RBI embarks on quantitative easing
The Monetary Policy Committee (MPC) of the Reserve Bank of India meets every two months to decide on the main policy interest rate. This is the rate at which the RBI gives an overnight i.e. a one day loan to a commercial bank that may be in temporary need of liquidity. The loan is given against collateral which is typically a government bond (or security) owned by the bank. This one-day transaction is called a repo transaction, since it involves a “repurchase” obligation on the borrower. That rate is called the repo rate. The lower the rate, the easier it is to get the loan (assuming there is enough collateral with the bank). Banks may very well garner huge amounts of repo loans, in case they are facing a stiff demand for loans from their customers and find themselves in a tight liquidity situation.
The MPC favours a low repo rate to spur higher credit growth, and loan growth in the economy.
The mandate of the MPC, as per a contract signed between the RBI and the Central government, is to set the repo rate so that inflation is between the band of 2 to 6 percent. That five-year contract expired recently, and has been renewed on the same terms. What if the MPC fails to meet its mandate, i.e. fails to do its job? The contract says that if the inflation rate goes outside the band for three consecutive quarters, the MPC has to explain to the government why it failed to keep inflation within the band. That explanation could be in writing, or as an appearance before a panel or something similar. But it has never been invoked, even though last year the inflation rate was above six percent for almost twelve months.
This was because of food prices mainly, and seasonal spikes in fruit and vegetable prices including the infamous onion price. It is possible that MPC (if at all it is called to account for its failure) might express helplessness, because it may say that inflation is affected by government actions more than anything else. For instance, a massive increase in excise taxes on petrol and diesel has caused those prices to race toward 100 rupees and cause inflation in transportation costs, and hence on everything else. Clearly these are fiscal actions, about which the monetary policy cannot do anything.
Even a one percent increase in the cost of borrowing means an extra interest burden of more than 1 lakh crore. Hence it is critical that interest rates remain low, since the biggest beneficiary is the biggest borrower, i.e. the government.
Many experts believe that inflation is affected much more by fiscal expansionism and deficits rather than by setting the repo rate. For what it is worth, the current repo rate is at a historic low of 4 percent. Indeed, barring a couple of occasions, for the past three years, the RBI has had a very long record of reducing interest rates, notwithstanding the inflation fears.
There has also been some talk of whether the MPC should be given a wider leeway, and a higher band, to tolerate higher inflation in India, so that low interest rates can live much longer. After all, in the western world, and also Japan, interest rates have been near zero for about twelve years now, so why should India bother? Why can’t we live with six or even seven percent inflation rather than a median rate of four? And is not inflation good for producers, who get the profit incentive of higher prices to produce more? Thankfully such debates have been put to rest by the RBI itself, which has reiterated through a research report, that the current band of 2 to 6, with a median rate of four is just right for India.
As the government embarks on its borrowing program to bridge a mammoth deficit of 12 lakh crore, it will sell bonds, which will be indirectly bought by the RBI through secondary markets, and thus ensure adequate funding and also low interest rates.
So clearly the MPC favours a low repo rate to spur higher credit growth, and loan growth in the economy. Thus, the main thrust of RBI’s policy ever since the pandemic began, and even earlier is to spur economic growth. It has tried all sorts of things beyond setting interest rates, to make cheap loans available to potential borrowers through the banking system. Thus, it allowed a moratorium on loan repayment, and also announced a Long-Term Repo Operation (LTRO), i.e. not just an overnight repo loan, but a three-year loan at low rates. Despite these measures, credit growth has been anaemic.
This fiscal year the biggest challenge for the RBI is to meet the huge borrowing requirement of the biggest borrower, i.e. the government of India. Its requirement is 12 lakh crore. In addition is the borrowing requirement of State governments which could also be another 10 lakh crore. The borrowing requirement from the private sector has not been growing robustly, but if that picks up, then that too will add demand pressure.
The supply of loanable funds of the banking system, comes from depositors. That deposit growth this year will not be more than around 15 lakh crore, even with optimistic assumptions. So, there’s going to be a shortage of loanable funds, and this can only cause interest rates to go up. That is the last thing the RBI or the government wants. Even a one percent increase in the cost of borrowing means an extra interest burden of more than 1 lakh crore. Hence it is critical that interest rates remain low, since the biggest beneficiary is the biggest borrower, i.e. the government.
Whether this infusion of freshly created money will be inflationary or not, only time will tell.
Since the RBI cannot just print money and loan it at an ultra-low cost to the sovereign (that is prohibited by law), it has found an indirect method. This is called Quantitative Easing as per western central banks. What the RBI has said after the latest MPC meeting is that it will commit itself to “buy” government bonds worth 1 lakh crore in the first quarter (and quite possibly throughout the year). Which means 4 lakh crore of extra loanable funds at low rates. This is very unorthodox, and a bold crossing of a “lakshman rekha” for the RBI.
This column had suggested a direct loan against shares swap deal between RBI and Central government, wherein PSU shares can be pledged. The current QE (which has been christened Government Securities Acquisition Program or G-SAP) is a step in that direction. As the government embarks on its borrowing program to bridge a mammoth deficit of 12 lakh crore, it will sell bonds, which will be indirectly bought by the RBI through secondary markets, and thus ensure adequate funding and also low interest rates. Whether this infusion of freshly created money will be inflationary or not, only time will tell. Watch this space!
(Dr.Ajit Ranade is an economist and Senior Fellow, Takshashila Institution)