One of the striking features of the Union Budget was the high borrowing requirement. The government plans to borrow Rs 15 lakh crore in 2022-23, to finance a higher-than-anticipated fiscal deficit of 6.4 percent of GDP. This decision will complicate the policy choices for the Reserve Bank of India.
During the two years of the pandemic, when the government’s borrowing requirements increased manifold owing to high fiscal deficits, the RBI stepped in to make it cheaper for the government to borrow. It lowered the short-term policy repo rate to a mere 4 percent in March 2020. Then, through a series of unconventional actions, it bought immense quantities of government bonds and injected vast amounts of liquidity into banks, to encourage them to buy bonds as well. As a result of these actions, the rate on 10-year government securities fell to 6 percent, even as inflation kept increasing.
The increase in inflation was fairly modest, considering the extent of the RBI’s actions. In ordinary circumstances, a large increase in liquidity would encourage banks to open the credit taps, allowing firms and households to step up their spending, which would then cause inflation to soar. But during the heightened uncertainty of the pandemic, banks were reluctant to lend, households were disinclined to spend, and firms were hesitant to embark on investment projects. As a result, spending was contained. CPI inflation reached the upper limit of the RBI’s target band, but did not spin out of control.
This situation made life easy for the official sector. The government could run large deficits and the RBI a stimulative policy, without worrying about the consequences for inflation. Even better, the advanced countries were pursuing similar policies. This in turn encouraged capital to flow to emerging markets, providing India with additional liquidity and reinforcing the RBI's strategic objectives.
However, in recent months, the global macroeconomic environment has changed quite significantly. After years of price stability, developed countries are experiencing a serious bout of inflation. Inflation has jumped to 5 percent in Europe and 7 percent in the US, the highest in four decades. This change has two implications for India.
First, for the first time in decades, India is now faced with a serious case of "imported inflation". Prices are rising rapidly on all the goods India imports, from oil to investment goods to vital industrial inputs. Even food prices have increased by 20 percent year-on-year as measured by the FAO Food Price Index.
Second, as a result of this global inflation, developed country central banks are getting ready to increase interest rates and withdraw the additional liquidity they had pumped into the system during the last two years. As a result, their policy has begun to diverge from the RBI’s accommodative stance, prompting capital to flow out of India in copious amounts over the past two months. This has weakened the rupee and pushed up domestic bond rates.
With foreigners fleeing the Indian market, domestic institutions panicked when they found out about the Budget borrowing plan, because it meant that they might have to shoulder the entire burden of absorbing the Rs 15 lakh crore that the government is planning to issue. In addition, they would also need to buy whatever amount of government securities the foreign investors are planning to sell in the coming months. Unsurprisingly, the 10-year rate has shot up to 6.9 percent in a matter of days.
This brings us to the RBI. Given the changed global environment and the government’s big borrowing plan, the RBI is faced with two difficult policy options, each with associated risks.
It could resume buying government securities in order to keep interest rates in check. The problem is that buying bonds will inject even more liquidity into the system, at a time when price pressures are intensifying. This could potentially jeopardize the RBI’s objective, since CPI inflation is already running close to its legally mandated limit.
Alternatively the RBI could wind back liquidity and raise the policy repo rate. This would be consistent with its inflation targeting objective, and bring its stance in line with that of the developed countries, thereby reducing the risk of further capital outflows. But it would also push up bond rates, making it costlier for the government and the private sector to borrow.
Both options have their costs. But between the two, the RBI should worry first and foremost about the costs to society of high inflation. Inflation is a tax that falls heaviest on the poorest, the most vulnerable segment of the society. And once inflation starts rising, it becomes very difficult and costly to bring it down, as we learned from our painful experience during 2013-14, when short-term interest rates reached 12 percent. As for bond rates, ultimately they need to be determined by demand and supply, without interference from the central bank, as this is the only way to ensure that they reflect the real cost of capital.
It will be interesting to see which way the RBI goes.
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