Thinking about financial sector reforms in India

Thinking about financial sector reforms in India, Ideas for India, November 15, 2021.

The difficult art of smooth landing

(with Harsh Vardhan), MoneyControl October 19, 2021

The October 8 monetary policy statement sent a mixed signal about the Reserve Bank of India (RBI)'s approach towards liquidity management. While the RBI seemed concerned about the surplus liquidity in the financial system, it was not clear what it plans to do about it. The communication highlighted the conundrum that the RBI faces regarding management of excess liquidity.

Since the start of the COVID-19 pandemic, the RBI has injected massive amounts of liquidity into the system through various schemes, including for the first time, pre-committed to buy government securities (G-Secs) under the G-Sec Acquisition Programme (GSAP). As of now, the surplus liquidity in the system is around Rs 13 trillion.

The RBI should be worried about how to absorb the excess liquidity due to three main reasons — all related to inflation. In September, CPI (consumer price index) inflation was 4.35 percent, which was close to the target of the 4 percent. If inflation remains low, then liquidity can remain easy for a longer period.

However, scenarios with rising inflation seem quite plausible now.

First, inflation in India has not yet been conquered. Core inflation (i.e. non-food, non-fuel inflation) was 6 percent in September, and has been persistently high and sticky for months (see graph below). Core inflation has been stubborn despite the negative impact of the pandemic on aggregate demand, and very low credit growth. As India comes out of the pandemic, the aggregate demand will only increase, thereby putting further pressure on inflation.

Second, the economy is facing an acute energy crisis with coal shortages, and rising global crude oil prices. The price crude oil has increased 122 percent, from $37 per barrel in June 2020 to $81 in October 2021. High fuel prices will feed back into overall inflation. Further, worsening coal shortages will aggravate supply side constraints, and push up the price of electricity, thereby pushing up inflation. We are yet to feel the full impact of this energy crisis.

Third, there is a big risk that we are entering a new phase of global inflation. As the advanced economies recover from the pandemic, and simultaneously experience prolonged supply bottlenecks in an environment of easy money, the era of low inflation seems to be over. If that is indeed the case, India cannot remain insulated.

If inflation pressures keep rising, at some point the RBI will need to withdraw the excess liquidity. While it is relatively easy for a central bank to infuse abundant liquidity, it is significantly harder to come out of it.

On October 8, RBI Governor Shaktikanta Das announced that the RBI will be conducting 14-day variable reverse repo rate (VRRR) auctions on a fortnightly basis. This means that the RBI will be absorbing some amount of the excess liquidity from the financial system on a short-term basis for 14-days at a rate decided in the auctions. This strategy will move liquidity from an overnight window (in case of absorption at the reverse repo rate) to a longer 14-day window. However, it is not clear from the RBI’s statement, what is their plan going forward to take out the liquidity structurally, and permanently, from the system. The VRRR alone is not sufficient to normalise the liquidity situation.

The RBI has suspended its GSAP programme for now. Technically it could conduct a reverse GSAP i.e. it could sell the G-Secs in order to bring the liquidity levels down. This can run into two problems.

First, banks would typically be the ones to buy, but banks are already holding much more than the minimum statutory requirement of holding G-Secs (i.e. the SLR norms). Further, as commercial credit picks up with normalising economy, such actions may crowd out private credit. Banks, focused on maintaining their spreads i.e. the difference between what they pay the depositors, and what they earn on their loans and investments will be reluctant to excessively invest in G-Secs — the lowest yielding investments, as it hurts profitability.

Second, any attempt by the RBI to reduce liquidity will inevitably lead to high G-Sec yields, and push up effective interest rates in the economy. This in turn will worsen the government’s budgetary position given that it is already struggling to finance an unprecedented level of debt.

The natural solution in the short term could be a compromise: withdraw some liquidity but not a whole lot. However, if inflation continues to rise, the RBI will be left with very little choice. If it does not act promptly, then, to normalise the liquidity situation, inflation would get worse, which in turn will force the RBI to raise rates; and if it does try to absorb the excess liquidity, interest rates will go up.

In other words, the very objective of the RBI’s liquidity injection policy of keeping interest rates down, may not be met beyond a few more months.

Understanding the dynamics of the rupee-dollar exchange rate

Understanding the dynamics of the rupee-dollar exchange rate, Ideas for India, October 11, 2021.

Sudden Rise of the Floaters

Sudden Rise of the Floaters, The Leap Blog, August 9, 2021.

‘Consumerisation’ of banking in India: Cyclical or structural?

‘Consumerisation’ of banking in India: Cyclical or structural?, Ideas for India, July 23, 2021.

How open is India's capital account?

How open is India's capital account?, Ideas for India, July 16, 2021.

Why RBI’s hoarding of forex reserves over currency concerns will be counter-productive

The Print, June 25, 2021 (with Ila Patnaik)

The Reserve Bank of India (RBI)’s foreign exchange reserves have been increasing sharply, suggests new data. Since April 2020, the RBI’s dollar reserves have grown by over $100 billion to now stand at $608 billion, making India the fifth-largest reserve holding country in the world.

The central bank has justified its forex intervention by talking about reserve adequacy. It has been argued that the RBI does not hold more than 15 months of import cover while some countries hold more. Switzerland, Japan, Russia and China hold more reserves than India and their import covers are 39 months, 22 months, 20 months and 16 months, respectively. However, over the last two decades, the RBI’s forex intervention has been motivated by concerns about currency movements.

Eye on currency, but conflict with inflation targeting

The recent increase in reserves has been prompted by an attempt to prevent large rupee appreciation. In June 2020 the rupee-dollar exchange rate stood at 75.6 while now it is around 72.8, a small appreciation. Intervention helped prevent a larger appreciation.

Not only does such currency manipulation invite the ire of other nations, it is costly as it is inflationary.Moreover, if there is a serious speculative attack on the currency, reserves are not used to prevent depreciation. In the past, the RBI has tightened monetary policy and used capital controls in order to prevent the rupee from falling, instead of selling off its billions.

The central bank does not want the rupee to appreciate as that makes exports uncompetitive. Hence it intervenes in the forex market to buy dollars. Such a course of action, as adopted by China for many decades, is seen as a "beggar thy neighbour" policy because it makes other countries worse off. This is not looked upon kindly.

In April this year, the US decided to retain India on its watchlist of currency manipulators. India had been on this list since December 2020. The US puts countries on the list of manipulators if they meet two of the three criteria over a 12-month period: (a) bilateral trade surplus with the US of over $20 billion; (b) current account surplus of at least 2 per cent of GDP; (c) net purchase of foreign currency amounting to at least 2 per cent of the country’s GDP.

According to the US Treasury Department’s report released in April, India was kept on this list because the RBI’s net forex intervention amounted to 5 per cent of GDP in the previous 12-month period, and because India’s bilateral trade surplus with the US had exceeded $20 billion.

Among the many costs of RBI’s currency intervention, an important one is that adding to its forex assets increases the money supply in the domestic financial system. An expansion in the money supply exerts inflationary pressures which might be damaging for the economy.

Are forex reserves held for preventing currency weakness?

One of the reasons a high level of reserves is considered useful is because it gives the central bank enough ammunition to fight against future currency depreciation. If the currency starts depreciating against the dollar, then the central bank can sell its dollar reserves and buy the local currency in order to stop the depreciation. But this rarely happens in the case of a speculative attack on the currency. With the US economy overheating due to the massive fiscal stimulus implemented by the US government, inflation in the US is on the rise. This could prompt the US Federal Reserve to start raising the policy interest rate.

If that happens, the situation for emerging economies like India will be similar to the Taper Tantrum episode of May 2013, when the US Fed had signalled a tapering of its Quantitative Easing policy. This had led to capital outflows from India as well as other emerging economies causing their currencies to depreciate.

Defending the exchange rate by selling reserves invites speculators. When people see that the RBI is selling reserves, they expect that when reserves will fall to a very low level, the central bank will be forced to stop intervening and the currency will weaken. Foreign as well as domestic investors start taking money out before this event materialises. Their speculative attack on the currency ends up hastening the currency depreciation.

During the taper tantrum, to prevent depreciation, the RBI tightened monetary policy, squeezed liquidity from the system and imposed capital controls. It used a very small part of its reserves. In May 2013, RBI’s forex reserves were at around $288 billion. Between May and September, 2013, it sold roughly $22 billion. Even so, the rupee witnessed a sharp depreciation from 56.5 in May 2013 to 62.8 in September 2013.

The central bank’s build up of reserves lets businesses believe that the rupee will not weaken sharply. They think that RBI’s stock of reserves will be used against big currency fluctuations. This in turn prevents these firms from hedging the dollar exposures on their balance sheets. It creates a never-ending vicious cycle wherein the more RBI hoards, the more confident these firms become to take unhedged exposure, thus avoiding the costs of hedging and then the greater the justification for the RBI to hoard reserves.

Indian economy & Covid-19: Risk aversion may be higher in 2nd wave

Indian economy & Covid-19: Risk aversion may be higher in 2nd wave , Trade Promotion Council of India Blog, May 26, 2021.

RBI’s never-ending dilemma

Indian Express, April 20, 2021

The Union government has recently announced that India’s monetary policy will continue to be guided by the inflation targeting framework for the next five years. This decision firmly establishes the mandate of RBI as an inflation-targeting central bank — at least on paper. In reality, the RBI’s priorities are not so clear. At some points, it seemed to target growth; at others, the exchange rate. More recently, it seems to be focusing on yields in the government bond market. These shifting priorities raise some questions: Are multiple and changing objectives compatible with the inflation targeting framework? Will pursuit of such a flexible strategy help the recovery or hinder it?

Consider the RBI’s attempts to control interest rates on government securities (G-secs). For some time, the central bank has made it clear to market participants that it would like to keep the 10-year rate around 6 per cent. When market participants pressed for higher rates, it repeatedly stepped into the bond markets, purchasing several trillion rupees of G-secs in the second half of 2020-21. Most recently, on April 7, it went one step further, announcing a plan to buy Rs 1 trillion worth of government securities in the first quarter of 2021-22. For the first time the RBI has committed itself to buying a specific quantum of G-secs over a specified period of time. What is distinctive about this Open Market Operation (OMO) plan is its aggressiveness, not only because it is large but also because it is an iron-clad commitment, invariant to future inflation or growth developments. And like all aggressive strategies, this one is not without risk.

There are three ways the OMO commitment can go wrong. First, it may not succeed in keeping a lid on G-sec rates. It does nothing to address the underlying reasons why bond investors are demanding higher interest rates: A large fiscal deficit leading to massive borrowing by the government in the bond market, and high and rising inflation. Market participants may also remain reluctant to purchase bonds at current interest rates. They may instead wait until the RBI has purchased its Rs 1 trillion, in the hope that afterwards rates will rise to more remunerative levels. By revealing the exact plan in advance, the RBI may have imposed limitations on the success of the programme.

Second, even if the strategy works in containing G-sec yields, this success may create collateral damage. In the short run, it could adversely affect interest rates for the private sector. If banks find they are not making adequate returns on their (very large) investments in G-secs, they will try to compensate by charging more on credit to the private sector. In this case, the plan would end up hindering the economic recovery.

There could be further collateral damage over the longer-term. One of the key benefits of a bond market is to impose fiscal discipline on governments, by forcing them to pay higher interest rates when government borrowing increases. Persistent intervention by the RBI would disrupt this process, increasing the risk that large fiscal deficits will persist.

Third, and perhaps most importantly, the plan may jeopardise the achievement of the inflation target. For the past year, the RBI has been injecting copious amounts of liquidity into the banking system, confident that this would not lead to an inflation problem. Even when inflation did rise above its central 4 per cent target, it argued that the problem was temporary and would disappear as soon as lockdowns eased and supply returned to normal.

In effect, the RBI has placed a large bet on the future of the economy. If inflation does collapse, then market interest rates will naturally fall, and the conflict between the two objectives will vanish. But if inflation remains strong, then the RBI will soon have to choose its priority. Either way there will be a problem. If it fails to fulfil its commitment and prematurely ends the liquidity injection, it could lose the confidence of the bond market for a long period of time. If, on the other hand, it goes ahead with its OMO plan — injecting Rs 1 trillion despite rising inflation — its credibility as an inflation-targeting central bank will be called into question.

What are the chances that the bet will come right? An inflation collapse cannot be ruled out. But so far developments are not encouraging. Inflation has stubbornly refused to dissipate. It has remained well above the 4 percent target. Forward-looking measures such as core inflation remain in the 5-6 per cent range, while fuel and commodity prices have been going up and are likely to firm further as more and more countries recover from the pandemic-triggered crisis. In India, several major states are experiencing a resurgence of COVID cases. To deal with this new wave, state governments have announced measures that will curb the mobility of goods and people. Like last year, these measures will lead to supply chain disruptions which will aggravate the inflationary pressures. RBI’s attempt to lower the interest rates can also lead to a depreciation of the rupee which may further add fuel to inflation by raising the import bill.

If the RBI is too slow to tighten policy and rein in the liquidity it has created, the country could end up facing the kind of inflation crisis that was witnessed in the post-2008 period. And we have seen how that movie ends — not just for interest rates, but also for growth and all the hopes that go along with it.

With a national election not too far away, that may not be a desirable outcome given that inflation has a greater political cost compared to other macroeconomic indicators.

Of twists and turns: Monetary policy and term premium

Of twists and turns: Monetary policy and term premium, Ideas for India, March 3, 2021.