More clarity needed over RBI’s role

It is ironical that financial markets that welcomed an inflation targeting regime for the central bank, as a shield from political and populist demands, now want the remit to broaden to cover financial stability. It is also ironical that markets, after favouring a tightening of monetary and financial conditions to defend the rupee, are now demanding liquidity injections to contain contagion from problems in the non-banking financial companies (NBFC) space.

But in Indian conditions, correct implementation of inflation targeting requires liquidity to play a role. The composition of money supply also matters. Intervention in the foreign exchange market, use of reserves and capital flow management, all affect the exchange rate in addition to monetary variables. A conservative textbook focus on the repo rate is likely to miss important contextual features. Moreover, after the exchange rate has over-corrected, foreign investors expect appreciation and tend to come back. Adequate liquidity and softening market rates give them capital gains and also attract them back. Therefore a liberal liquidity regime is consistent with a strengthening rupee.

The RBI has done well to announce a calendar of open market operations for the months of October and November. G-Sec yields have fallen and the rupee has stabilised. Liquidity injections are still inadequate as sale of forex reserves has sharply reduced domestic liquidity. Overall long-term liquidity continues in deficit at a time when it should be provided in plenty.

Shadow banking

The second reason liquidity is inadequate is the sectoral mismatch of liquidity. Banks can avail themselves of short-term refinance from the RBI, but NBFCs, which are currently liquidity constrained, cannot do so.

There are interesting parallels between the Indian situation, and the regulatory and liquidity concerns arising out of the global financial crisis. The concentration of regulation on banks led to arbitrage away from banks to markets. There is a concern on who will fulfil banks’ traditional market-making role as liquidity tightens on quantitative easing withdrawal. Market liquidity itself tends to be pro-cyclical. Similarly in India stronger regulation of banks made their credit growth to industry negative. NBFCs stepped in providing funding through liquid funds and the money markets loop. The RBI, however, did not expand its balance sheet, or offer liquidity against a wider class of securities, widening its lender of last resort function (LOLR), as the US Fed did.

An additional complication in India is that of infrastructure financing. Public sector banks (PSBs) as well as NBFCs like IL&FS are in trouble because they borrowed short to lend long. Infrastructure assets maturing in 20 years were financed with three-month commercial papers (CPs), especially since longer-term credit was not available from banks and the RBI provided more short-term liquidity. Such financing structures are vulnerable to shortage of liquidity. The absence of refinancing can turn illiquidity into insolvency with a destruction of potential asset value. In most countries, including China, authorities have had to help with infrastructure financing.

If CPs involve credit risk, making them less acceptable as collateral in a refinancing window, a possible alternative is to provide refinance to banks for higher rated NBFC paper. There are many NBFCs with viable business models. The RBI has taken a few steps to ease bank lending to NBFCs.

But Prompt Corrective Action (PCA) imposed on about half the PSBs limits their use as the channel of refinancing. Indian regulations impose higher capital adequacy on the grounds that recovery is slow here. But since recovery is happening now through the IBC, and provisions already made can be utilised, the requirement can safely be reduced to international levels.

Moreover, because of the safety element from sovereign backing PSBs under PCA continue to get deposits. If restrictions are put on how they can earn from them how are PSBs supposed to service them or improve profit rates? Since ongoing risk-based regulation is improving underwriting standards, PSBs under PCA should also be allowed to lend as long as higher rates cover higher risk, and caps are put on exposure to any one party. Thus there can be a selective relaxation of PCA norms. The international literature also favours counter-cyclical prudential regulation. Regulatory prescriptions cannot be written in stone regardless of what is happening in markets.

As the better NBFCS shift from short-term market finance to longer-term bank finance at higher rates, as NBFCs credit growth contracts somewhat and that of banks expands, a nuanced relaxation of PCA can give earnings opportunities to PSBs, improve diversity in credit provision and the resilience to the Indian financial structure. Markets with a number of agents performing diverse functions are more robust.

Central bank independence

The debate on central bank independence is a red herring that diverts attention from the RBI’s rigid stance on liquidity provision and PSB regulation. The RBI has full independence in monetary policy, enshrined in the inflation targeting framework. But with the Financial Stability and Development Council (FSDC) having been set up, the RBI has to coordinate with other regulators on financial stability issues. Inadequate or delayed response to short-term illiquidity can create irreversible long-term asset destruction.

Many MSMEs are unable to migrate from PSBs to other credit sources. As NBFCs also contract, a credit squeeze can have systemic effects. A central bank has a comparative advantage in financial stability, given its operational experience. That is why, after the GFC, the UK chose to send the responsibility back to the central bank. But if departments operate in silos; there are no inputs from operational departments to the Monetary Policy Committee; no discussion of macro-prudential measures; all market feedback is disregarded as lobbying then the responsibility for coordination is better with the FSDC, which the Finance Minister chairs.

Technocrats in the RBI do have a longer-term view while the Finance Ministry is concerned about elections. But the short-run has persistent long-run effects, and if it is very extensive it becomes the long-run. Extended sacrifices imposed cannot be justified by saying it is only short-run.

Populism has deleterious long-run effects but so does undue strictness. Non-performing assets festered for 10 long years. In a dynamic environment, policy determined on principles established in US markets with no adaptation or learning from Indian contexts cannot be adequate.

While the central bank must be independent of the government it has to be accountable to the people in a democracy. It cannot think only of foreign investors, and use the latter as a threat. When Raghuram Rajan’s term was not renewed some analysts expected an outflow of foreign investors. No such thing happened. It is the country’s potential that brings them here, not any individual. Markets also appreciate the importance of the LOLR function for financial stability.

The writer is a part-time member of EAC-PM. The views are personal.

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