India RBI watch: Life in an ‘unconventional’ world
December 2, 2020 7:00 AM
Unconventional easing globally suggests that inflows could remain elevated, requiring RBI to juggle between objectives; it may be well served by keeping the repo rate unchanged at 4% in the December 4 policy meeting
Going forward, if RBI doesn’t intervene in the FX market, the rupee could appreciate further, hurting export competitiveness.
By Pranjul Bhandari, Aayushi Chaudhary & Priya Mehrishi
RBI faces a triple challenge of high inflation, elevated government borrowing and large capital inflows. In the economist parlance, RBI’s policy choices have narrowed, as the ‘impossible trinity’ has become more binding. The latter, as per economic theory, suggests that RBI can simultaneously pursue any two of the three—keep the rupee from appreciating, allow large capital inflows, or keep monetary conditions loose.
Let’s start with the first of the three challenges—inflation. The October inflation reading marked the seventh consecutive month of remaining outside RBI’s 2-6% tolerance band (chart 1). The rise in inflation over this period has been led by food, but not just food. While food inflation has contributed 66% to the rise this fiscal year, core inflation has contributed 33%.
The dominant narrative on inflation is that it is led by a weak vegetable crop and lockdown-led supply disruptions. When a new crop is harvested, and the supply economy begins to rumble back into action, these will fade, and low demand will pull inflation down. Alas, it’s been several months and this narrative is not coming to bear. Perhaps it is too simplistic, and the real problem may be deeper.
For instance, we think the disruption in the informal sector, which makes up 50% of GDP and tends to produce essential goods like food and clothing, may have played a role in stoking inflation. True that both the death and the birth rate of informal firms are high, but the period between when they get disrupted and when they reappear may well be one of high inflation.
…Government borrowing is large…
Alongside, public sector borrowing is likely to rise to a record of c16% of GDP in the current year. RBI has stepped up on bond purchases to help the government borrow in a non-disruptive way. To be fair, when possible, it has resorted to ‘operation twist’ (by which it converts its holding of T-bills and other shorter maturity bonds to longer maturity bonds), in order to fund the fiscal deficit without adding to domestic liquidity. But that may not be sufficient in the face of the large borrowing programme*. And therefore RBI has also begun to do fresh OMO purchases for both central and state government bonds.
The problem here is that each time RBI does a fresh OMO purchase, it adds to the already elevated surplus banking sector liquidity. Over time, a large surplus can stoke macro imbalances like inflation, eventually hurting the very recovery it was meant to support.
…But the most pressing problem is the large foreign capital inflows
Finally, foreign capital inflows remain strong. A few months ago, it was led more by FDI inflows, and more recently there is a sharp rise in FII inflows. RBI has been intervening actively. Since early April, RBI’s foreign currency assets have risen by $90 billion. Despite this, the rupee has appreciated 3% in real trade weighted terms in this fiscal year.
Going forward, if RBI doesn’t intervene in the FX market, the rupee could appreciate further, hurting export competitiveness. If it does intervene, it would add to the already elevated banking sector liquidity, stoking inflation worries further.
Indeed, very loose liquidity is one of the reasons the short end of the government yield curve has recently dipped below the reverse repo rate (chart 4). And large foreign inflows have been the main driver of surplus domestic liquidity. Since October, dollar purchases (on the back of strong inflows) have created about three times more domestic liquidity than bond purchases (chart 5).
This, then, narrows down the question to the following: When will these foreign capital inflows stop? What should RBI do in the upcoming December 4 meeting, and beyond?
An unconventional world of policymaking
Fiscal and monetary policymaking around the world has become far more adventurous and unconventional. The last few months have witnessed a dramatic rise in the use of terms such as Modern Monetary Theory (MMT), ‘no more austerity’, QE-infinity, yield curve control (YCC), and so on.
The MMT view of the world suggests that as long as inflation is not a problem, governments should keep spending, and central banks should keep printing.
Some believe that the exit from expansionary fiscal policy in advanced economies happened rather abruptly in previous crises. And this time, the loose fiscal stance should stay for longer. And to make the extra government borrowing non-disruptive for the bond market, and support growth more generally, several advanced central banks have used tools such as QE without bounds and varying forms of YCC.
But what does all of this mean for emerging markets like India?
Implication for EMs: Don’t get carried away
One, perhaps EMs like India should not get too carried away by the unconventional policies that advanced economies pursue. Several advanced economies have established strong institutions over the decades, driven by rules-based policymaking. Perhaps they have earned the licence to be more adventurous.
Back in India, while rules-based policies like inflation-targeting are important reforms, they are still in the early years of implementation. Inflation expectations need to be stabilised further (chart 6).
The cost of high public debt, too, can be meaningful in EMs; ranging from high inflation, to volatile growth and, in some cases, default. For India, the benefits of running loose fiscal policy over time need to be seen in the context of country-specific issues, such as implementation constraints, and weak taxing capacity to lower debt and the deficit easily over time.
Beware the double-edged sword
But even if EMs do not pursue unconventional policy, they would still find themselves at the receiving end of loose policy in advanced economies. And that could turn out to be a double-edged sword.
The good news is that advanced economies would do a lot of the easing for EMs. Loose financial conditions and related economic recovery globally could help EMs both directly (via lower rates and growth enhancing inflows) and indirectly (via recovery in export demand).
But in some cases it could become a policy headache; for instance, if loose policy abroad for long results in a gush of inflows over time, resulting in a host of domestic problems such as inflation.
This, as explained above, is exactly the problem RBI is gripped with.
What should the RBI do in the upcoming policy meeting?
If global policymaking remains accommodative for longer, foreign capital inflows into India could also remain elevated for long. In order to sail through, RBI will perhaps have to strike a balance between its objectives on inflation, bond yields and the rupee. It could do a bit for each but not go overboard on any. This could also be made possible by focusing more on one objective over the other, depending on the more pressing problem of the day. For instance, FII equity inflows shot up in November and RBI focused most on FX market intervention.
Given varying challenges, we believe RBI will also be well served by not making many changes in the upcoming policy meeting. Keeping the repo rate unchanged at 4% yet maintaining an accommodative stance could be a prudent strategy.
RBI may have to update some of its macro forecasts; for instance, mark up the current year inflation forecast (currently at 5.8%) and perhaps also lower the growth contraction for the current year (currently averaging 9.5%). In fact, in a recent report, we are now calling for a lower growth contraction in FY21 (-8.5% y-o-y versus -11%).
RBI may want to share its insights on some matters that continue to confound the market. One, why is inflation so high at a time demand is so weak? Two, is the liquidity glut at the short end expected to linger on for long? What is the central bank’s strategy on it? Three, for how long will recovery need the crutch of excess domestic liquidity? On the last question, we believe monitoring bank credit growth and core inflation are key. If the former picks up (currently credit is only growing 5.7% y-o-y despite broad money growing 12% y-o-y), or the latter sticks on, RBI may want to recalibrate its strategy.
*On our estimate of fiscal deficit, gross market borrowing of the central and state governments would be over Rs 20 trillion in FY21, versus Rs 13 trillion last year.
(Excerpted from ‘India RBI Watch’ report by HSBC Global Research dated December 1, 2020)
Bhandari is chief economist, India, Chaudhary is economist, HSBC Securities and Capital Markets (India) Pvt Ltd; Mehrishi is associate