined objectives and quantitative targets that guide its formulation. Given the challenges of defining and measuring, it is difficult for monetary policy to target financial stability as compared to price stability which can be both defined as well as measured. In India, for example, the IT framework clearly lays out the goal of the RBI’s monetary policy as achieving a 4% CPI (consumer price index) target. Such a clear, quantitative target is inconceivable when it comes to financial stability.

Finally, and most importantly, policymaking must be guided by the Tinbergen principle which conceives of economic policy as the relation between instruments and goals. It stipulates that the number of achievable goals is limited by the number of available policy instruments. Under the inflation targeting framework, the repo rate in India (or the Fed funds rate in the US) must be used to target inflation. It is therefore best to find another tool to address financial stability so that the Tinbergen principle can be applied.

So if monetary policy is not the answer, then what can be done to address financial instability?

Some have argued that central banks can inject liquidity to safeguard financial instability. There are three problems with this. First, injecting liquidity only makes sense when the underlying problem is illiquidity, say an irrational run against a bank with safe but illiquid assets (such as a loan to a profitable factory). But this is hardly ever the case. Usually, as in the case of SVB, runs occur because banks are insolvent i.e. the value of their assets has fallen below the value of their liabilities. In such a situation, the only solution is to inject capital. Injecting liquidity can in fact make matters worse because it enables more people to flee the ailing bank(s), thereby increasing -- not reducing – panic.

Secondly, liquidity can be a temporary solution in situations involving a credit freeze and, it may help restore confidence in the system. But it is like calling the fire brigade in the event of a fire; it is needed to douse the fire but does not help prevent future fires.

Third, addressing instability using liquidity may also mean keeping the system flooded with excess liquidity for a long time which in turn may endanger price stability.

Broad based financial stability can be achieved only by improving governance standards, and establishing strong supervisory oversight over the concerned institutions to help avoid the build-up of risks. The SVB collapse, like the Global Financial Crisis of 2008, reflected a colossal failure of governance and supervision.

In summary, in the short run, the solution to financial instability is capital; in the long run, it is better governance and supervision. Monetary policy would then be free to pursue its "natural target": price stability.

In the case of India on the other hand, price stability is a pressing concern. CPI inflation has been higher than the RBI's target level of 4% for a while now and in particular, core inflation has been remarkably stubborn at 6% for a long period of time. Hence, as the RBI gears up to announce its monetary policy decision on April 6, it needs to retain its focus on lowering the CPI inflation to the target level. The US Fed may have slowed down the pace of rate hikes in view of the latest financial market turmoil but that should not distract the RBI from prioritising domestic macroeconomic stability and inflation control.

3 potential problems for India's economy

Times of India, March 21, 2023

If 2022 was the year of “heightened global uncertainty”, this year is proving to be no different. Until last week, the US financial system seemed resilient to the aggressive interest rate hikes of the Federal Reserve. That perception has now been shattered. With the collapse of as many as three banks, including the Silicon Valley Bank (SVB) which was the 16th largest bank in the country, cracks have started showing in the US banking system, triggering fears of a possible financial contagion. The macroeconomic repercussions will be felt far away in India, even if our banking system does not immediately face the same kind of problems. How might the US situation play out, and what does it imply for the Indian economy?

The genesis of the SVB episode can be traced to the decisions of the US Federal Reserve during the pandemic period. The Fed lowered interest rates close to zero and injected vast amounts of liquidity. Banks consequently received large volumes of deposits and, invested them in treasury bonds. This meant that many banks, like SVB, whose loans books are much smaller in comparison to their deposits, became dependent on the treasury bonds for earning returns.

This became a problem when the Fed started aggressively raising rates in 2022 in its fight against inflation. As interest rates go up, bond prices fall. As a result, SVB began incurring losses on its bond portfolio. Sensing problems, depositors began withdrawing money from SVB—a classic case of a bank run, which led to its eventual collapse.

The problem, however, is far broader than just SVB. Any bank which has a smaller loan book, a bigger deposit base, and a large portfolio of treasury bonds now faces similar risk. In fact, US banks are currently sitting on an estimated $600 billion in potential losses owing to the erosion of their bond portfolios, on a capital base of $2 trillion. In other words, interest rate risk has eroded about 30 percent of the capital base. Within this aggregate, the distribution varies considerably, with midsize banks facing significantly higher capital erosion, which is why they have been facing runs in recent days.

This has put the Fed on the horns of a dilemma. If it sticks to its current strategy of raising interest rates to curtail inflation, bond losses will only increase, putting more stress on vulnerable banks. Alternatively, the Fed could pause or even start reducing rates, thereby relieving the stress on the banks, but at the cost of worsening the inflation problem. In other words, the important question for the US economy now is: will growing concerns of financial stability deter the Fed from pursuing its goal of price stability?

Irrespective of what the Fed decides, there will still be difficulties for India.

In particular, investors will remain very cautious, and will continue to doubt the financial stability of the midsize US banks – as we have seen over the past week. Things may get even more complicated if there are bank failures in the European Union. EU banks are vulnerable to similar risks given that the ECB has been tightening monetary policy as well. Already, fears of a contagion were running high when Credit Suisse, one of the systemically important banks at a global level, began witnessing rapid fall in its share prices last week. This eventually led to a takeover of the bank by rival UBS, a move orchestrated to calm the financial markets.

Any further bank failure could trigger a system-wide panic, and push depositors away from smaller banks to bigger, more diversified banks thereby precipitating more bank-runs. The resultant uncertainty would lead to heightened risk aversion.

In such an environment of risk aversion, there is typically a flight to safety. This will have important implications for India. There will be a surge in demand for “safe” assets such as gold etc., while the currencies of emerging economies like the Indian rupee will come under pressure as foreign investors flee these markets. The rupee has depreciated a fair bit in the last one year and, this trend may continue.

In addition, risk aversion is likely to dampen sentiments in the US, at a time when concerns about an impending slowdown have already persisted for a while. This may lead to a decline in credit growth and hence consumption, given that a large part of the US consumption is credit-fueled. Simply put, financial market turmoil might cause people to hold back spending. If this takes too severe a shape, then the US economy could fall into a recession, thereby hampering India’s growth prospects through the exports channel. Exports bailed out the Indian economy during the pandemic, but they have now stopped growing and, the situation is likely to worsen if the US goes into a recession.

Finally, if the Fed abandons its fight against inflation, this too will be problematic for India because we end up importing high inflation from the countries we trade with. This would aggravate domestic inflation, at a time when it is already running at 6.5 percent, well above the Reserve Bank of India’s 4 percent target.

The Indian economy has experienced a stuttering recovery from the pandemic. Its medium- term growth outlook remains weak, because private investment continues to be sluggish, exports are declining, consumption demand is lackluster and, the fiscal situation is overstretched. Now, the shockwaves from the banking crisis in the developed world are likely to create further headwinds for India’s growth.

We should consequently gear up for another year of volatility, amidst growing global uncertainty.

SVB crisis has brought the trade-off between price stability and financial stability back into focus

(with Harsh Vardhan), MoneyControl, March 17, 2023

Just as it seemed the world had come to terms with a certain level of uncertainty that was triggered last year by the US Fed tightening monetary policy, the Russia-Ukraine war and the Covid resurgence in China, a new source of uncertainty sprang up over the last few days—financial stability concerns in the US economy as manifested through the collapse of the Silicon Valley Bank (SVB). The shock reverberated through the US stock market with shares of several banks plunging. Some European banks have begun experiencing steep losses in share prices as well. For India, the relevant questions are: can something like this happen here, and what lessons can we learn from this saga?

Several analysts and commentators in India have written extensively about this episode. The general consensus seems to be that, thanks to the business model of Indian banks, the regulatory oversight of the RBI, relatively gradual monetary tightening in India compared to the US, and careful management of the yield curve by the RBI, an event like this is unlikely to occur in Indian banking.

While that may be true, this episode nonetheless offers some important lessons for Indian banking and its regulation.

Market risk in banks: This episode is a rare one where a bank collapsed due to market risk and not credit risk i.e. not due to a rise in non-performing loans, something we have witnessed frequently in India. The total marked to market losses that US banks are currently sitting on owing to the fall in the value of the government bonds in their portfolios, are estimated to be $600 billion on a capital base of $2 trillion, thereby implying that market risk has eroded about 30% of the capital base of US banks. Generally, In India we do not pay adequate attention to market risk in banks. But banks are steadily increasing their holding of bonds (see here: https://www.moneycontrol.com/news/opinion/why-banks-are-buying-more-bonds-6139661.html) which enhances their exposure to market risk. It is high time we started looking at this risk carefully.

Swift resolution: It was remarkable to see the speed with which the authorities acted to resolve the SVB crisis. Within a matter of days, the Fed and the FDIC (Federal Deposit Insurance Corporation) stepped in, evaluated the situation, and reopened the bank under a modified name. The bank is now being auctioned off and will be sold shortly. FDIC also publicly announced that they would bail out all the depositors.

Quick action is critical in the resolution of financial entities to restore public confidence, and prevent a contagion. It requires clearly laid-out laws, and protocols and also institutions empowered to implement them. Else, each resolution is dealt with on a sui generis basis and could lead to inefficient outcomes as is often the case in India. While we now have a bankruptcy law for non-financial companies, we do not yet have a well-defined law for resolution of financial entities. It is also important to note that the FDIC followed the expected pecking order of loss absorptions – they wiped out equity holders, followed by bond holders and saved the depositors. Contrast this with the Yes Bank resolution in India where AT1 bond-holders were written down before equity.

Moral hazard: One action taken by the FDIC however may offer lesson of what not to do. They announced that they would bail out not only the 7% secured depositors, but also the uninsured depositors.

In case of a bank failure, deposit insurance is meant to safeguard the deposits of small investors. Large depositors whose deposits are beyond the threshold stipulated in the deposit insurance schemes ($2,50,000 in the case of SVB) are expected to be “informed” depositors who should take into account the robustness of the bank before making a deposit. Such depositors are expected to bear the risk of the bank defaulting. Bailing out these depositors as if they were insured, creates a “moral hazard” problem. It creates expectations among the uninsured depositors of similar institutions that they too will be bailed out if such a situation arises. It generates an illusion of implicit government guarantee for all depositors.

Age of social media: As the depositors started shifting out of the bank, SVB had to sell some of its bonds to repay them, but in doing so it incurred losses since the bonds had lost value with rising interest rates. The size of this loss and the potential for future losses in relation to its capital doomed the bank and created the perfect recipe for a “bank run”. Once panic spread in social media about the bank’s stability, this ensured that the run happened very quickly, before the bank or the authorities had any time to react. Some commentators have rightly called it a “Twitter” driven collapse. This exposes the vulnerability of banks to such attacks in the era of social media.

Over and above these lessons for Indian banking, this episode has once again brought to focus the old issue of the trade-off between price stability and financial stability, and how should central banks deal with this. The roots of the SVB collapse lie in the policy decisions taken during the pandemic, when the US Fed first injected abundant liquidity into the system, and then aggressively raised interest rates to fight inflation.

The crucial question therefore is: should a monetary authority (for example, the Fed or the RBI) take financial stability into account when setting its monetary policy or be guided by the mandated objectives of inflation control and economic growth? The SVB episode is likely to reignite the debate on this issue.