Ashima Goyal

How to boost India’s monetary transmission

Ashima Goyal | Updated on December 01, 2019

In order to reverse the growth slowdown, we need to look beyond the repo and focus on liquidity-enhancing interventions

Inflation targeting is meant to allow policy counter-cyclicality, but it has been implemented as a structural reform. Macropolicy must become counter-cyclical now. The temporary spike in food items driven by prolonged rains and floods can be looked through by a flexible inflation targeter, especially as growth falls much below potential. Core and wholesale price inflation remain much below 4 per cent, and the headline CPI is also likely to come back towards 4 per cent. In no case is it expected to breach the RBI’s target band. In the long run, core inflation affects the household’s inflation expectations more. Raising domestic demand is the priority. There remains room to cut as weak demand reduces the neutral real rate. Moreover, global conditions continue to be uncertain.

That no monetary transmission is taking place is a myth. At the last MPC meeting, the repo rate was cut only 25 bps, but the one-year treasury bill fell 45 bps; thus, the one-year ahead real rate also fell by so much, reaching 1.2 per cent. This was the effect of higher liquidity. The one-year treasury bill had almost come to the level of the repo, but there was hardly any movement in the 10-year G-Sec, the MCLR fell 20-30 bps, and corporate spreads remained high, although with more discrimination between firms.

But to improve transmission, it will help to look beyond the repo:

Term premium

The historical spread over the repo of the 10-year G-Sec was about 60 bps since 2011. The G-Sec yield rose from 6.4 per cent in September 2017 to a peak 8.18 per cent in September 2018, before coming down with open market operations (OMOs) and repo rate cuts. But since July 2019, it has been sticky around 6.5-6.7 per cent. The spread over the repo remains above 1 per cent, because of expectations of higher government borrowing as tax revenue growth weakens, together with the RBI’s announcement of forex swaps, rather than OMOs, as the preferred means of injecting durable liquidity. In Indian conditions, OMOs decrease spreads on G-Secs even after controlling for other factors affecting 10-year yields.

The FRBM has an escape clause that allows a 0.5 increase in fiscal deficit (FD) if growth falls by 3 per cent in four quarters. This condition is met. Even so, the government is committed to restraining the FD and is aggressively pursuing privatisation and squeezing waste out of the system to limit any increase in FD, despite tax revenues falling with growth in nominal income.

Maintaining productive government spending is essential to increase the denominator (GDP) and therefore reduce deficit ratios. Allegations of actual deficits being much larger are not consistent with falling growth. Moreover, the markets have undergone a complete reversal. There are cries for the government to spend more. Markets are more accepting of the required rise in government borrowing. Even internationally, this is true. If the RBI supports a limited expansion in FD with OMOs, in a coordinated counter-cyclical fiscal-monetary response, it will also decrease term premium and improve transmission.

This is not the same as monetisation or automatic financing of the FD, as used to happen with the ad-hoc treasury bills or primary devolution, and was discontinued with the reforms. Here, it is secondary market intervention, in special circumstances and at the RBI’s choice, while it retains full control of its balance sheet. Central banks around the world are doing this, and following suit would be a sign of the RBI’s maturity.

Since more than 75 per cent of the RBI’s balance sheet currently comprises foreign securities because of sterilisation of excess foreign inflows (which imposes a huge loss in RBI interest earnings), holding more G-Secs may require an expansion of the RBI balance sheet. This would allow M0 growth to compensate for the slowdown in M3 — a type of quantitative easing (QE).

Credit risk

Corporates spreads are falling but remain high on suspicion; for example for NBFCs that do not have corporate backing or have real estate exposure. Since the RBI is now the regulator and has detailed knowledge of balance sheets, it can either send insolvent institutions for resolution or provide an expensive window, over-collateralised but with a range of assets, for those who only have liquidity issues. This would be much faster than the various government schemes to inject liquidity, all of which have operational issues. It would remove asymmetric information in the market — by signalling who is safe for the market to lend to and reducing spreads for NBFCs that suffer from liquidity constraints, while the insolvent ones go for a quick resolution. The window itself would not be used much. The RBI had provided such a window to NBFCs and effectively quelled market panic in 2008.

A fast-acting lender of last resort (LOLR) is needed for financial institutions that are systemic. Otherwise, cumulative credit contraction occurs, leading more firms to fail. Risk averse rises. The failure of the earlier regime to provide an LOLR in 2018 when the problems arose is responsible for the fall in flow of funds to the commercial sector — from above seven lakh crore in H1 2018-19 to below one lakh crore in 2019-20; only 12 per cent of the earlier total. It is no wonder growth crashed.

Much of the damage is done now. Those who can, have found market solutions. But in the absence of an LOLR, NBFCs are being forced to raise equity abroad when their share prices are low. Again, this is a huge potential loss to national wealth, and gain for foreign equity.

Bank loan rates

Banks do not want further cuts in repo, since they have to compete for deposits, which are sensitive to interest rates. External benchmarking has driven some fall in marginal rates. The economy has to get used to lower nominal rates that accompany lower inflation. Savings are now getting a real positive return, compared to negative returns earlier. Banks may be allowed to compete for firm deposits by providing services — cross-selling for young people, higher rates to senior citizen deposits.

For bankers to have the certainty and confidence to push for loans, durable liquidity must be kept in surplus, while the RBI demonstrates the ability to respond fast to frequent exogenous liquidity shocks.

It is argued that if the financial sector is broken, transmission cannot take place. Moreover, extended monetary stimulus and QE, as in Europe, is not delivering.

But in crisis times, liquidity-enhancing interventions are required; business as usual would imply pro-cyclical monetary and regulatory tightness. The LOLR function is also important for financial stability.

For India today, the correct comparison is not with Europe, but with the experience of the US in 2008 and its very successful QE1 when markets had frozen. Lengthy aggregate as well as sectoral liquidity shortfalls while markets were freezing has inflicted continuing damage, not delivered a new dawn as those addicted to pain therapy promise. Growth has slowed with over-tight money since 2011. It is time to reverse, and signs of such a turn give hope.

The writer is Professor, IGIDR, and Member, EAC-PM

Published on December 01, 2019

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