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.

India's banking sector: a liability for monetary policy effectiveness?

India’s banking sector: a liability for monetary policy effectiveness?, East Asia Forum, October 16, 2020.

With high inflation, capital inflows, currency appreciation, tough decisions are needed

Indian Express, September 16, 2020

In a recently released report, the Reserve Bank of India mentioned that an appreciating currency will help contain imported inflationary pressures. This has given rise to a fervent debate as to whether the RBI is no longer able to handle the Impossible Trilemma. The Impossible Trilemma, an important paradigm of open economy macroeconomics, asserts that a country may not be able to stabilise the exchange rate, and conduct an independent monetary policy when it is financially integrated with the rest of the world.

Policymakers in all sophisticated economies face this trilemma, forcing them to make choices about which targets they are going to pursue. The RBI has tried to avoid these choices: It has tried to pursue all three objectives simultaneously in an especially aggressive manner since the pandemic struck. It has reduced its policy interest rate to negative levels in real terms. It has bought government securities to push down long-term interest rates. It has allowed large capital inflows, then intervened in the foreign exchange market to prevent the appreciation of the rupee. These actions are incompatible, and will eventually generate a serious policy dilemma.

Budget estimates of tax revenue for 2020-21 of Rs 16.3 lakh crore were already an ambitious target over the previous year’s revised estimates of Rs 15 lakh crore. It was based on a nominal GDP growth projection of 10% made before Covid-19 hit India.

One of the corners of the trilemma has to do with capital inflows. In the first few months of the pandemic and the associated lockdown, the Indian economy witnessed a net outflow of foreign portfolio investment (FPI). However, this trend has reversed in recent months, as policymakers in the developed world have adopted stimulative measures to revive their economies, creating excess liquidity in global financial markets.

Between June and August, Indian capital markets received a net FPI inflow of close to $10 billion as foreign investors returned to the stock market. In September so far, for the first time in the last six months, inflows into the debt market have turned positive. India also received close to $17 billion of foreign direct investment (FDI) during April-July. Capital has also been flowing to India in the form of external commercial borrowing (ECB) by Indian corporations.

At the same time, the combination of weak economic growth, lacklustre domestic demand, and low oil prices have shifted the current account balance from deficit into surplus. Imports have fallen more than exports suggesting that India is doing worse than its trading partners. These factors have changed the balance of supply and demand in the foreign exchange markets as a result of which the currency has begun to face appreciation pressures against the dollar.

This brings us to another corner of the trilemma — currency stability. In the face of rising appreciation pressure, the RBI has been actively intervening in the foreign exchange markets to prevent the rupee from strengthening further. It has been buying dollars both in the spot and in the forward markets. In May and June, RBI’s net dollar purchase in the spot market was to the tune of $14.4 billion. In June, its net purchase in the forward market was more than $4 billion. As a result of the RBI’s currency trading, India’s foreign exchange reserves have increased by around $80 billion since January, to reach an all-time high of $540 billion.

When the RBI buys dollars in the FX market, it sells rupees. This increases the domestic money supply and is therefore inflationary. In order to counter this inflationary pressure that is being generated by RBI’s FX interventions, the central bank will ideally sterilise its interventions. This entails the RBI selling government bonds to banks and in the process absorbing excess rupee liquidity from the system.

But the RBI has not been absorbing the liquidity created through dollar purchases, it has been adding to it by buying government securities through its open market operations and targeted liquidity injection programs such as the T-LTRO. In the last couple of months, some of these operations have been neutral, such as the Operation Twist programme wherein the RBI buys long-term government securities and sells short-term bonds in order to lower the yields on the longer end of the maturity spectrum. But in total, the net bond purchase by the RBI has been positive. This implies that instead of sterilising its FX operations, the RBI is adding further liquidity into the system through its bond market interventions. As a result, liquidity has soared, reaching as much as Rs 8 trillion at one point.

For the moment, this injection of liquidity may not get readily converted into broad money because the growth of credit to the private sector has been weak, depressing the money multiplier. But if the RBI continues to ignore the Impossible trilemma, it will eventually fail. There are two main ways this could happen: It might need to give up on its exchange rate objective, as the recently released report hints. Or it might need to give up on its inflation objective.

Both would be problematic. Exchange rate appreciation will further damage the already hard-hit export sector. But allowing high inflation is even more of a problem in a country where the RBI has committed to the public not to allow a repeat of what happened after the last global financial crisis, when inflation soared to double digits.

Already, the constraints of the trilemma have tightened. Retail inflation has now breached the upper limit of 6 per cent for more than three quarters. Core inflation has been rising and inflation expectations have jumped sharply. And while credit to the private sector remains depressed, credit to the government has been strong, implying that overall broad money is growing rapidly. The time for difficult decisions seems to be approaching.

India’s fiscal crisis can only get worse as tax revenue is seen dropping 12.5% in 2020-21

The Print, September 4, 2020 (with Ila Patnaik)

Data released earlier this week shows a contraction in Goods and Services Tax collections in August. The decline in tax revenue was to be expected. Since Covid-19 hit India, economic activity has been lower due to the lockdown. Lower economic activity means lower production and thus lower taxes. Based on expectations of lower activity, we expect tax revenues to decline by about 12.5 percent for the year as a whole.

The data on GST released earlier this week showed that the gross GST revenue collected in the month of August, 2020 was Rs 86,449 crore, 12% lower than the collection of August 2019.

Budget estimates of tax revenue for 2020-21 of Rs 16.3 lakh crore were already an ambitious target over the previous year’s revised estimates of Rs 15 lakh crore. It was based on a nominal GDP growth projection of 10% made before Covid-19 hit India.

With the outbreak of the pandemic and the subsequent nationwide lockdown, nominal GDP growth and tax collections are expected to be lower. In a recent paper, we estimate the tax revenue for 2020-21 based on the lower expected growth.

Due to the pandemic, the economy is facing the twin shocks of widespread supply-side disruptions and large-scale reductions in aggregate demand. Although there has been a gradual relaxation in the lockdown from June 2020 onwards, the economy has been coming back to life only slowly (LINK limping back to normalcy ) since then. While rural areas opened up relatively quickly, urban India continues to see lower economic activity. Consequently, in the April-June quarter of 2020, India’s GDP contracted by 23.9%.

Nominal GDP growth will be zero

The central government earns revenues from five main types of taxes. The sum total of revenues obtained from these taxes is referred to as the Gross Tax Revenue (GTR). These include direct taxes such as tax from corporate profit and income tax (accounting for roughly 28% and 26% of GTR, respectively), indirect taxes such as GST, customs duties from non-oil imports and Union excise duties from oil imports (accounting for roughly 28%, 6% and 12% of GTR, respectively).

We project the GTR for 2020-21 using a bottom-up approach. We start with the individual components of GTR (i.e. Corporate tax, Income tax, GST, Customs duties, and Excise duties) and calculate the long term averages of the ratios of these components to the relevant aggregates such as nominal GDP, corporate profit, imports etc. Then, we multiply these long-term average ratios, with the projected values of the relevant aggregates for 2020-21.

Although it is difficult to come to a precise forecast of GDP due to the continuing uncertainty about the pandemic, a real GDP growth rate of -5 per cent for 2020-21 is what a number of economists and analysts expect. Consumer price index (CPI) inflation can be expected to be 5 per cent, given the recent surge in inflation. This gives us an expected nominal GDP growth rate of zero.

Tax collections won’t be same as last year

In other words, we anticipate that nominal GDP in 2020-21 will remain the same as in 2019-20. We expect that tax collections this year will be lower than last year because of the pandemic. Thus, instead of assuming that at the same nominal GDP levels, we get the same income tax and GST revenue as last year, we expect that these tax collections will be in line with the long-term average ratio.

Applying the average income tax-to-GDP ratio of the last nine years (since 2011-12 when the new GDP data became available) to the projected nominal GDP, we get a 7 per cent decline in income tax revenue for 2020-21. Similarly we get a decline in GST of 4.1 per cent.

We expect that corporate profit will fall by 20 per cent in 2020-21 compared to last year. Profits of the NIFTY50 companies listed on the National Stock Exchange fell by 15 per cent in the January-March quarter. The situation is likely to worsen significantly in the April-June quarter owing to the lockdown. Even if sales and profits improve later in the year, overall, we expect a 15 per cent decline in corporate profits for this year. This gives us a projected decline in corporate tax by 17.6 per cent.

In March, non-oil imports fell 21 per cent and in April, by 41 per cent. Accordingly, in our baseline scenario, we expect non-oil imports, and hence Custom duties, to fall by 20 per cent for the year as a whole. Finally, the value of oil imports may be expected to fall by 30 per cent owing to the reduction in oil prices. This gives us a decline in excise tax revenue by 22.2 per cent.

Our projections for the growth rates of the various components of GTR for 2020-21 are summarised in the table below. We predict that GTR will contract by around 12.5 per cent.

Financing the budgeted expenditure of Rs 30 lakh crore estimated in the Union Budget 2020-21, as well as the Covid-19 fiscal package, was already a challenge. With the additional challenges that lower tax collections pose, this is going to be an even bigger challenge.

The impact of the pandemic and the associated lock down is highly uneven. While some sectors (e.g. hospitality, aviation, automobiles) have been severely impacted, the shock to some other sectors (e.g. pharmaceuticals and fast moving consumer goods) has been modest. Some sectors (e.g. telecom, internet based services) have benefitted from this episode. Even within a sector, businesses have experienced varying degrees of stress depending on their size, financial constraints, geography of their operations, etc. Restructuring must be permitted only for those firms that have been badly hit by the pandemic and not to those who were financially stressed before the outbreak of Covid-19.

Analysing monetary policy statements of the Reserve Bank of India

Analysing monetary policy statements of the Reserve Bank of India , (with Aakriti Mathur), VoxEU, September 3, 2020.