The policy seeks to reassure bond markets while hoping a good crop and fixing Covid-bottlenecks will ease inflation
Reserve Bank of India (RBI) Governor Shaktikanta Das knows his top priority is to ensure the government’s borrowings for 2020-21—of which a third remain—go through smoothly. And that he simply cannot afford to spook the bond markets at this juncture. Not surprising then that the central bank’s stance remains accommodative and that the language is one that comforts and reassures even though the inflation projections are now a lot worse. Clearly, there are going to be no more rate cuts for at least a year now, or maybe even longer, but the bond markets are satisfied with rates remaining low for a longer time; they too know interest rates are bottoming out.
This is pretty much in sync with what central banks across the globe are doing, i.e., ensuring an abundance of liquidity. There are, no doubt, risks to this approach—runaway inflation, for one, since it is not just food prices but also core inflation that is turning sticky. RBI said in its defence that it was aware of potential inflationary pressures building up, but that a large part of inflation right now is still emanating from supply-side deficiencies and from high margins charged by retailers.
It believes the element of inflation that could create trouble is relatively small, and is confident that the arrival of the kharif crop would help. It is true that full restoration of the supply-chains could help lower retail margins and that deposits with banks could taper off as consumers regain confidence and start spending. However, the inflation projections, even for 6-8 months out, are way above 4% which is the mid-point of the MPC target). So, while the Governor asserted inflation targeting has not been junked and that taming the rise in prices is still a priority, RBI is clearly looking the other way since it is determined not to upset the borrowing programme and also the sumptuous profits that banks will make on their bond portfolios.
This is not a bad strategy. Indeed, the stance is justified at this juncture when the economy is struggling to keep its head above water. While the Q3FY21 GDP numbers may have been better than expected and consumer spends in the festive season have been reasonably good, it would be foolhardy to believe we are out of the woods. RBI may have upped the GDP growth forecast to a negative 7.5% for FY21 from a contraction of 9.5%, but Governor Das is not fooled; he knows fully well the recovery is not broad-based and is a fragile one. And, therefore, it is critical the government is able to borrow at affordable rates and put the money to work at a time when the stimulus has been a small one anyway and banks are most reluctant to lend.
While the dangers of excess liquidity—of some `6 lakh crore sloshing around in the system—are well-known, RBI has done well to bat for revival. Indeed, for many sectors of the economy, it is a question of survival. And, therefore, even if inflation remains elevated or gets entrenched or if some assets do get mispriced—which is very likely—we need to be able to live with that. Given how the low interest rates have helped companies raise money from the corporate bond markets and boosted retail loans at banks, one understands RBI’s reluctance to let yields harden just yet.
In fact, since it is primarily the AAA companies that are mopping up the money, it is just as well the spreads are low, and if banks, too, are participating in the bond markets, that is not a bad thing. Any knee-jerk measures to soak up liquidity would have unnecessarily upset the markets, and in any case, the central bank can, at its own pace, quietly start sucking out liquidity if it feels the need to do so. It probably will soon enough—post-January, once the government has finished borrowing.
But, it is important for the rest of the crowd—lenders, borrowers, fund managers and treasurers—to understand why RBI has chosen to remain dovish. It is because the durability of the recovery is uncertain and could lose momentum post the festive and wedding seasons. Only in March or so would we have a better idea. The concern is that if inflation was to remain high and yields were to harden next year—which seems inevitable right now with commodity prices like steel and crude oil inching up—how is the government going to borrow next year?
s NNN After all, the bounce-back in the economy in FY22 is not expected to be meaningful, coming as it would on a contraction of 7.5-8% in the current year. Consequently, the deficit—and market borrowings—will remain elevated as the government attempts to spur growth. It is critical that the government works overtime to address supply-side issues and keep prices in check; otherwise, it could be challenging for RBI to hold the yields at affordable levels. Strange as it may sound, a temporary moderation in foreign portfolio flows could be a blessing in disguise.