Reserve Bank of India's Interventions to maintain excess liquidity - Part 2

11 Jan 2021 Tweet central-banks · economic-theory · economy · governments · india

In the previous post, we looked at what the RBI has been doing over the 2020 calendar year. The over-all effect of RBI’s interventions have been that the exchange rate (INR to USD ratio) has remained within a narrow window, despite the unprecedented capital inflows into the Indian equity market. This is by design, and the RBI has tried to explain their policy a few times in various documents. Although this excess liquidity can theoretically cause high inflation and have an adverse impact on the currency, a couple other things are happening simultaneously and making this policy prudent (existing over-valuation and RBI’s strong balance sheet). After reading some of these documents, here’s my thesis of the advantages and disadvantages of what the RBI has been doing, as I best understand it.

Advantages

Monetary Policy Transmission

One of RBI’s goals is to set monetary policy. In an ideal world, they would set a policy with a given policy goal (e.g. bring down food inflation) and this policy would be transmitted to end-consumers perfectly through the various economic institutions that sit in between them and the RBI (e.g. state banks, corporate investors, foreign investors, etc). As you might have guessed, we don’t live in an ideal world and the RBI has to have a policy to ensure that their monetary policy is transmitted to end-consumers and has the required effects.

By maintaining excess liquidity in the system, they are trying to ensure that policy transmission is close to perfect by maintaining the operating rate (the interest rate at which banks borrow in reality) close to the policy rate (the interest rate at which banks borrow directly from the RBI). The high supply of local currency and constant deregulation at the RBI ensures that banks can borrow at rates close to the policy rates. This can be seen in the release from 8th January 2021: The short term market repo rate was 3.20%, whereas the policy repo rate for this period was 4.00%, and the reverse repo policy rate was 3.35%.

This can be a crucial tool during a recession to increase consumer spending and economic activity, as it has been found to be effective at (say) increasing the amount of real estate loans that are being issued and helping firms and households start spending again. The RBI has noted this in their last Monetary Policy Committee (MPC) meeting in early Dec 2020:

Point 33:

My own view is that just as the reversal of the liquidity drought had led to a revival of growth that was visible in the high frequency data for February 2020, the various measures to make liquidity available through the economy not only helped firms survive but have also revived demand. The bank credit growth figures show a turnaround but underestimate it. … Real estate inventory is beginning to move. Both households and firms have deleveraged, are cash rich, and ready to spend. There are early signs of firms beginning to invest.

– https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=50831

Control over-valuation of the INR

When foreign inflows into an economy are high due to a perceived increase in forward earnings, the risk of over-valuation of the local currency starts going up. This over-valuation adversely impacts exports (As the local currency appreciates against reserve currencies, foreign buyers will have to pay more for the same commodity, provided that their local currency is not appreciating as quickly). To curb over-valuation, the Central bank will purchase the foreign inflows and park them as Forex reserves on their balance sheet.

This absorption of the capital inflow by the central bank is also lucrative as it ensures that a sudden-stop in the capital inflows will not destabilize the market. The central bank can start removing liquidity from the market gradually, allowing the sudden-stop gradually. In India’s case, the probability of a sudden-stop is low as 1-year forward earnings are still high, and there are no big changes in policy or government that are expected until Dec 2021. The next central government election is only in 2024, a long time away.

Once again, here’s an excerpt from the MPC minutes:

The intervention that is raising foreign exchange reserves is required because over-valuation of the rupee can hurt exports, raise country risk and lead to a sharp depreciation later. Prolonged inflows can lead to over-valuation without intervention. Surges and sudden stops of capital flows to emerging markets due to advanced economy quantitative easing have hurt emerging market growth in the decade after the global financial crisis.

Disadvantages

The RBI has been weighing these disadvantages against the economic growth that is being supported by the excess liquidity. Ultimately, their decision to stick with their current policy comes down to their belief that these disadvantages are not devastating even in the worst case and that the risk is bearable.

Impact on Consumer Price Index (CPI) Inflation

Excess liquidity’s biggest impact is on CPI inflation: the excess liquidity in the system makes it easier for firms to invest and they subsequently raise their commodity prices. In some cases, it is possible to maintain high liquidity but prevent an increase in inflation due to this. These cases generally happen when the inflation rates are already quite high and expected to remain high due to external reasons. As we saw in the previous post, the current high inflation rates in India (October CPI inflation = 7.6%) are caused by the COVID-19 pandemic’s impact on supply chains and some untimely rains in the harvest season. RBI’s monetary policy is not connected to the current high inflation rate.

Even in these situations, the already-high inflation rates can be exasperated by the liquidity surplus. So, the effect on inflation should be closely watched and liquidity suppression tools should be used when the trend shifts. RBI is on track to do this, although some economists and analysts believe that RBI’s hand will be forced in 2021 as (say) food inflation starts to go up again before or during the summer months.

Analysts suggest the RBI will be forced to address the [liquidity] glut early in 2021.

Here’s an excerpt from the MPC minutes:

To the extent it is transient the contribution of excess liquidity to cost push inflation is limited. In an open economy import competition also caps price rise, especially with a rupee that is tending to appreciate, provided tariffs and taxes are moderated.

RBI keeps government borrowing costs low

As the economy is stressed due to various state-wide lockdowns and a sluggish consumer, the government has been borrowing heavily. The budget deficit for FY2020-21 is now estimated to end up at about 8%, which is twice the budgeted value of 4%. This deficit is being made up by government debt issues. A lot of these debt issues have been purchased by the RBI. This has ensured that the government’s borrowing costs in the long term (i.e. 3-, 5- and 10-year bond yields) have actually gone down.

This is one facet of the RBI’s theory of Economic Capital Framework. This theory enhances the central bank’s role from simply avoiding financial volatility, to being a backstop when the government’s finances are deteriorating. The central bank aims to achieve this goal by maintaining a strong balance sheet and transferring balance sheet capital surplus (equity above the required rate and whole of net income) to the central government. (Note: I have been reading about this theory and I am still trying to understand it’s background and where it came from. I might do a series of posts about this in the future.)

Short-term rates crash

This article makes an interesting claim:

Lower shorter rates without a similar drop in long-term borrowing costs means a steeper yield curve, which tends to undermine efforts to stoke growth.

This is also discussed vaguely in the MPC minutes:

Point 40.

As long as the MPC stance is accommodative durable liquidity will be in surplus and short-term rates will not rise above the reverse repo rate. Rates have fallen below the reverse repo because of the combination of excess foreign inflows, intervention and reverse repo access limited only to banks. Even so, excess liquidity is still absorbed. Regulatory exposure norms can help prevent excess low rates driven short-term borrowing that creates risks.

Point 46.

I believed then and believe now that this reduction of rates carries significant risks and very little rewards. The rewards are low because long rates are what are relevant for stimulating investments and supporting an economic recovery; a steepening of the yield curve by a reduction in short rates does not accomplish this. Also, a reduction in long rates that stimulates investment not only increases demand in the short run, but it also stimulates supply in the medium term as the new capacity becomes operational, and this new supply dampens inflationary pressures.

I don’t know whether this short-term interest rate crash can have long-term impacts. It looks like the Monetary policy committee is divided on this point and while the decrease in short term rates is not being supported by any of the members and is being opposed by some members, they don’t feel that the risk has risen to a level where they have to act and intervene to support this rate.