Limits to an accommodative monetary policy

 The resolution of the Monetary Policy Committee (MPC) on February 05, 2021 came against the back drop of a perceived optimism of growth revival set out in the Union Budget for 2021-22, the Economic Survey, the 15th Finance Commission report drawing a fiscal road map along with the growth and inflation forecasts and the cautious optimism seen in the revised World Economic Outlook of the IMF.

The MPC, as expected, kept the policy repo rate unchanged at 4 per cent with a commitment to an accommodative monetary policy in what was a unanimous decision of all its members. The MPC further resolved that the accommodative policy will continue during the current financial year and also in the next financial year to revive growth on a durable basis while keeping inflation within the target, going forward. The inflation target, which will be reviewed in March 2021, is expected to be kept unchanged at an average 4 per cent Consumer Price Index- Combined (CPI-C) with a band of +/- 2 per cent.

The growth and Inflation outlook disseminated by the MPC inter alia were steered by  various forward-looking surveys conducted by the RBI relating to consumer confidence, inflation expectation, capacity utilisation, industrial outlook and bank lending. The common thread running in these surveys reflects some guarded optimism. In general, the surveys reported that a) the current economic situation has improved over the period when Covid-19 hit us hard; but b) cost-push pressure predominates and could adversely affect profit margins even though selling price has increased; c) inflation expectations by households in a one-year ahead period reflected price pressures and uncertainties; e) bank lending surveys depicted revival in the bank lending across sectors.

How does this align with what we see on the ground?

The CPI-C remained at an elevated level, surpassing the upper target of 6 per cent continuously during the period June- November 2020, with a dip in the December print to a level below 6% so that it slipped in below the upper end of the toleration band. The MPC resolution recognised the upward pressure on retail inflation with pressure on core inflation (headline inflation minus food and fuel inflation) due to “broad-based escalation of cost-push pressure on services and manufacturing prices”. Uncertainty in international crude prices coupled with higher excise tax duties on petrol and diesel will also adversely affect the fuel inflation. The MPC has recognised that food inflation will shape the inflation trajectory.

In general, the surveys reported that a) the current economic situation has improved over the period when Covid-19 hit us hard; but b) cost-push pressure predominates and could adversely affect profit margins even though selling price has increased; c) inflation expectations by households in a one-year ahead period reflected price pressures and uncertainties; d) bank lending surveys depicted revival in the bank lending across sectors.

In the end, the MPC projected CPI-C inflation at 5.2 per cent in Q4 of 2020-21, and 5.0 per cent in H1:2021-22 and 4.3 per cent in Q3: 2021-22, with risks broadly balanced.

The perception of the MPC that risks of inflation are evenly balanced needs to be seen in the context of a much higher level of borrowings as projected in the Union Budget 2021-22, coming on the top of a record level of borrowings in 2020-21.

But how will these borrowings be financed when we see a marked decline in the overall financial savings rate of our economy relative to Gross National Disposable Income (GNDI)? In that sense, the supply side of the borrowings is constrained and will be unable to meet the demand side coming from a higher level of borrowings of the general government (Central plus State governments) which will be to the tune of around 10.8 per cent of GDP over and above the borrowing level of around 14.5 per cent relative to GDP in 2020-21.

It is a mythical argument that such a high level of borrowings will not impact inflation. This activity inherently has the potential for inflation written into it. As long as we have in the economy a higher fiscal deficit accompanied by a higher revenue deficit relative to the GDP, the inflation potential is very real and looms large. In view of this, the 15th Finance Commission’s assumption that inflation during the period 2021-22 to 2025-26 will be at 4% looks doubtful, and is unlikely to be translated to reality.      

As long as we have a higher fiscal deficit accompanied by a higher revenue deficit relative to the GDP, the inflation potential is very real and looms large.

The optimism in the MPC resolution (10.5% growth rate for 2020-21), Union Budget and the Economic Survey (11% growth rate) and the January 2021 outlook of the IMF (11.5% growth rate) all offer an upbeat view for revival of growth with a ‘V’-shaped recovery. In particular, the MPC resolution perceives rural demand remaining resilient on good prospects of agriculture, plus a strong urban demand and demand for contact-intensive services with the substantial fall in COVID-19 cases and the spread of the vaccination. Furthermore, the MPC resolution is hopeful that the fiscal stimulus under ‘atma nirbhar’ 2.0 and 3.0 schemes coupled with the higher provision of capital expenditure in the Union Budget will accelerate growth momentum. Accordingly, in 2021-22, the rate of growth will be in the range of 26.2% to 8.3% in H1 and 6.0 per cent in Q3. The 15th Finance Commission has assumed that our economy will record a growth rate of 8 per cent by 2025-26.

But economic growth critically hinges on investment, and investment is linked to savings. As alluded to earlier, both the savings and investment rate has been showing a declining trend. For example, in 2019-20, investment relative to GDP was 32.2 per cent and saving rate was 30.9 per cent. These are clearly lower than the levels recorded in 2007-08, when India reached a growth rate of over 8%. The component analysis suggests that on account of the continuation of the large revenue deficit component in the fiscal deficit (for example, the revenue deficit is budgeted to account for 75 per cent of the fiscal deficit or borrowed resources), the dis-savings of government sector has been increasing. Therefore, what is more important for India to move to a higher growth trajectory is the elimination of the revenue deficit, apart from a higher provision of capital expenditure in the budget.

The opening up of the participation of individuals in the market borrowing programme will not be helpful as there are procedural constraints in the bidding process compared to bank deposits, stock market and mutual fund investment.

The RBI is also the debt manager and banker to the government. As mentioned in the Governor’s statement, “gross market borrowing of the Centre for 2021-22 is budgeted at Rs. 12 lakh crore. As the government’s debt manager and banker, the Reserve Bank will ensure the orderly completion of the market borrowing programme in a non-disruptive manner. In this context, we look forward to the continuance of the common understanding and cooperative approach between market players and the RBI during 2021-22 also.”

The perception that such a high level of borrowings will be non-disruptive is beset with problems. In 2020-21, the market borrowing was conducted as per the RBI’s perception in a non-disruptive manner because of the large-scale liquidity injection by RBI. If the same trend continues in 2021-22, i.e., to finance government borrowing by liquidity injection by the RBI, it will mean large scale printing of money (money finance) to meet debt financing. It is important to mention that the market has already started bidding a higher rate of interest for market borrowing and RBI has rejected all the bidding on February 05, 2021.

Therefore, the RBI perception that the market borrowing programme will be conducted in a non-disruptive manner with longer maturity accompanied by lower interest rate will not be achieved. The opening up of the participation of individuals in the market borrowing programme will not be helpful as there are procedural constraints in the bidding process compared to bank deposits, stock market and mutual fund investment.

To conclude, the revival of growth critically depends on the elimination of the revenue deficit and strong private sector investment and consumption rather than an accommodative monetary policy stance or a further reduction in policy repo rate.

(Dr. R K Pattnaik is a former Central banker and a faculty member at Bhavan’s SPJIMR. Views are personal)