The QE that no one noticed

At a recent function to release a book History of the RBI , the Prime Minister said “that the time has come, when we should revisit some areas — the possibilities and limitations of monetary policy in a globalised economy, in a fiscally constrained economy”.

Many newspaper reports on this function “opined” that the PM wanted the RBI to re-think on its “tight” monetary policy and hawkish stance on inflation.

Indeed, the perception that the RBI has, in the past many years, been following a tight monetary policy has become so well entrenched that whenever somebody from the Government talks about the RBI, it is taken as opposition to its “tight” monetary policy. Reserve Bank officials also very frequently reinforce such perceptions with their public speeches. The RBI Governor, for example, recently said that RBI has followed a tight policy not because it does not care for economic growth, but because it does care for growth.

RBI QE is reality

But did the PM really mean that the RBI should re-think its tight policy? Can we make such an inference at all from what he said at the meeting?

Or, was he talking about broader issues — indicating that the time has come to take a serious look at the overall institutional arrangements relating to the RBI and its role in the economy? More importantly, is it the case at all that the RBI has been following a tight money policy all these years?

It may be noticed that much of the public discussion about the Government and the RBI, in recent times, has been occasioned primarily by the prospect of the US Federal Reserve, at first reducing and then completely ending its policy of quantitative easing (QE) — during the course of the next several months. This ensuing policy action of the Fed has brought into sharp focus the serious macro-economic imbalances in many countries such as India; which has, in turn, compelled policy-makers to not only look for solutions (and scapegoats for who caused the problems) in the near term but also (hopefully) for more enduring solutions for the longer term.

Since QE has been a key catalyst in this environment, it would be appropriate to look at whether the RBI has followed a tight money policy in the past many years from the QE angle itself.

What is QE?

Broadly, QE can be taken as changes in the composition and/or size of a central bank’s balance-sheet that are designed to ease liquidity and/or credit conditions. In other words, QE is designed to easy monetary conditions and is a specific strategy followed when a central bank’s traditional tools (more limited open market purchases of financial securities) to “ease” monetary conditions have been fully utilised.

Also, note that such changes in the size of the central bank’s balance-sheet can be brought about either through purchase of domestic assets (domestic financial securities such as government bonds) or foreign exchange. What matters is the increase in the size of the balance-sheet.

(In the Indian case, foreign exchange purchases accounted for a bulk of the balance-sheet expansion in the period up to 2007; thereafter, the RBI has expanded by government securities purchases).

What is the key take-away from this definition?

It is that when the size of the central bank’s balance-sheet increases, it effectively delivers easy/easier monetary conditions — reflected in low/soft interest rates — to the broader economy.

With this explanation in mind, look at the following numbers.

The size of the RBI’s balance-sheet in March 2002 was close to Rs 3,50,000 crore. In March 2013, it had ballooned to as much as Rs 22,00,000 crore.

If this is not QE, what else is?

And, how did interest rates behave in that decade when the central bank’s balance-sheet increased nearly six times?

As can be seen, Indian government bond yields have been on a long-term declining trajectory in the past decade — and a key driver of such long-term softness is the relentless expansion in the central bank’s balance-sheet. Given this track record, how is it that everybody keeps saying that the RBI has been following a hawkish monetary policy, which the RBI also seems to be very shrewdly reinforcing with its public pronouncements? It is all the more ironical that even the Government and its Finance Minister say that the RBI has kept interest rates stiff and high!

But it is not surprising how long-term yields have softened in the face of central bank balance-sheet expansion. That has been the experience with the US Fed’s QE programme as well.

Indeed, it should be when QE in a country such as the US is directed at vastly more liquid markets in prime financial assets such as government bonds.

Larger issues

The Fed delivered a broad softening in yields from the 3.50 per cent levels down to as low as 1.50 per cent by late 2012.

Yields have since moved up noticeably as the talk of a Fed taper gathers momentum. And, how much did the Fed expand? Its balance-sheet expanded roughly four times — from $800 billion in late 2008 to around $3.7 trillion now.

There are a number of larger issues flowing from the US Fed’s publicly announced QE and the RBI’s “more discreetly” conducted QE programme.

Relative to the size of their respective economies, the RBI has delivered a larger QE than the Fed — though it has been done over a longer period. But, is the longer time horizon a mitigating factor at all in an economy as chronically short on the supply-side as India?

How different would have been India’s economic experience of the last decade if the RBI had not done its QE? Fiscal expansionism, by itself, is no evil.

But, can you permanently have a draft on the central bank? Would we have landed in the current crisis in a different institutional setting? These are probably the questions the PM wants answers for.

Raghuram Rajan, on taking over as RBI Governor, seems to have answered all those questions with this forthright statement: “The primary role of the central bank is monetary stability, that is, to sustain confidence in the value of the country’s money. Ultimately, this means low and stable expectations of inflation”.

(The author is a Chennai-based financial consultant.)

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