Economy, foreign exchange, and bonds – A balancing act

Rarely do policymakers ever have it easy. Even so, the particular context that the Reserve Bank of India (RBI) now faces is perhaps trickier than usual. This piece considers the context around inflation and the real economy, and then explores possible options for the RBI around monetary policy, foreign exchange intervention, and bond markets.

An Uneven Recovery

India’s economic recovery from COVID-19 has been brisk, but uneven.

India’s vaccination drive is gathering steam, and we will hopefully avoid a COVID-19 second wave. Consumption has recovered and sustained — witness robust GST collections for the past five months — even before all services fully resume. Government spending continues. With all this, listed companies have registered excellent results over the past two quarters.

Yet, there is much distress among swathes of MSMEs and contact-based services, besides chronic stresses in sectors such as financial services, power, real estate, telecom, and airlines and shipping. There is a sharp divide between the haves and the have-nots, and sustained economic reform and recovery is needed to bridge this chasm.

Inflation Worries

Somewhat paradoxically, there are worries around domestic inflation. Rising global food, energy and commodity prices, disruptions in global supply chains, strong growth in domestic and international M1 money supply, healthy rural demand, sticky core inflation, and high fiscal deficits all portend that inflation in FY22 may well trend above MPC estimates.

This does seem ironic, given our substantial idle capacity and underemployment. In the past, however, our supply-side response has often disappointed. Between 2009 and 2013, for instance, amidst robust consumption, government spending, and private investments, we faltered in our domestic output growth and job creation. Over time this led to twin deficits and inflation, and eventually to financial instability, triggered by the taper tantrum of 2013.

Jobs, Output and Aatmanirbhar Bharat

The situation now is not comparable with 2009-13. For one, there is now a strong focus on raising domestic output and jobs through Aatmanirbhar Bharat, in contrast to the policy paralysis of 2009-13. On the flip side, however, the levels of public debt, and the chronic stresses in crucial sectors of the economy are worse now than it was then.

The strength and sustainability of our economic recovery now squarely depends on our success in increasing domestic output and employment, rather than on monetary policy. Nevertheless, monetary authorities will have to work with what they have.

RBI and Inflation

The RBI is walking a tightrope, trying to manage inflation and a volatile global context, while nurturing economic revival and managing the government’s large borrowing programme.

What can monetary authorities do to control inflation?

M1 money supply — the sum of currency in circulation, and banking current account and savings account balances — is money that is readily available for consumption and asset purchases. This has grown by 20.3 percent year-on-year. The broader (and slower) M3 money supply — which includes banking term deposits as well — has grown by 12.6 percent YoY.

To control inflation, economists might prescribe slowly reducing banking liquidity surpluses (to nudge banks away from lending) and increasing interest rates (to make loans more expensive, and to nudge M1 money into term deposits). They might argue that reducing credit growth would reduce growth in money supply, and less M1 could help control the velocity of money.

Before we use such thumb rules, it is important to understand the context. Over the past year, the RBI data shows that M3 money supply has grown by Rs 8.9 lakh-crore due to bank funding of government deficits, by Rs 7.4 lakh-crore due to FX inflows, and only by Rs 3.2 lakh-crore due to growth in bank credit.

The standard monetary prescriptions that target credit growth ignore the real causes behind growth in money supply. Would we really wish to curb private credit growth when it is at only 6.6 percent YoY, even before signs of a credible uptick in private investment?

Equally important and less appreciated, higher short-term interest rates in today’s context can paradoxically increase money supply, and the risks to financial stability.

RBI and FX Flows

In FY21 till December 2020, Observatory Group estimates that net durable foreign currency inflows across current account surpluses, FDI, and FPI in equity amounted to $100 bn.

During the same period, the RBI data shows that it mopped up nearly $120 bn through its intervention purchases of foreign currency, across spot and forward markets.

The difference of $20 bn can be attributed to less durable ‘carry’ inflows. When the rupee interest rates are seen as high in relation to global yields and expected rupee depreciation, exporters sell foreign currency in forward markets, domestic borrowers leave their foreign currency liabilities unhedged, and foreigners opportunistically sell foreign currency to purchase rupee assets.

Higher rupee interest rates, therefore, can attract more FX ‘carry’ inflows, and perversely increase domestic money supply. This risk is particularly high at a time of immense global liquidity, even as the US considers an additional $1.9 trillion fiscal package.

In addition, an overhang of opportunistic ‘carry’ flows can bring in undesirable volatility if they were to rush out together, as they did in 2013. In fact, some of the sudden weakness in the rupee recently can be attributed to a partial exit of the carry trade.

FX Flows and Liquidity

In addition, in order to avoid injecting further Rs 3.4 lakh-crore of banking liquidity, the RBI had purchased a record $47 bn of foreign currency in forward rather than spot markets in FY21 till December. Through such intervention, the RBI has effectively placed US Dollar balances with banks, while borrowing rupee from them.

The sheer scale of this intervention, coupled with restrictions on how Indian banks can deploy US Dollar balances, pushed up the effective RBI cost of borrowing rupee through this route to 5.7 percent for 1-year at one point in time, when the corresponding money market rates were at 4 percent.

This implied rate has now come down to 5.25 percent for 1-year, after the RBI relaxed some restrictions on bank deployment of US Dollar balances recently. As yet though, these rates remain well in excess of money market rates.

It would have been much cheaper to withdraw this liquidity via money market instruments such as Market Stabilisation Scheme (MSS) bonds. Worries that the use of the MSS would push up bond yields are not tenable, given the overhang of excess liquidity even now. The preference for FX intervention is perhaps linked to the fact that the MSS issuance has obvious and visible fiscal costs, while the cost of liquidity management through currency markets is opaque and hardly tracked.

In addition, these distortions added to the attraction of the ‘carry’ trade, further drawing in opportunistic foreign currency sellers in FX markets, at a time when the RBI was already grappling with a problem of plenty.

In short, higher short-term rates may actually end up increasing money supply, and the risks to financial stability, depending on their impact on FX markets versus rupee credit markets.

RBI and Bond Markets

The RBI has capped the government’s borrowing costs at historic lows, despite the record high borrowing by central and state governments in a COVID-19 impacted FY21.

In FY21 to date, the RBI has net purchased over Rs 3 lakh-crore of government bonds. In addition, by keeping banking liquidity in consistent surplus and easing accounting rules around bond valuation, it has nudged banks to increase their holdings of government bonds by a record Rs 7.4 lakh-crore in FY21 so far.

The experience of FY21 underscores the RBI’s immense capability to similarly finance future government fiscal deficits. The question is, should it continue to cap long-term interest rates, in the evolving context?

This is admittedly a tough call to take. Lower long-end rates would indeed help revive investments. As an example, the SBI’s recent offer of housing loans at 6.7 percent augurs well for housing, construction and employment.

However, low long-term rates at a time of uncertain inflation prospects also represses savers. Weighted average banking term deposit rates fell to a record low of 5.46 percent as of January 2021. Especially on a tax-adjusted basis, this is far lower than the 6.3 percent average CPI inflation over the past year.

Such low deposit rates likely help account for the sharp 20.3 percent growth in M1 money supply, as savers wait for better — and often riskier — investment opportunities. Some part of the ‘irrational exuberance’ around asset prices that policymakers fear can be traced back to this.

One way out of this imbroglio might be for the government to attract money directly from savers, perhaps by offering a limited window of attractive tax-adjusted rates on their borrowings. As an example, a window of 7-year government borrowing — only for retail savers — at say 6 percent tax-free, might draw in significant amount of retail savings and reduce the need for banks and the RBI to fund the government. This would also help curb money supply, asset price inflation, and the velocity of money.

Summary

The RBI is currently walking a tightrope, as it confronts fears of inflation and an uncertain global context, even as it tries to nurture our economic revival while capping borrowing costs.

Much of our prospects around inflation — and indeed around the strength and sustainability of our economic revival — depends on how our real economy responds over time with more domestic output and jobs through Aatmanirbhar Bharat. In contrast, monetary policy may have a much more limited role to play here.

As yet, credit growth in the economy is muted, and much of the growth in money supply relates to bank funding of fiscal deficits and to net foreign currency inflows. Before drawing out banking liquidity and pushing up short-term rates, policy-makers would have to weigh the potential impact on credit growth against ‘carry’ foreign currency inflows. On balance, despite inflation risks, short-term rates may have to stay low for longer, until there are clear signs of a revival in credit growth, alongside a healthier external balance.

The RBI should perhaps desist from distorting foreign currency forward markets, which is currently leading to higher (but hidden) costs of liquidity sterilisation, in addition to increasing risks to financial stability by drawing in opportunistic and reversible ‘carry’ flows.

Finally, the RBI’s capping of government bond yields and facilitating funding of the government deficit may arguably help revive private investments. However, this is taxing long-term savers, pushing them into riskier assets, and perhaps keeping M1 money supply high.

A limited window of the government borrowing long-term directly from savers at attractive post-tax rates might help keep term borrowing costs low, offer savers some respite, and help control the velocity of money.