RBI policy pickle and rupee risk

This is an expanded version of my MINT column published today:

The Reserve Bank of India (RBI)’s recent policy announcements have cast some cloud over the central bank’s well-deserved reputation for professional competence and integrity. To set the context, in its sixth monetary policy meeting of 2017-18, the monetary policy committee (MPC) of RBI had projected an inflation rate of 5.1%-5.6% in the first half (H1) of 2018-19, dropping to 4.5% to 4.6% in the second half (H2). In the April meeting, it had lowered this forecast to 4.7%-5.1% in 2018-19 H1 and 4.4% in H2. Risks to the inflation were said to be pointed to the upside.

With respect to the growth in Real Gross Domestic Product (GDP), the MPC had maintained its forecast unchanged at 7.4% but has slightly increased the upper end of the possibility in 2018-19H2 to 7.6% (vs. 7.4% earlier). It had lowered the range for H1 slightly. It did not matter to the overall forecast. This was a ‘goldilocks’ revision: faster growth than in 2017-18 and lower inflation forecast than earlier.

Then, on 27th April, RBI announced a relaxation in the norms (all-in costs and eligible borrowers) for external commercial borrowings. On 1st May, RBI announced some relaxation in the norms for investment by foreign portfolio investors (FPI) in Indian debt. FPI can now buy bonds with residual maturity of less than one year across government and corporate issuers subject to a ceiling of 20% of investment by that FPI across all categories of bonds. On 4th May, RBI announced that it would conduct Open Market Operations (OMO) to the tune of INR100bn (INR10,000 crores). Through OMO, the central bank buys government bonds and credits the accounts of the banks from whom it buys. It will help increase liquidity in the economy.

In a research note published on the 8th of May, economists at JP Morgan India estimate that cash to GDP ratio is rising, presumably due to improvement in the rural economy. This demand for cash is unlikely to be met by RBI buying foreign exchange and letting domestic money circulation rise because India they do not expect strong foreign currency inflows this year. Even though net portfolio investment flows in the first nine months of 2017-18 have been much stronger at USD19.84bn vs. USD3.19bn (same period for 2016-17), the high and rising trade deficit and the persistence of oil price per barrel in the seventies of U.S. dollars will see to that. Further, on a net basis, foreign direct investment (FDI) as per RBI Balance of Payments (BoP) statistics for the first nine months of 2017-18 at USD23.73bn has been lower than USD30.57bn for the same period in 2016-17. Finally, in September 2017, RBI reported that India’s external debt with residual maturity of less than one year amounted to USD120bn (appx.), net of NRI deposits. Hence, RBI has to engage in OMO to the tune of INR1.1trn (110,000 crores) in the current financial year, according to JP Morgan.

Generally, money demand function is hard to estimate. Hence, money demand is only indirectly perceived through money supply. Base money expansion happens based on assumptions of nominal GDP growth, velocity of circulation of money, mainly. If the central bank perceives the need to do OMO, then, it is a sign that it is accommodating demand for cash, rather than letting interest rates rise. The currency in circulation and demand deposits with banks have grown at a compounded annual growth rate (CAGR) of over 12.2% in the last four years (end-March 2014 to end-March 2018). That is somewhat higher than the 10.5% CAGR in nominal GDP during the same period.

Therefore, market participants have correctly concluded that RBI is interested in holding down the government borrowing cost. That is only going to further aggravate the issue of inadequate demand (inadequate demand at five government bond auctions in as many weeks) with the bonds eventually ending up in RBI balance sheet. If bond yields does not compensate for inflation, then banks won’t be interested holding government debt securities more than is required under statutory requirements.

OMO may help hold down the government borrowing cost but only for a while. Between 2012 and 2013, the 10-year Indian government bond yield did come down from around 9% to 7.5%. But, if one expanded the window to the period between 2009 and 2014, the 10-year bond yield went from 7% in March 2009 to 8.8% in March 2014. In this period, the net RBI credit to the Government (and this, on paper, includes State governments too) ballooned from Rupees 61,580 crores to Rupees 698,710 crores – that is more than eleven times. Inflation raged for five years and the rupee did a cliff-dive in 2013. RBI had to content itself with writing a long chapter on fiscal dominance of monetary policy in its Report on Currency and Finance for the period 2009-12.

To the credit of this government, it has been fiscally far more prudent than its predecessor. Internal market borrowing (including amounts borrowed from National Savings Schemes) have grown at CAGR of 2% in the last four years compared to the CAGR of 18% in the ten years (it is 29% CAGR in nine years from March 2005) of the UPA government. Let the government borrowing programme and the demand for money reflect in interest rates and exercise their restraining effect on government spending in an election year. Autonomous central banks exist only to hold back politicians from priming the pump in an election year with medium-term adverse consequences.

The price of oil is firm and the Persian Gulf faces uncertain times. Inflation risks are tilted to the upside from rising farm prices and uncertain monsoon rainfall distribution. The Federal Reserve is raising interest rates. Several emerging economies are in trouble and dollar demand for repayment is set to rise as US dollar securities issuance by non-bank borrowers in emerging economies went up by 22% in 2017. India too is in need of dollars for debt repayment and purchase of crude oil. All of these set the stage for a big fall in the Indian rupee. The costs from a rupee crash will exceed the benefits accruing from stable to lower interest rates. National pride will be a hard-sell in the election with an emaciated rupee.

On its part, RBI must go back to the drawing board and examine what exactly it is targeting and why. There is the official inflation target. But OMOs smack of interest rate intervention. Autonomous central banks exist only to hold back politicians from priming the pump in an election year, with medium-term adverse consequences. Relaxing ECB and FPI norms hints at desperation on the exchange rate. In trying to be all things to all people, RBI is risking its own credibility and encouraging discussions on its competence too.

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