Is the good run of the Indian banking sector over?

Is the good run of the Indian banking sector over?, MoneyControl, June 6, 2023.

The post-pandemic credit landscape in India

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

Budget 2023-24: Fiscally conservative but lacking economic strategy

Budget 2023-24: Fiscally conservative but lacking economic strategy, Ideas for India, February 27, 2023.

Food subsidy for thought

Times of India, January 2, 2023

The government has recently announced that it will discontinue the free-food scheme that it started during the Covid-19 pandemic and will instead distribute foodgrains for free under the Public Distribution System (PDS). According to some analysts, this is good news because it will reduce the government’s food subsidy bill. However when looked at closely, this announcement could raise questions about the fiscal conservativeness of the government and also about the direction of agricultural policy.

Let’s try to unravel these issues.

During the pandemic, the government’s fiscal deficit understandably soared, as revenues fell and the need for spending increased. But even after the economy has recovered from the pandemic, the fiscal deficit remains large. The deficit of the centre and states put together is likely to be around 10 percent this year, the highest among G20 countries. The deficit of the centre alone is budgeted to be 6.4 percent of GDP.

Such a high fiscal deficit is not sustainable. Hence, economists expect the Union Budget, to be presented by the Finance Minister on February 1, 2023, to establish a clear glide path of consolidation, which would ensure that the deficit is brought down over the medium term.

How does the recent announcement fit into this picture?

To answer this question, some background is necessary. In March 2020, the government launched the PM-GKAY (PM Garib Kalyan Anna Yojana) free food scheme as a Covid-relief measure. The scheme provided 5 kg of free foodgrains (wheat or rice) per person, per month to all families holding a ration card, around 80 crore people. The scheme was meant to run from April to November 2020 but was extended multiple times and most recently to December 2022. While being well-intentioned and appropriate as an emergency measure, this scheme imposed a serious fiscal burden on successive Union Budgets.

Accordingly, on December 23, the government announced that it will discontinue the PM-GKAY scheme. Instead, it would provide free foodgrains through the existing PDS system for a period of one year, starting from January 1, 2023. This policy action will supposedly generate savings for the government on account of a reduced food subsidy bill. Hence, at first glance, it seems that the announcement achieves the right objectives – help the poor and reduce subsidy burden. But does it, really?

The food subsidy will undoubtedly fall next year, compared to this year, but that is not the right comparison. This is because PM-GKAY was meant to be a temporary relief provision to help people tide over the pandemic. So, the post-health emergency plan needs to be compared to the pre-pandemic situation. Evaluated against that base, the announcement implies that food subsidy will go up since (a) the selling prices of PDS grains have been reduced to zero, and (b) the quantities provided have been increased. In other words, the scheme will increase the fiscal burden when compared with the pre-pandemic base.

The medium-term implications could be significant. In the past, there was always the possibility that the government could reduce the budget deficit by raising the prices at which foodgrains were distributed through the PDS. But now that the government has made grains free, it will be difficult to start charging the households again. In other words, this announcement commits the government to a scheme that arguably makes it more difficult to achieve medium-term fiscal consolidation targets.

This announcement is likely to have repercussions for the overall agricultural policy as well. The government will now be even more constrained than before as far as raising the Minimum Support Price (MSP) is concerned. If it raises the MSP, its budget will get squeezed further because it will procure the grains at a higher price and then distribute them for free. Yet if it does not raise the MSP, farmers’ income from selling to the government will fall in real terms.

In that case, the farmers may decide to sell to the free market rather than the government. But then, the government will face a shortage of foodgrain stock and will not be able to fulfil its commitment. In other words, over and above fiscal issues, this announcement may have opened a Pandora’s Box.

Some may argue that this is nonetheless a good measure, since the government is giving more help to poor people. But the new programme is aimed at 80 crore beneficiaries: is more than half the country’s population poor? Put another way, why is it necessary to provide free foodgrains tomorrow to people who could afford to pay for them yesterday, when the country is becoming more prosperous every day?

The main task of the approaching Union Budget is to present a credible plan for reducing the fiscal deficit over the medium term. This will be difficult, since most of the major items in the centre’s budget – interest payments, wages, defence, and such like – cannot effectively be reduced. Until recently, the largest scope for reduction lay in steadily narrowing the food subsidy, the largest component of discretionary current expenditure. But with the recent announcement merging the PM-GKAY into the PDS this option may have been foreclosed.

While this may make for good politics, it reflects questionable economics.

Playing it safe

Indian Express, August 5, 2022

The RBI's latest Financial Stability Report (FSR) has given the banking system a reasonably clean bill of health. It's a significant achievement, considering the stress of the previous decade, the shock of the pandemic and the associated slowdown of the economy. However, the improvement in banks' financials presents a glass half-full picture. It is still unclear whether the banking system is healthy enough to provide the sustained credit growth needed for a strong economic recovery.

Two key indicators demonstrate the banking system’s progress. Successive waves of recapitalization have given banks enough resources to write off most of their bad loans. As a result, they have been able to bring down their gross NPAs from 11 percent of total advances in 2017-18 to 5.9 percent in 2021-22. NPAs for industrial credit have been reduced even more dramatically, from 23 percent to 8.4 percent. Even after these large write-offs, most banks retain comfortable levels of capital.

This financial turnaround has given banks the space to resume their business of extending credit. During the decade when banks were under stress, non-food bank credit growth had been declining, reaching just 6 percent in 2020, its lowest point in six decades. Since then, credit growth has nearly doubled.

These are the visible signs of a healthier banking system. However, the broad aggregates conceal a worrisome picture, raising questions about the role bank credit will play in supporting GDP growth. The problem is that very little of this credit is going to large-scale industry or for financing investment.

Consider first the sectoral distribution of credit. Over the last decade, banks have increasingly shifted away from providing credit to industry, favouring instead lending to consumers. Consequently, the share of industry in total banking credit has declined from 43 percent in 2010 to 30 percent in 2020, while that of consumer loans has increased from 19 percent to 29 percent. This trend is continuing: in the year ending March 2022, consumer loans grew at 13 percent, whereas loans to industry grew at just 8 percent.

Bulk of the industry loans has been extended to the smaller firms (MSMEs), which benefitted from the credit guarantee scheme offered by the government in the wake of the pandemic. Loan growth for MSMEs went up from 3 percent in 2020 to 31 percent in 2022. In contrast, lending to large industries has been stagnant in nominal terms during the last two years, implying that it has declined sharply in real terms.

A related problem is that there has been little lending for private sector investment. Over the last one year, bank lending to infrastructure has grown by 9 percent, up from 3 percent in 2020, but this was fuelled mainly by public sector capital expenditure. Meanwhile, much of the lending to private industry has been in the form of working capital loans, necessitated by the increase in commodity prices, which has led to a sharp rise in the cost of holding inventories.

Why is there so little lending for investment by large firms? Both demand and supply side factors seem to be at work. On the demand side, private sector investment has been sluggish for nearly a decade. The boom-and-bust of the mid-2000s had saddled firms with excess capacity, giving them little reason to expand their production facilities. In addition, the Global Financial Crisis had shown the dangers of ambitious expansion supported by excessive borrowing, leading firms to conclude that it would be prudent to scale back their plans and instead focus on reducing their debts.

On the supply side, banks have learned similar lessons. During the period 2004-2009, rapid GDP growth in the Indian economy was fuelled by an unprecedented lending boom. Credit doubled within the span of a few years, primarily on the back of lending to large infrastructure projects. Subsequently, many of those loans turned bad, leading to high levels of NPAs on bank balance sheets. As a result of these financial problems, banks for a decade were unable to extend much in the way of credit. Even when their health improved, they remained wary of lending to large-scale industrial projects, preferring instead to shift to smaller-scale and less risky consumer lending. This situation of risk aversion on the part of firms and banks has not changed perceptibly during the post pandemic recovery.

On the positive side, firms seem to have finally used up much of their spare capacity. But on the negative side, the fundamental problems that led to the difficulties of the past decade still have not been resolved. There is still no framework that will reduce the risk of private sector investment in infrastructure, certainly not in the critical and highly troubled power sector. Nor is there any reassurance for the banks that if problems do develop, they can be resolved expeditiously, since the Insolvency and Bankruptcy Code (IBC) has been plagued by delays and other problems. Now, heightened global macroeconomic uncertainty, growing geopolitical tensions and uncertain recovery prospects of the domestic economy are likely to make matters worse.

In other words, a healthy balance sheet of the banking sector is a necessary but not a sufficient condition for economic growth. The important question is whether banks and firms will once again be willing to take on the risk of investment in industry and infrastructure. And this seems unlikely unless there are deep structural reforms – to the infrastructure framework, the resolution process, and indeed in the risk management processes at the banks themselves. In the event that these reforms do not materialise, there may continue to be shortfalls in credit, investment, and ultimately in economic recovery and growth.

Why weaker rupee isn't all bad news

Times of India, July 22, 2022

Over the last few months, the exchange rate has come under intense pressure, falling to nearly Rs. 80 to the dollar, its lowest level ever. Some observers have argued that this pressure can be managed easily, since the country can simply sell a portion of its foreign exchange war chest, which amounts to a healthy $580 billion. Unfortunately, currency management is not that simple. In fact, it is not obvious that dollar sales will be sufficient to resolve the exchange rate pressure – or even whether preventing depreciation is the right strategy for the economy at present.

Let’s start by considering why the rupee has been under so much pressure. A key reason is that the US Federal Reserve has begun to tighten monetary policy aggressively to control inflation, which is at a four-decade high. The Fed has already raised interest rates by 150 basis points so far this year and is expected to tighten by a further 75 basis points later this month. When the Fed raises interest rates, global investor funds shift their portfolio allocations towards US financial markets, taking the money out of other countries. In India’s case, the net sales of foreign portfolio investors have amounted to a sizeable $31 billion in 2022 so far, according to data from NSDL.

The inflow of money into the US has led to an appreciation of the dollar. The dollar index (DXY) has strengthened against its trading partners by more than 11 percent this calendar year, reaching levels last seen in 2002. The counterpart to this appreciation has been a depreciation of the pound sterling, the euro, and nearly all Emerging Market (EM) currencies. In the case of the rupee, the depreciation has amounted to a relatively modest 7 percent since January 2022.

In fact, the rupee’s depreciation has been surprisingly modest, considering that at the same time that capital has been flowing out of the country, India’s current account deficit (CAD) has also been widening. Typically, the CAD increases when aggregate demand grows so rapidly that imports rise faster than exports. However, aggregate demand in the Indian economy has been tepid since the onset of the Covid-19 pandemic and the recovery has been slow and gradual at best. So why is the CAD worsening?

Much of the answer lies in the rapid growth of import prices. India is heavily dependent on imports of petroleum (which cover 80 percent of the country’s needs) and other commodities. And supplies of commodities have been disrupted since the Russia-Ukraine war started in February 2022, causing the prices of petroleum, fertilisers, edible oils, and other products to soar. This has automatically inflated the import bill, pushing the monthly trade deficit to an all-time high of $26 billion in June 2022. On current trend, the CAD for the fiscal year could reach 3-3.5 percent of GDP.

This has put India in a difficult situation. Just when the country needs more financing to cover a widening CAD, capital has started to flow abroad. That is why the rupee has taken a tumble.

So what can be done?

Without doubt, India can utilise some of its ample foreign exchange reserves – and indeed, it has already done so. However, this is not a complete solution. When the central bank sells foreign reserves, commercial banks need to give rupees in return, draining them of liquidity. Consequently, when reserve sales become large, the liquidity drain becomes sizeable, potentially tightening the money supply far more than what is appropriate, thereby endangering economic recovery.

To address this problem, the foreign exchange intervention can be “sterilised” if the central bank buys government securities from the banks. In that case, banks will receive rupees, thereby replenishing their liquidity. But if the central bank purchases large amounts of bonds, this could push G-Sec rates down to inappropriately low levels, thereby endangering the inflation target.

For these reasons, there is a limit to the amount of foreign exchange that the central bank can sell without jeopardising its other targets. And there is a further problem: since investors know that there is a limit to the foreign exchange sales, they will be tempted to try to purchase as much as they can right now. In that way, a policy of foreign exchange sales can sometimes – paradoxically – increase the pressure on the exchange rate.

In view of the complications arising from the strategy of selling reserves, it might help to go back to fundamentals and ask a deeper question: do we really want to prevent the rupee from depreciating?

After all, if the rupee fails to follow when other EM currencies are depreciating, then India’s exports will lose competitiveness. Already, the rupee has appreciated significantly against other Asian currencies such as the South Korean won, the Thai baht and the Taiwanese dollar. If competitiveness is further eroded just when the global economic environment is turning difficult, export growth could really suffer. And that might be a big problem.

The two most important drivers of growth for an emerging economy like India are investment and exports. Private sector investment has been sluggish for several years. Last year’s recovery was highly dependent on exports, which fortunately grew exceptionally rapidly. If this engine of growth starts to sputter, so might the economic recovery.

Of course, there are costs to a weak rupee. In particular, depreciation will push up prices at a time when inflation is already a problem. But there are other mechanisms for addressing inflation, such as increases in the repo rate, which indeed are already happening. In contrast, there are no other ready mechanisms to safeguard export competitiveness, apart from the exchange rate.

In sum, reserves can indeed be used to stabilise the rupee – but only to a certain extent. And there are some important advantages to allowing the rupee to weaken, as a way of supporting India’s economic recovery process. Striking the right balance is going to be a challenge not only for India, but for all emerging economy central banks.

Rating RBI’s rate hikes

Times of India, June 9, 2022

On June 8, the Reserve Bank of India increased the policy repo rate by 50 basis points. This is a step in the right direction. There is an ongoing inflation crisis in the country and the central bank seems to have finally woken up from its slumber. This however raises deeper questions about inflation control in India.

This is the second time in the last 15 years that India has faced an inflation crisis and the RBI has been caught napping. The first time was right after the 2008 Global Financial Crisis. One big difference between these two episodes is that the RBI is now an inflation targeting central bank. IT was implemented precisely to help avoid a situation of high and volatile inflation. So what went wrong, and what lessons can be learnt from the current crisis?

Let’s first understand how the RBI missed the inflation bus. The inflation problem has been brewing since 2020. During March-Dec 2020, CPI inflation exceeded the 6% upper limit of the RBI’s target band, for three quarters in a row. According to the RBI Act 1934 (amended 2016), this is considered a failure of the RBI to meet the inflation target. The RBI is required to write a report to the Central Government explaining the reasons for the failure, remedial actions to be taken and the estimated time period within which the target will be achieved. At the time however the RBI succeeded in dodging this accountability, citing data problems aggravated by the lockdown. This was also the time when the pandemic was in full swing and central banks all over the world were rolling out easy monetary policies. Hence the analysts and experts (barring a few) in India also did not question the RBI’s overlooking of the inflation problem.

Moving on to more recent times, the Russia-Ukraine war and persistent supply chain bottlenecks have once again pushed CPI inflation above the 6% level starting Jan 2022. More worrisome has been the persistent increase in WPI inflation which has steadily gone up from 10.7% in April 2021 to 15% in April 2022, the highest level in three decades. Wholesale inflation impacts retail prices with a lag. This implies that CPI inflation will continue to increase.

The table below summarises the RBI’s response to this surge in inflation. Even as CPI inflation kept rising and WPI inflation reached alarming levels, the RBI continued to underestimate inflation. It stuck to an accommodative stance and refrained from increasing the policy repo rate. This shows that the RBI did not consider inflation a serious problem till May 2022. Even though no new information surfaced between April and June, the RBI increased interest rates by a steep 90 basis points in a little more than a month, between May 4 and June 8.

This shows that the RBI was behind the curve and is now trying to overcompensate. This does not instill confidence about how inflation is being managed despite RBI being an inflation targeting central bank.

This episode raises deeper questions about the working of the IT framework and highlights some important lessons.

First of all, in the IT regime, the Monetary Policy Committee is responsible for forecasting inflation, setting the policy rate as well as deciding the monetary policy stance to help keep inflation within the target band. We need to ask why did the MPC fail in anticipating the surge in inflation months ahead of time and what reforms are required to help avoid a similar situation going forward.

Secondly, and a related point, it seems the MPC is not using the power that it has been vested with by the law. For instance, a critical feature of an effective committee is dissent by its members. This reflects diversity of opinions, one of the main reasons we have a committee now looking into inflation. It is remarkable that despite the uncertainty of the underlying macro environment, there has not been a single dissent in the MPC as regards the policy rate, for several months. Lack of disagreement raises questions about the MPC’s efficacy.

Third, the greatest contribution that monetary policy can make is inflation control. For this to happen, all other objectives of the RBI must be delegitimised, including, ensuring low-cost borrowing for the government, and exchange rate management.

Finally, a key element of IT is accountability. We need to create an environment where it is costly for the RBI to stray from its primary objective of inflation control. For example, when CPI inflation exceeds 6% for three quarters in a row in 2022, the RBI must explain where it went wrong and what steps are being taken to remedy the situation.

In India, inflation harms the poor the most, and hence it is directly relevant for politicians trying to win elections. In such a situation, the best thing that the RBI can do is to deliver a predictable 4 per cent CPI inflation for decades so that economic policymaking can get back on track and firms and households can start planning for the future. Both the RBI and the government must therefore learn from the current inflation crisis and further strengthen the IT framework so that India does not face a similar episode of high and volatile inflation, the third time around.

Price of wrong price strategy

Times of India, June 2, 2022

India is now facing a dual problem of low growth and high inflation. The recovery has proved much weaker than expected, with growth amounting to a meagre 4.1 percent in the fourth quarter of 2021-22. At the same time, inflation has been surging so much so that over the past few weeks the government has taken a wide range of measures to deal with it. Unfortunately, this strategy is misplaced. The government’s actions will have only a marginal effect on inflation, while they may do significant damage to the incipient recovery. The government needs to step back from the inflation fight, and instead encourage the RBI to tighten monetary policy.

CPI (consumer price index) inflation was close to 8 percent in April, nearly double the RBI's legally mandated target of 4 percent. Most of this inflation is caused by supply-side bottlenecks, triggered first by the pandemic and subsequently by the Russia-Ukraine war and lockdowns in China. Yet even as supply has been constrained, the RBI has been pursuing an easy monetary policy, aimed at encouraging demand. As a result, inflation has been increasing.

With inflation surging, and the RBI still in "accommodative" mode, the central government has now announced a slew of measures to ease the supply constraints, focusing on those commodities whose prices have increased sharply. It has banned wheat exports, lowered the excise tax to Rs 8 per litre on petrol and Rs 6 per litre on diesel, and reduced the import duty on steel.

That's not all. The government has also imposed an export duty on steel products at the rate of 15 percent and increased the export duty on iron ore from 30 percent to 50 percent. It has imposed a cap on sugar exports. There is a demand to ban cotton exports as well.

It is clear that the government is trying hard to bring down the cost of commodities. But these actions will only have a modest effect on inflation. Part of the reason is that price increases are no longer confined to just a few commodities. Inflation is now broad-based, extending to virtually every good and service in the economy. Further inflationary pressure is building up, as seen from a WPI (wholesale price index) inflation of 15 percent, the highest in more than two decades. As these wholesale price increases are passed through to the retail level, CPI inflation could rise further.

While the government’s bans and market interventions will do little to dent inflation, they are likely to damage growth by undermining exports and investment. Let’s consider these one by one.

India now faces a historic opportunity to use exports as a lever to boost GDP growth. China, the main export engine of the world, has been locking down its factories even as international firms are scouting for new production locations. Meanwhile, Russia is being subjected to ever-tighter economic sanctions. As a result, two large Asian countries are reducing their presence on the international trade landscape, creating an unprecedented scope for India to attract international firms to produce and export from here.

Exploiting this opportunity requires an appropriate policy stance. Perhaps the single most critical element of such a stance would be a stable and consistent trade policy. Whenever the government suddenly bans exports or imposes export duties, it puts firms with export orders in a position where they cannot fulfil their contracts. This is not only embarrassing, it also exposes both exporters and importers to large losses. To avoid this situation, domestic firms will shy away from entering the export business, while foreign firms will be reluctant to place orders with Indian firms. In addition, multinationals will be discouraged from shifting their production to India. After all, why should a firm relocate here, if there is a risk that its exports could be banned, its imports subjected to high duties, and the rules governing its sector changed overnight?

Similarly, sudden and radical policy announcements discourage investment. After two difficult pandemic years, the economy is now reviving, leading firms to consider whether now is the time to start increasing their production capacity. But firms will start to think again when the government alters policy frameworks overnight, even if the change is in a sector far removed from their own. The cost of major investments can only be recouped over a long payback period, and if over this timeframe the government takes an action that renders their investments uneconomic, the firms could end up in serious financial trouble. So better to play safe and avoid major investments.

Finally, the government's actions will affect growth in yet another way. The reduction in excise taxes on petrol and diesel will deprive the centre of revenue at a time when the budget deficit is already far too large. That means the government may need to compensate by cutting spending on infrastructure projects that are vital for the nation’s development.

At this crucial juncture, macroeconomic policy has the delicate task of simultaneously tackling inflation and promoting the recovery. The first task is the job of the RBI. The central bank must take full responsibility for its actions so far, sending a clear signal that henceforth it will focus on bringing inflation down without getting distracted by any other objective. The government on the other hand needs to focus on growth. It needs to reduce market interventions, eliminate prohibitions, and dismantle trade barriers, so that firms are incentivized to export and invest.

If instead, we continue to get the policy “assignments” mixed up, we will end up with objectives that are mixed up. That is, instead of entrenching growth and derailing inflation, we will derail the recovery and entrench inflation. That would not just be a policy mistake. It would be a recipe for a crisis.

4-point battle plan for RBI

Times of India, May 14, 2022

As the Indian economy struggles to recover from the pandemic, it is facing another obstacle in the form of high and rising inflation. Keeping inflation low and stable is the legal mandate of the Reserve Bank of India under the inflation targeting (IT) framework. It is therefore worth asking: why is inflation so high, and what should be done differently to ensure it comes down and stays down?

Consider the first question. In recent months, the Russia-Ukraine war and China’s lockdowns have pushed up the prices of critical items including crude oil, edible oils, and fertilisers. On top of that, for the first time in four decades, India is now “importing” high inflation from developed economies such as the US and Europe. Without doubt, these external developments have exacerbated India’s inflation. But they are not the cause of the problem.

The real cause of the problem lies closer to home. Inflation is high today because underlying pressures have been building up for years, and the RBI, despite its legal mandate, has not acted in time to stop them.

Since the start of the pandemic in March 2020, consumer price index (CPI) inflation has averaged 5.8 percent. This implies that inflation has been close to the 6 percent upper threshold of the RBI’s target band, despite an unprecedented collapse in demand. For the first three months of 2022, inflation has consistently exceeded the 6 percent upper limit. The wholesale price index (WPI) has been increasing at an even faster rate, averaging 13 percent since April 2021. This is the highest WPI inflation in more than two decades. This matters for the CPI target because persistent increases in wholesale prices get passed on to retail customers with a lag of a few quarters. Of particular concern has been the recent spike in WPI food inflation, which is now translating into high retail food prices.

In other words, the warning bells about growing inflationary pressures have been ringing loud and clear for a while now. Yet, despite being an IT central bank, the RBI has not been paying much heed to these alarm bells. On the contrary, it kept arguing that inflation was a temporary problem. This was presumably based on the assumption that inflation would disappear when the pandemic subsided, that the supply constraints--both domestic and international, would soon abate, and that global inflation was also temporary. The RBI’s inflation projections reflected this assessment. Over the past few months, its forecast of CPI inflation for 2022-23 remained in the range of 4.5 - 5.7 percent.

It is quite clear now that inflation is not a temporary problem. The war in Ukraine is unlikely to end soon, and even when it ends, the international sanctions on Russia will remain for some time. The lockdowns in China are getting worse by the day. Even the US Fed has now acknowledged that inflation is not a transient phenomenon and has been forced to act aggressively. In all likelihood, the era of low global inflation is now over.

Meanwhile, in India, with inflation predicted to subside on its own and remain well within the band, the RBI did not feel the need to act to contain it. Instead, its “accommodative” policy has trapped the economy in a vicious circle. With interest rates falling and inflation rising, real interest rates have been falling sharply, intensifying excess demand, feeding inflation, thereby further reducing real rates. During the first three months of 2022, real 91day Tbill rates fell to the exceptionally low rate of -2.6 percent. Clearly, the RBI needed to act on time to stop this dynamic.

This brings us to the second question: what should the RBI do differently to address this problem?

First, it needs to clearly communicate that it is serious about inflation and will do whatever it takes to bring inflation down to the target level over the next few months. This is important for anchoring inflation expectations. If the public expect inflation to keep rising it will become even more difficult for the RBI to tame inflation.

First, it maybe argued that the increased capex spending by the government since last year has not resulted in the desired “crowding-in” of private sector investment which continues to be sluggish.

Secondly, the RBI needs to stick to the operating procedure outlined in law, and announce monetary policy changes in a predictable manner. This is crucial for restoring its own credibility as an IT central bank. The surprise May 4 announcement, when the repo rate was suddenly raised by 40 basis points, is exactly the kind of policy action that the RBI should avoid. A sudden reaction like this sends a signal that the RBI has lost control of the situation and that after ignoring inflation for too long, needs to overcompensate. This kind of an action undermines rather than builds confidence.

Third, any decision to raise the policy rate must be accompanied by an inflation forecast that justifies the rate action. Releasing credible inflation forecasts instils confidence about the capability of the RBI to do IT.

Finally, the Monetary Policy Committee (MPC) should be restored to its rightful role as the overseer of policy decisions. Over the past few years, the RBI has essentially bypassed the MPC, thereby losing a vital “reality check” on its forecasts and actions.

The inflation problem in India has reached worrisome proportions. As a result, the adjustments needed are more painful than they would have been if the RBI had acted on time. But late is better than never. The RBI now needs to be decisive and resolute in pursuit of its inflation target. The future of India’s economy, and the livelihood of its people, depend on it.

Question of timing

Indian Express, May 31, 2022

The Reserve Bank of India normally makes policy announcements on a well-defined schedule. But on May 4 it unexpectedly tightened monetary policy, increasing its policy interest rate and reducing liquidity in the banking system. Markets were taken aback by the announcement, with the 10-year government bond yield jumping by 25 basis points to reach 7.38 percent.

Why did the RBI do this? Even after the Governor’s careful explanations, the answers remain unclear.

At one level, the answer is obvious: inflation pressures are rising. Since the last MPC meeting of April 8, headline CPI (consumer price index) inflation has gone up from 6.1 percent to 7.0 percent, and the forthcoming inflation numbers are expected to be even worse. Clearly, the RBI had to respond. So, it raised the policy repo rate by 40 basis points to 4.4 percent and increased the cash reserve ratio by 50 basis points to 4.5 percent.

This explanation however does not seem entirely adequate, because nothing fundamental has changed since the last policy meeting of April. Even back then, it was obvious that inflation pressures were rising. The wholesale price index (WPI) was already in double digits, inflation in the US and Europe was increasing, commodity prices were spiking owing to the Russia-Ukraine war, and supply chain constraints were tightening, as China imposed severe lockdowns to deal with a resurgence of the Covid-19 pandemic. But the RBI did not think that these pressures warranted a policy tightening.

What made the RBI change its mind? Under the Inflation Targeting framework, the central bank’s thinking is typically revealed by its inflation forecast. If it projects that inflation will be above target for some time, this implies that the central bank is concerned about rising prices and will be taking action to bring inflation down. In the last Policy Review, the RBI projected that inflation would abate to 5 percent by the end of the fiscal year, somewhat higher than the 4 percent objective but not unduly so, thereby explaining why the central bank saw no need to tighten at that time.

Presumably, the RBI now thinks that the inflation pressures will either be more intense or more durable than it had earlier expected. And presumably, the RBI felt that its policy stance was now “behind the curve”, meaning that urgent action was needed to quell these pressures. Otherwise, it would have waited till the next MPC meeting on June 8 to increase the repo rate. But it is impossible to know whether this was really the motivation, as the RBI didn’t release a revised inflation forecast—and because other explanations are also possible.

One possibility relates to the exchange rate. The US Federal Reserve was expected to announce a 50 basis point increase in interest rates later in the day of May 4. So, it is possible that the RBI wanted to jump ahead of this announcement by announcing its own 40 basis point rate increase, maintaining (more or less) the interest differential against the US dollar and thereby keeping the dollar-rupee exchange rate relatively stable.

It's not obvious why exchange rate stability would be a priority for the RBI. After all, its legal mandate is to achieve an inflation target, not an exchange rate objective. But the RBI does seem determined to limit the rupee’s depreciation. The April 8 statement highlighted that India's foreign exchange reserves had increased to US 607 billion at the end of 2021-22. In contrast, the May 4 statement mentioned that India’s foreign exchange reserves now amount to US 600 billion, a decline of US 7 billion. So, clearly the RBI has been intervening in the foreign exchange market to stem the rupee depreciation. It therefore appears plausible that the unexpected increase in the policy rate was done to defend the currency against further depreciation pressures.

So, there are two potential explanations for the RBI's sudden move. Both have rationales, but both also have costs. Consider the first possibility, that the RBI has now radically revised its inflation forecast (without of course releasing the same). Inflation targeting works best if monetary policy is predictable, with interest rate actions being announced on a regular schedule, based on clearly-explained inflation forecasts. On the contrary, sudden moves convey the message that the RBI is getting worried that it is no longer in control of the inflation situation, which is hardly a reassuring signal to send to the markets.

Next, consider the possibility that the RBI wanted to keep the exchange rate stable. The problem is that India is facing an adverse terms of trade shock in the form of rising oil prices, which is putting pressure on the current account deficit. If the RBI allowed the exchange rate to depreciate in response, this would alleviate the current account deficit. Perhaps more importantly, depreciation would help the nascent recovery by ensuring that exports can continue to grow, despite the difficult international circumstances. And there is the additional problem that targeting the exchange rate violates the RBI’s legal mandate.

The RBI now faces a difficult task in the months ahead. At the broadest level, it needs to address the costs of its surprise announcement by reinforcing the credibility of the inflation targeting framework. Specifically, it will need to focus – and be seen to focus – squarely on its inflation target, rather than exchange rate or other objectives. And it will need to convince the public that it is actually trying to get inflation under control.

To do this, it will need to continue to tighten policy – but in a gradual, predictable and transparent manner.

Why RBI must heed inflation

Indian Express, March 29, 2022

The Reserve Bank of India is an inflation targeting central bank. It is legally mandated to keep inflation in check. Yet the RBI has persisted with its easy monetary policy, even as inflation pressures have increased. We need to understand why, and what could be the repercussions.

Let's first ask, is inflation a problem in India? Indeed, it is. For most of the past two years, CPI (consumer price index) inflation has been hovering close to the 6 percent upper threshold of the RBI’s target band. Inflation averaged 6.1 percent during the pandemic period (April 2020 to June 2021), despite a massive collapse in aggregate demand. It then dipped somewhat as food prices eased, but underlying inflation (i.e., core inflation, excluding food and fuel items) has remained around 6 percent for the last twelve months. Then in January 2022, as food prices recovered, headline inflation once again crossed the upper threshold of the RBI's inflation targeting band.

Inflationary pressures do not seem to be diminishing either. Instead, they continue to build up. The standard measure of inflation "in the pipeline" is WPI (wholesale price index) inflation, since price increases at the wholesale level tend to translate into retail inflation in due course. And the WPI is sounding a loud alarm. Between April 2021 and February 2022, WPI inflation averaged 12.7 percent, the highest in more than a decade.

The problems do not stop there. Russia’s invasion of Ukraine has resulted in a sharp increase in global commodity prices, including prices of crude oil, edible oils, and fertilisers. At the same time, a resurgence of the Covid-19 pandemic in mainland China and Hong Kong has led to shutdowns that will further constrain supplies of raw materials. Even if the war and the pandemic in China both subside soon, their effects will not. Sanctions on Russia are likely to remain for some time, while it will take a while for China to clear the backlog of orders that the shutdowns have caused.

Indian firms are already adapting to this situation, passing on the commodity price increases to retail prices. We have reports of double-digit increases in the prices of consumer goods (FMCG) as well as in the real estate sector. Even though the government continues to suppress domestic pump prices, prices of petrol, diesel and cooking gas have gone up in major cities.

Standard economics gives us a guide for how central banks should react in a situation like this. It says that monetary policy should accommodate the first round of commodity price increase, but only under certain conditions, notably that inflation is initially on target, and expectations are firmly anchored. But neither condition holds at present. Inflation is already too high, and so are expectations. As of January 2022, 68 percent of households surveyed by the RBI expected prices in the 1-year ahead period to increase more than the current rate, up from 63 percent one year ago; more than 57 percent households expected cost of services in the 1-year ahead period to increase more than the current levels, up from 51 percent one year ago.

In some quarters, an argument is nonetheless being made that monetary policy should not be tightened when inflation is driven by supply-side factors, as it can adversely impact growth. This is fallacious; it has things exactly backward. When there are supply constraints, using easy monetary policy to boost demand is not going to boost output. It will only create a situation of excess demand, pushing up prices even further. And if firms are expecting high inflation, this will send things into a vicious spiral, as they will increase their prices even more in advance of any input price pressures.

Surely the RBI is aware of all of this. So why is it still not acting on it? To answer this let’s take a step back and look at what is happening globally.

The RBI is not the only central bank that is not reacting to inflation. In the US, the Federal Reserve has been slow to raise rates even as inflation has reached a four-decade high. The ECB in Europe has been even slower to react. The problem seems to be that governments all over the world are worried about growth. They are hoping that central banks can somehow solve this problem, since government debts are at exceptionally high levels. Until governments accept that reviving growth is their responsibility, not that of the central banks, and especially not when inflationary pressures are on the rise, central banks will not be able to focus on inflation.

In India, monetary policy also suffers from a strong fiscal dominance. As a result, not only is the RBI expected to support growth, it is also expected to keep the government’s borrowing costs in check, which is in direct conflict with its inflation targeting objective.

What are the repercussions of the RBI ignoring inflationary pressures? A decade ago, we were in a similar situation where inflation had started increasing but the RBI delayed its response because it was focusing on growth. When inflation subsequently took off, it reached double digits and the RBI had to raise interest rates aggressively to bring it down. That was a very painful adjustment. We do not need a repeat of that episode now. In other words, we need to recognise that high inflation is the real threat to growth, not a prudent monetary policy tightening.

In addition, if the RBI does allow inflation to take off, there will be long-lasting repercussions for the credibility of the RBI. Inflation control requires anchored inflation expectations. But if the public see the RBI consistently ignoring inflation, expectations can rapidly get unanchored and then it becomes very costly to bring inflation down.

In summary, inflation is best addressed by the central bank using monetary policy, not by the government adjusting taxes. The RBI needs to urgently revisit its inflation forecast and its monetary policy stance in order to avoid potentially painful adjustments down the road.

Monetary policy: Losing clarity on instruments and goals

(with Harsh Vardhan), Times of India, February 15, 2022

After the Union Budget, economists as well as financial market participants eagerly waited for the Reserve Bank of India to announce its strategy for the coming fiscal year. On February 10, the Governor and the Monetary Policy Committee (MPC) duly outlined their approach. These statements, however, only raised more questions than they answered.

Before the pandemic began, monetary policy was straightforward. The RBI’s objective was clear, as it had a legal mandate under the Inflation Targeting regime of ensuring that consumer price index inflation remained within a 2-6 percent band. Accordingly, at each Policy Review the MPC would set the repo rate at the level it thought would be sufficient to achieve this target. All other interest rates were sideshows, because they were automatically adjusted whenever the repo rate was changed.

Since the pandemic however, the RBI’s operational strategy has changed dramatically. The repo rate has ceased to be the policy instrument, being replaced by the reverse repo rate, i.e. the rate at which banks park their short-term liquidity with the RBI. At the same time, other rates have become detached from the policy rate. So, there is no longer one clear measure of the policy stance, making it difficult to understand what strategy the RBI is pursuing.

After the February 10th review, this confusion has only deepened. Here we highlight four areas of particular ambiguity.

First, it is unclear whether the RBI is maintaining its stance – or tightening it. The official settings have not been changed. But at the same time the Governor emphasized that the effective reverse repo rate has increased from 3.37 percent in August 2021 to 3.87 percent in February 2022, suggesting that behind the scenes policy is being tightened.

How is the RBI doing this? Over the past few months, it has introduced a new facility, the variable reverse repo rate (VRRR) auction. The RBI is now absorbing liquidity under two facilities at two different prices – the reverse repo, with a rate of 3.35 percent, and the VRRR, with a rate of 3.87 percent. Markets expected this anomalous situation to be regularised at the Policy Review, through an increase in the reverse repo rate. But this did not happen. So markets are now confused: what is the RBI’s policy rate?

Second, markets are confused about the RBI’s liquidity stance. During the pandemic period, the RBI injected massive amounts of liquidity into the banking system by buying government bonds, and then stopped as the situation improved. Presumably, the next step would be to wind back the excess liquidity it had created. That would require selling some of the bonds it has accumulated, putting upward pressure on the rates on government securities. Alternatively, it might want to contain G-Sec rates to support the government’s large borrowing programme, but this would entail buying more government bonds, adding to the excess liquidity and risking higher inflation. So, which way is the RBI planning to go? The RBI did not say.

Third, the RBI tried to shed some light on its stance by stating that it will remain accommodative. But this statement has been stripped of much of its meaning. The RBI’s stance has remained “accommodative” across the last 12 meetings, even as it has gone from reducing the reverse repo rate to raising the effective rate, and from injecting liquidity to containing liquidity. So, what precisely does "accommodative" mean?

Finally, the RBI has indicated that it is comfortable with the inflation outlook, predicting that CPI inflation will be 4.5 percent in 2022-23. But can it really be that comfortable? Developed countries are experiencing their highest inflation in four decades, with inflation in the US now running at 7.5 percent. As a result, India faces the risk of importing high inflation. In particular, since the last time retail oil prices were raised, global crude oil prices have increased from USD 75 to USD 90 per barrel. If this increase is passed on to consumers, inflation is bound to rise.

Meanwhile, the Union Budget has announced that it plans to stimulate aggregate demand by increasing capital expenditure, at a time when private sector activity has started to revive. But if the pandemic continues to restrain supply, a significant increase in aggregate demand will only intensify inflationary pressures.

So, there is a real risk that inflation will be far higher than 4.5 percent. If so, what will the RBI do? Again, the market has no idea.

The end result is considerable confusion. It is unclear whether the RBI is committed to low inflation – or to coming up with highly dovish forecasts in order to support the government’s stimulative policy. Nor is it clear what the instruments of monetary policy are, as the repo rate and now the reverse repo rate have lost relevance. So what is the policy rate, and where is it heading? No one knows.

The Governor quoted a line from the late Ms Lata Mangeshkar’s famous song "Aaj Phir Jeene Ki Tamanna Hai". It is wise for us to remember the second line of the song “Aaj Phir Marne Ka Iraada Hai” and note that Tamanna means desire and Iraada means intention!

Budget 2022-23: Hits and misses

Budget 2022-23: Hits and misses, Ideas for India, February 14, 2022.

RBI’s dilemma: Let prices rise or interest rates?

Times of India, February 8, 2022

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.

Why it’s not time to cut taxes

Indian Express, January 31, 2022

With the Union Budget round the corner, many people hope that taxes will be cut to boost private spending and growth. While ordinarily this might be a good idea, there are four main reasons why tax cuts are not prudent now.

First, the strong revenue performance during 2021-22 gives a misleading impression of the government’s fiscal position. Revenues this year have benefitted from some exceptional factors: (i) strong profit growth in the private corporate sector, led mostly by the large firms; (ii) robust collections from the Goods and Services Tax (GST); and (iii) rapid GDP growth. The crucial question to ask is what might happen to these factors in 2022-23. And here we run into some difficulties.

It is risky to assume that corporate profit will continue to grow rapidly going forward. This is because we do not yet fully understand what led to the growth in 2021-22. If we look at the data of listed non-financial, non-oil firms in the private sector, we find that by June 2021, their profit margins were higher than the pre-pandemic period. This could have been the result of an increase in their market share, given that the smaller firms bore the brunt of the pandemic. The larger firms also took emergency measures to cut costs. It is not obvious that as the pandemic recedes, the same trend will continue in 2022-23. If it does not, then corporate tax growth would not be as high as in 2021-22.

In addition, GST growth is likely to slow down. In 2021-22, average monthly collections increased to Rs 1.2 trillion from Rs 0.94 trillion in 2020-21. This increase was mostly on account of resumption of economic activity. GST on imports also played a big role, fuelled by an import boom and higher tariffs. It is unlikely that we will witness a similar import boom next year.

As the recovery period ends and the economy normalizes, GDP growth will slow down too. The main engine of growth for an emerging economy like India is private sector investment, which still shows no signs of acceleration, even as the broader economy recovers. Another engine of growth is exports. While India experienced an export boom in 2021-22, as the developed countries normalise their macro-policies, the global exports boom will diminish, and this will impact India as well. Hence it is not certain where a high GDP growth will come from in the next fiscal year.

All these factors lead to uncertainty about tax revenues.

Second, the fiscal deficit, targeted at 6.8 percent of GDP for 2021-22, continues to be very high. There is little room to cut spending, since demands for social spending such as on NREGA remain high, interest payments continue to be a big component of expenditure, and there is mounting pressure on the government to increase capital expenditure. There is consequently no room to provide tax relief without imposing further pressure on the deficit. Nor is it a good idea to allow the deficit to increase. Government’s total debt has already reached 90 percent of GDP, the highest ever, and there is significant pressure on the bond yields to go up, which would make it costlier for everyone to borrow.

Third, the pandemic has caused supply shortages the world over. In India too we have been experiencing supply chain bottlenecks. In a supply-constrained environment, any attempt to boost demand by increasing households’ after-tax income would lead to inflation. This is exactly what has been happening in the US and other developed economies. In India, CPI inflation has been running at 5-6 percent, close to the upper limit of the RBI’s target band. And already there are pressures for inflation to go up, coming from rising oil and commodity prices. Tax cuts and the resultant increase in spending might push inflation beyond the limit, forcing the RBI into an uncomfortable choice: raise interest rates sharply at a time when the recovery is beginning or allow inflation to tax the country’s poor.

Finally, globally we are entering into a period of macroeconomic uncertainty. The US economy is experiencing its highest inflation in 40 years. The US Fed will consequently raise interest rates this year. When the developed world pulls back their expansionary policies, it is important for emerging economies like India to display strong macroeconomic fundamentals, and for the government to come across as credible.

One of the key reasons India was badly affected by the Taper Tantrum episode of 2013 was because it was doing poorly on macro fundamentals. In a way, the situation now is not very different. Once again, we are running a high fiscal deficit and the real interest rate is negative because inflation is higher than the policy rate. True, inflation is lower than it was in 2013, but the government debt ratio is substantially higher. Hence, the government needs to be somewhat careful about its fiscal math.

With state elections coming up, it might be tempting for the government to slash taxes and win votes. But given its own fiscal limitations and the uncertainty surrounding India’s growth and inflation trajectories in the next fiscal year, this would not be a prudent call.

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.

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.

Covid-19 crisis: Response should not undermine institutions

Covid-19 crisis: Response should not undermine institutions, Ideas for India, December 15, 2020.