Overarching fiscal dominance in RBI policy

The Monetary Policy Committee of the RBI, which concluded its third meeting for 2020-21 on Friday, kept the policy rate unchanged at 4 per cent and also announced its intention to continue the current accommodative stance. This resolution of the MPC was almost a foregone conclusion, with several market analysts describing it as a ‘pause’, as they did the last time, implying thereby that more rate cuts are likely in the foreseeable future.

The overall tone and tenor of the policy statement didn’t belie their optimism. As a consequence, and also due to the announcement of some G-Sec and State Development Loans (SDL)-supportive measures, the 10-year G-Sec yield fell by about seven basis points after the announcement.

Economy still in a deep trench

MPC’s assessment of the current macroeconomic situation and its prospects for H2: 2020-21 are more or less in sync with the mainstream views that have been aired publicly of late: the deep contractions of Q1:2020-21 are behind us and silver linings are visible in the decline in rates of growth of infections and active cases throughout the country and restoration of the disrupted supply chains. Consumer confidence is turning upbeat on the general economic situation, employment and income over a one-year ahead horizon.

As widely believed, agriculture and allied activities would lead the revival by boosting rural demand. Capacity utilisation of manufacturing is expected to recover in Q3:2020-21 and activity to gain some traction from Q3 onwards. Services are also expected to recover. But private investment and exports are likely to be subdued. For 2020-21 as a whole, real GDP is expected to decline by 9.5 per cent, which estimate is close to 9.6 per cent forecast by the World Bank recently.

Extraordinary times perhaps call for this bias in liquidity management, but this shouldn’t become the norm

CPI inflation, which has been rising since March 2020, breaching the upper limit of 6 per cent in June is projected at 6.8 per cent in Q2. As per the MPC, the rise in CPI is largely due to supply disruption and it expects CPI to decline to 5.4 per cent in Q3, and 4.5 per cent in Q4. However, aggregate demand remains lacklustre with evidence of considerable resource slack, thereby indicating space for continuing with the accommodative stance. This explains the market’s optimism for further rate cuts.

Replacement of the extant automatic caution-listing of exporters by a recommendation-based procedure is a welcome step. In fact, there is a need to have a relook at the regulations on realisation/repatriation of export proceeds to make them more incentive-compatible. As for the modified TLTRO to be made available on tap now, it is doubtful if it will fly in a big way. The hitherto available option of investing the TLTRO fund in debt securities of corporates in certain specified sectors was unattractive/unviable, since the risk-adjusted return on such investments would not pass muster, particularly for banks with high operating cost.

The position will not alter very much with the freedom to use TLTRO funds for making loans to these sectors. In any case, the expected loan growth in 2020-21 is low. Come 2021-22, there will most probably be a spurt in the NPA of banks, with negative implications for credit expansion. The eagerness of the RBI and the Government for a quick uptick in credit flow by banks, especially public sector banks (PSBs), is understandable. But it is not going to happen in a hurry.

The pandemic has driven home a reality: Using PSBs for macroeconomic management has limitations. While PSBs can be goaded to expand credit in a boom period, it is difficult to do so when the economy is in a trough.

For one, PSBs, for a variety of structural reasons, cannot go sprinting for this purpose. For another, infusion of more equity in MSMEs and corporate borrowers is a pre-condition for them to get more loans. In the current situation caused by Covid-19, fiscal help for replenishing at least a part of the equity that has been lost due to the lockdown and other disruptions would have helped. But absence of adequate fiscal space has resulted in very little being done in this regard.

Oddly, the pandemic has driven home a reality: Using PSBs for macroeconomic management has limitations. While PSBs can be goaded to expand credit in a boom period, it is difficult to do so when the economy is in a trough.

The measure to increase the investments permitted to be classified as Held to Maturity (HTM) from 19.5 per cent to 22 per cent of NDTL in respect of SLR securities acquired on or after September 1, 2020 up to March 31, 2021, and the rationale provided therefore makes interesting reading.

The intention here appears to be that banks should make the Central government debt issuances post September 1successful at rates that are acceptable to RBI. Two important pieces of information provided elsewhere in the policy statement on government borrowing are significant in this connection: The weighted average cost of borrowings by the Central government during H1:2020-21 at 5.82 per cent is the lowest in the last 16 years and the weighted average maturity of the outstanding stock of the Centre has also been the highest so far. Thus, the government wants to lock in historically low interest rate by borrowing long-term.

When interest rates go up, while the government will have reasons to rejoice, the banks’ net interest margin will suffer and hardly any of these G-Secs can be sold at a profit then. In fact, the current regulations on the classification of debt instruments owned by banks, which are at variance with international standards, clearly reflect fiscal dominance and thus suffer from multiple drawbacks.

This looks very rational from the government’s point of view, but holding these G-Secs is highly sub-optimal from the banks’ point of view even if they are parked in the HTM segment with no mark-to-market requirement. When interest rates go up again, while the government will have reasons to rejoice, the banks’ net interest margin will suffer and hardly any of these G-Secs can be sold at a profit then. In fact, the current regulations on the classification of debt instruments owned by banks, which are at variance with international standards in this regard, clearly reflect fiscal dominance and thus suffer from multiple drawbacks.

The decision of the RBI to conduct OMOs (open market operations) in SDLs as a special case during 2020-21 is welcome. It appears to have a direct link to the still unresolved issue surrounding the additional borrowing option given by the Central government to the States to meet the GST revenue shortfall in 2020-21.

Lurking fiscal dominance

It goes to the credit of RBI that the fresh-look MPC with three new external members could get down to business within 48 hours of its re-constitution in the present difficult situation. The RBI has thus been successful in swiftly erasing the ominous uncertainties that had arisen in the wake of the deferment of this meeting that was scheduled to be held from September 29 to October 1.

It will require extraordinary professional foresight and conviction on the part of the MPC as also the top leadership in the RBI to steer clear of this ‘new normal’ and hold on to MPC’s mandate both in letter and spirit.

However, fiscal dominance in monetary, liquidity and regulatory policies, though ever-present to varying degrees in India, has become conspicuous and looks somewhat over-arching in this policy. While this development can be defended on the ground that the present historically extraordinary macroeconomic challenges demand extraordinary solutions, the fear is that fiscal dominance can become a habit as also a ‘new normal’ in the days to come.

A lot has been said and articulated, especially in the recent past about the pitfalls of such a dispensation for macro-financial stability. It will require extraordinary professional foresight and conviction on the part of the MPC as also the top leadership in the RBI to steer clear of this ‘new normal’ and hold on to MPC’s mandate both in letter and spirit.

(The writer is a former central banker and consultant to the IMF)