Monetary Policy Committee Notifications

Monetary Policy Committee Notifications

Maintaining the inflation target at 4%

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Inflation

Mains level : Inflation management

On the last day of the financial year 2020-21, the Finance Ministry announced that the inflation target for the five years between April 2021 and March 2026 will remain unchanged at 4% (+/-2 %).

Inflation targeting in India

  • India had switched to an inflation target-based monetary policy framework in 2015, with the 4% target kicking in from 2016-17.
  • Many developed countries had adopted an inflation-rate focus as an anchor for policy formulation for interest rates rather than past fixations with metrics like the currency exchange rate or controlling money supply growth.
  • Emerging economies have also been gradually adopting this approach.

Try this PYQ:

Which one of the following is not the most likely measure the Government/RBI takes to stop the slide of Indian rupee?

(a) Curbing imports of non-essential goods and promoting exports

(b) Encouraging Indian borrowers to issue rupee denominated Masala Bonds

(c) Easing conditions relating to external commercial borrowing

(d) Following an expansionary monetary policy

What is the rate of consumer price inflation?

  • Moody’s Analytics recently pointed out that volatile food prices and rising oil prices had already driven India’s consumer price index (CPI)-based inflation past the 6% tolerance threshold several times in 2020.
  • While inflation headwinds remain, especially with oil prices staying high, there was some speculation that the Central government may ease up on the inflation target by a percentage point or two.
  • This would have given the Reserve Bank of India (RBI) more room to cut interest rates even if inflation was a tad higher.

What is the RBI’s position on this?

  • The RBI had, in recent months, sought a continuance of the 4% target with the flexible tolerance limits of 2%.
  • The 6% upper limit, it argued, is consistent with global experience in countries that have a large share of food items in their consumer price inflation indices.
  • Accepting inflation levels beyond 6% would hurt the country’s growth prospects, the central bank had asserted.

Why should these concern consumers?

  • The central bank’s monetary policy and the government’s fiscal stance may not have necessarily reacted to arrest inflation pressures even if retail price rise trends would shoot past 6%.
  • As high oil prices spur retail inflation higher, the central bank is unhappy as its own credibility comes under a cloud if the target is breached.
  • If the upper threshold for the inflation target were raised to 7%, the central bank may not have felt the need to seek tax cuts (yet).
  • Thus, the inflation target makes the central bank a perennial champion for consumers vis-à-vis fiscal policies that, directly or indirectly, drive retail prices up.

Back2Basics:

Types of Inflation: Demand Pull, Cost Push, Stagflation, Structural Inflation, Deflation and Disinflation

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

How did inflation targeting really impact India?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : MPC

Mains level : Paper 3- Analysing the performance of inflation targeting policies in India

The article analyses the success of the inflation targeting mechanism in India and its impact on the growth of the economy.

Background of the inflation targeting policy in India

  • It has been three decades since inflation targeting was first adopted in New Zealand and subsequently by 33 other countries.
  • India adopted it in 2016.
  • The primary goal of inflation targeting was to contain inflation at around 4 per cent, within the allowable range of 2 to 6 per cent.
  • The RBI has announced a formal review of the policy instrument now.
  • At the first meeting of the RBI Monetary Policy Committee in October 2016, it was also formally announced that the MPC considered a real repo rate of 1.25 per cent as the neutral real policy rate for the Indian economy.
  • By a neutral real policy rate, the RBI meant a policy rate consistent with growth at potential (i.e. growth at full employment).

Has inflation targeting worked in India

  • The evaluation of IT must provide answers to the following two questions:
  • Did inflation decline post the adoption of inflation targeting and what was the role of IT in the decline in inflation?
  • Was the adoption of inflation targeting associated with the policy of the highest real repo rates in India — ever — for almost three years 2017-2019?
  • The answer is yes to the latter, but it also needs to be acknowledged that high real repo rates were the primary cause of the GDP growth decline in India from 8 per cent to 5 per cent.

Need to take into account the global context of inflation

  • An interesting feature of the Indian defence of inflation targeting is that very few take into account the global context of inflation in which the decline in inflation has occurred in India.
  • A research paper by Balasubramanian, Bhalla, Bhasin and Loungani at ORF evaluates inflation targeting in a global context and separately for Advanced Economies (AEs) and Emerging Economies (EES).
  • Some facts from the paper are the following.
  • First, the annual median inflation in AEs has been consistently low, so low that many central banks have official campaigns to raise the inflation rate.
  • One conclusion might be that IT succeeded beyond anyone’s dreams in these economies.
  • But attributing this decline in inflation to IT would be erroneous.
  • Inflation is global and price-taking by millions of producers in the world means that no one producer or one country can influence the price of any item.
  • Oil has ceased to be a factor in global inflation, at least post the mid-1980s.
  • The lowest inflation in Indian history occurred during 1999-2005, averaged only 3.9 per cent.
  • The average median rate among EM targetters during 2000-04 was 4 per cent, and among the non-targeting countries was 3.8 per cent.

Did fiscal deficit play role in inflation targeting

  • In 2003, India passed the FRBM act to control fiscal deficits and inflation.
  • There is precious little evidence, either domestically or internationally, about fiscal deficits affecting inflation.
  • For three consecutive years preceding the FRBM announcement, the consolidated Centre plus state deficits registered 10.9 per cent(in 2001), 10.4 and 10.9 per cent.
  • For the seven-year 1999-2005 period, consolidated fiscal deficits averaged 9.4 per cent of GDP.
  • Yet, that these years represented the golden period of Indian inflation — without FRBM and without IT.

Cost of inflation targeting in India

  • There are also costs to inflation targeting in India.
  • It led to higher real policy rates, in the mistaken belief that high policy rates affect the price of food, oil, or anything else.
  • But high real rates affect economic growth, by affecting the cost of domestic capital in this ultra-competitive world.
  • It is very likely not a coincidence that potential GDP growth, as acknowledged by RBI, was reached just before the MPC took over decision making in September 2016. 
  •  Since then there was a steady increase in real policy rates, and a steady decline in GDP growth.

Consider the question “How far has the inflation targeting mechanism been successful in India? Give reasons in support of your argument.” 

Conclusion

So, in the inflation targeting mechanism has not been successful in containing the inflation though there had a cost associated with it which we paid in the form of growth.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

Challenges ahead for the RBI

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Taper tantrum

Mains level : Paper 3- Challenges ahead for the RBI in withdrawing expansionary policy measures

With the Indian economy showing green shoots, RBI has to face some fundamental challenges while withdrawing the expansionary measures. 

Expansionary policy as a response to pandemic

  • To manage the financial pressures unleashed by COVID-19, the RBI unleashed several measures.
  • It reduced policy interest rates aggressively.
  • It released an unprecedented amount of liquidity in the market.
  • It instituted a slew of measures for targeted assistance to, especially distressed sectors.

Time to roll back the expansionary monetary policy

  • As the Indian economy is showing the signs of recovery, the RBI must be planning for a non-disruptive exit out of the easy money regime.
  • Reversing a crisis-driven expansionary policy has to be a deliberative process, with the timing and sequencing carefully planned.
  • A big lesson of the global financial crisis is that any missteps on the exit path by way of commission, omission, or importantly communication, can be costly in macroeconomic terms.

Challenges RBI will face on the way out of expansionary monetary policy

1) Restraining inflation while supporting the recovery

  • Inflation remained above the RBI’s target band for the past several months.
  • According to the RBI’s own estimates, inflation is expected to remain above the band for the next several months.
  • Yet, the MPC, in its recent review, decided against any rate action out of concerns for growth and financial stability.
  • The MPC expects inflation to soften on its own in the weeks ahead.
  • That outcome is not inevitable.
  • Inflation could be pressured upwards by several factors even though there could be some apparent softening purely because of base effects.
  • There is the risk that persistent high inflation expectations would result in food inflation getting more generalised.
  • Core inflation could firm up because of rising input prices.
  • ‘Excessive margins’, among the factors cited by the MPC as one of the causes of high inflation, may not disappear.
  • Equally, there are concerns that the recovery, for all the positive signals, is still fragile. 
  • And there is heightened concern about an aggravated unemployment problem caused by big firms retrenching labour to cut costs.

2) Impact on savings

  • RBI should also be concerned about the plight of savers who are being shortchanged by low-interest rates at a time of high inflation.
  • Low-interest rates, its impact on inflation and economic recovery taken together make a complex cocktail of dilemmas for the RBI as it seeks to normalise the policy rates.

3) Withdraw excess liquidity at right time and to avoid ‘taper tantrum’

  • Another related challenge will be to withdraw the ‘excess’ liquidity in good time.
  • Banks are routinely depositing trillions of rupees with the RBI every day, evidencing that all the money that the central bank injected into the system is not doing much good anymore.
  • Every financial crisis can be traced back to mispricing of risk.
  • Mispricing of risk results when there is too much liquidity sloshing around the system for too long.
  • It will drive investors into dodgy ventures and threaten financial stability.
  • As the RBI seeks to guard financial stability by normalising liquidity, it will have to contend with possible market tantrums.
  • The lesson from the taper tantrums in the U.S. is that the RBI will have to manage its communication as carefully as it does the liquidity withdrawal.

4) Stability of the rupee

  • Next challenge for the RBI will be to restrain the rupee from appreciating out of line with fundamentals.
  • Here, the RBI is confronted with a classic case of ‘the impossible trinity’.
  • The impossible trinity deals with allowing free capital flows while simultaneously maintaining a stable exchange rate and restraining inflation.
  • The current account surplus this year together with massive capital flows has meant an excess of dollars in the system putting upward pressure on already overvalued rupee.
  • The RBI has absorbed nearly $90 billion this fiscal year to prevent exchange rate appreciation and to maintain the competitiveness of the rupee.
  • The RBI’s ability to continue to intervene in the forex market will be constrained by its anxiety about how the resultant liquidity might aggravate inflation and the risk to financial stability.

Consider the question “What are the challenges ahead for the RBI while winding down the expansionary monetary policy measures that were announced to deal with the economic disruption of caused due to pandemic and subsequent lockdown.

Conclusion

It is better to be rough right, as Keynes said, than be precisely wrong. That should be the guiding principle for RBI as it navigates its way out of the crisis driven easy money policy.


Back2Basics: What is taper tantrum?

  • Taper tantrum refers to the 2013 collective reactionary panic that triggered a spike in U.S. Treasury yields, after investors learned that the Federal Reserve was slowly putting the breaks on its quantitative easing (QE) program.
  • The Fed announced that it would be reducing the pace of its purchases of Treasury bonds, to reduce the amount of money it was feeding into the economy.
  • The ensuing rise in bond yields in reaction to the announcement was referred to as a taper tantrum in financial media.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

RBI keeps repo rate unchanged

Note4Students

From UPSC perspective, the following things are important :

Prelims level : MPC

Mains level : Paper 3- Tackling inflation while maintaining the availability of easy money

The MPC decided on Friday to leave the Repo rate unchanged at 4%. However, the RBI faces a dilemma over the excess liquidity in the economy while tackling inflation.

Limits of monetary  policy

  • Even though our economy slumped into a recession in the first half of 2020-21, there seems little further RBI can do with monetary policy to spur growth.
  • Its monetary decision to leave its main policy rate unchanged at 4%, the rate at which it lends money to banks, thus seems appropriate.
  • This is because retail inflation has hovered above its 6% upper tolerance limit for much of this year.
  • It is the first time its 2016-adopted price-stability framework looks poised for failure.
  • Meanwhile, it has announced wider coverage of an earlier scheme by which banks buy bonds issued by firms in specific stressed sectors–a way to ease credit.

Poor credit demand

  • Supply-side measures have their limits of efficacy, with aggregate demand observed to be in a bad way and investments restrained by uncertainty.
  • Therefore, RBI’s focus had to shift to the inflationary effects of excess liquidity detected in the economy.
  • Oddly, this doesn’t seem to have happened.
  • With over 6 trillion still being parked daily by banks with RBI at its reverse repo window, a reflection of poor credit demand.

Dilemma RBI faces in maintaining low interest rate

  • Plus, India has seen a large sum of dollars coming into India.
  • To keep the rupee’s global value stable and Indian exports competitive, RBI has been buying those dollars, thus raising our foreign exchange reserves and pumping more liquidity into the domestic arena.
  • Sterilizing the inflationary effect of this usually requires bonds to be sold, which increases their market supply and pressures yields up-a dilution of its stance on easy money.
  • This poses a dilemma that RBI may soon have to grapple with.
  • RBI’s core task as a central bank, of watching both the external and internal stability of the currency under its charge, may get more complex than ever if capital inflows stay high, global investors see an opportunity in ‘carry trade’ profits, and price trends don’t go by its expectations.

Conclusion

If India’s broad policy frame is being pushed by our covid crisis towards a major reset, with the Centre’s fisc granted a freer run and its debt burden to be partially inflated away over the years, then that would call for another debate.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

Reinforcing the RBI’s accountability

Note4Students

From UPSC perspective, the following things are important :

Prelims level : MPC and inflation targets

Mains level : Paper 3- Inflation targeting by the RBI

Inflation targeting and legal provisions

  • The inflation target, notified in August 2016, is 4%.
  • The upper tolerance level was set at 6% and the lower tolerance level at 2%.
  • Inflation was 6.7% in the January-March quarter, 6.6% in the April-June quarter and 6.9% in the July-September quarter.
  • Breaching limits for any three consecutive quarters constitutes a failure to achieve the inflation target.
  • In such an event, the Reserve Bank of India (RBI) is required to send a report to the Centre, stating the reasons for the failure to achieve the inflation target, the remedial actions it proposes to initiate, and an estimate of the time-period within which it expects to achieve the inflation target through the corrective steps proposed.
  • Through amendments passed by Parliament in 2016, these new provisions were written into the RBI Act.
  • They are aimed at ensuring enhanced transparency and accountability of the central bank.

Reason given by the RBI for missing the target

  • The normal data collection exercise of the National Statistics Office was disrupted during the lockdown imposed due to the COVID-19 pandemic.
  • The minutes of the Monetary Policy Committee (MPC) meeting after its August policy review suggest that the RBI’s defence for the breach of the 4% inflation target and 6% upper tolerance limit was the handicap of data limitations.

Issues with the reason given by the RBI

  • The range around the inflation target that the Ministry provided to the RBI is for accommodating constraints and challenges like data limitations.
  • The whole point of the range around the target, the statement emphasised, is that it “accommodates data limitations, projection errors, short-run supply gaps and fluctuations in the agriculture production”.

Way forward

  • RBI should be made to explain what it plans to do to control inflation.
  • The central bank should be allowed to state expressly what support by way of government policy it needs to meet the inflation target.
  • This can only strengthen the RBI’s hand; it should not let go of the opportunity to reinforce the MPC framework.

Conclusion

Transparency can enable more informed decision-making within the government, greater public scrutiny of the RBI’s performance, and an improved inflation-targeting regime. To slack off on it would be to compromise with the credibility, transparency and predictability of monetary policy.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

The RBI tunes in to the economy

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Inflation targeting mechanism

Mains level : Paper 3- Issues with the inflation targeting mechanism of the RBI

The article analyses the recent changes signalled by the RBI in its policymaking.

Changes in the economic policymaking

  • Recently the U.S. Fed declared that the Fed will not let inflation stand in the way of maximising employment.
  • The reason for this was that the Phillips Curve, the relationship between inflation and unemployment, may no longer hold in the U.S. economy.
  • This is significant, given that the Anglo-American economics has been dominated by Phillips Curve.

Why there was need for change in inflation targeting

  • Data show that the model that currently guides India’s inflation control strategy may be quite irrelevant.
  • This is seen in the recent behaviour of inflation.
  • We know that output contracted by more than 23% in the first quarter of this year.
  • Despite this staggering decline the inflation rate did not change,
  • This was contrary to experience that inflation reflects an ‘over heating’ economy, one growing too fast in relation to its potential.
  • This view represents the RBI’s official understanding of inflation, and presumably forms the basis of its policy of inflation targeting.
  • It was endorsed by the Government of India when it legislated the modern monetary policy framework to enable the RBI to pursue inflation targeting.
  • If the Phillips Curve, which the RBI’s approach internalises, exists, inflation should have decreased as India’s economy contracted during the lockdown.
  • The current inflation targeting mechanism had been imagined with developing economies in mind.
  • Inflation targeting mechanism is based on the idea that food prices are an important determinant of inflation along with imported inflation.
  • Accordingly, a macroeconomic contraction need not lower inflation.

Role of food prices in India

  • A recent working paper of the RBI’s research department suggested that a more eclectic model than the one that underlies inflation targeting does a better job of forecasting inflation in India.
  • This model accepts a role for food prices, a possibility that is missed when embracing economic models developed in the western hemisphere, where food prices have stopped trending upwards over half a century ago.

Conclusion

The RBI shifting away from its rigid inflation targeting policy is in tune with the time and signals that the central bank is finally alive to India’s economy.


Back2Basics: What is Philips Curve?

  • The Phillips curve is an economic concept, stating that inflation and unemployment have a stable and inverse relationship.
  • The theory claims that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment.
  • However, the original concept has been somewhat disproven empirically due to the occurrence of stagflation in the 1970s, when there were high levels of both inflation and unemployment.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

Dilemma the RBI faces

Note4Students

From UPSC perspective, the following things are important :

Prelims level : MPC

Mains level : Paper 3- Role of the RBI and contradictions in its functions

Limitations and contradictions in the functioning of RBI

  • The Reserve Bank of India, along with the monetary policy committee, has undertaken measures to address the fallout of the COVID-19 pandemic.
  • Their actions are guided by multiple considerations — inflation and growth management, debt management and currency management.
  • These multiple considerations have inadvertently exposed the limitations of and the inherent contradictions in the central banking framework in India.

Monetary policy functions

  • The MPC is guided by the goal of maintaining inflation at 4 plus/minus 2 per cent.
  • In its August policy, despite dire growth prospects, MPC chose to maintain the status quo.
  • This decision was driven by elevated inflation i.e. above 4 plus/minus 2 per cent. 
  • This raises the question: At the current juncture, should the MPC be driven by growth considerations or should short-term inflation concerns dominate?

Understanding the nature of current inflation

  • The current rise in inflation is driven by supply-chain dislocations owing to the lockdowns.
  • This is evident from the growing disconnect between the wholesale and consumer price index.
  • Since April, while WPI has been in negative territory, CPI has been elevated.
  • The MPC’s mandate is to deliver stable inflation over long periods of time, not just a few months.
  • Yet, it would appear as if it is more concerned about elevated inflation in the short run.
  • Equally puzzling is the refusal of MPC to provide any firm projection of future inflation.

Manager of government debt

  •  As manager of the government debt, the RBI is tasked with ensuring that the government’s borrowing programme sails through smoothly.
  • To this end, it has carried out several rounds of interventions popularly known as operation twist.
  • in operation twist government RBI intended pushing down long-term Gsec yields, and exerting upward pressure on short-term yields as a consequence.
  • In doing so, the RBI ended up doing exactly the opposite of what the MPC was trying to achieve by cutting short term rates, well before it reached the lower limit of its conventional policy response.

3) RBI’s intervention in currency markets

  • The RBI’s interventions in the currency market have constrained its ability to carry out open market operations as these would have led to further liquidity injections into the system.
  • Put differently, its debt management functions have run up against its currency management functions.
  • Underlining the complexity of all this is the talk of sterilisation — the opposite of injecting liquidity in the system.

Consider the question “RBI’s functions at the current juncture suffers from contradicting functions. Examine such contradictions in its role and suggest the ways to avoid such contradictions.”

Conclusion

The central bank must develop a clear strategy on what to do. At this juncture, there is a strong argument to look past the current spurt in inflation, and test the limits of both conventional and unconventional monetary policy. At the other end, while it may want to intervene to prevent the rupee’s appreciation, in doing so, it is constricting its debt management functions which will have its own set of consequences. There are no easy answers.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

Monetary Policy Committee (MPC) to meet 5x this Fiscal

Note4Students

From UPSC perspective, the following things are important :

Prelims level : MPC and its various tools

Mains level : Not Much

The rate-setting Monetary Policy Committee (MPC) will be meeting five times in FY21, against seven in FY20.

Monetary Policy tools are all-time favourites of UPSC. Kindly go through the link given in the Back2Basics section.

Monetary Policy Committee (MPC)

  • The Monetary Policy Committee (MPC) is a committee of the RBI, which is entrusted with the task of fixing the benchmark policy interest rate (repo rate) to contain inflation within the specified target level.
  • The RBI Act, 1934 was amended by Finance Act (India), 2016 to constitute MPC to bring more transparency and accountability in fixing India’s Monetary Policy.
  • The policy is published after every meeting with each member explaining his opinions.
  • The committee is answerable to the Government of India if the inflation exceeds the range prescribed for three consecutive months.
  • Suggestions for setting up a Monetary policy committee is not new and goes back to 2002 when YV Reddy committee proposed to establish an MPC, then Tarapore committee in 2006, Percy Mistry committee in 2007, Raghuram Rajan committee in 2009 and then Urjit Patel Committee in 2013.

Composition and Working

  • The committee comprises six members – three officials of the RBI and three external members nominated by the Government of India.
  • The meetings of the Monetary Policy Committee are held at least 4 times a year and it publishes its decisions after each such meeting.
  • The Governor of RBI is the chairperson ex officio of the committee.
  • Decisions are taken by a majority with the Governor having the casting vote in case of a tie.
  • They need to observe a “silent period” seven days before and after the rate decision for “utmost confidentiality”.

Back2Basics

Monetary Policy tools and Money Supply in India

 

Also read:

How reverse repo rate became benchmark interest rate in the Indian economy?

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] Operation Twist

Note4Students

From UPSC perspective, the following things are important :

Prelims level : OMO

Mains level : OMO - effectiveness

Context

The Reserve Bank of India announced its decision to conduct simultaneous purchase and sale of government securities for Rs 10,000 crore each, under Open Market Operations (OMO). 

The need of the hour

  • This is done after a review of the current liquidity, market situation and evolving financial conditions.
  • Similar to past US experiments – Financial markets perceive this as an Indian variant of Operation Twist. This is said to be similar to the asset purchase programme kicked off by the Kennedy administration in the US in 1961 and later in 2011 by the US Federal Reserve to help lower long-term interest rates.

OMO

  • It is an instrument of monetary policy aimed at either withdrawing liquidity or boosting it, including during periods of robust capital flows.
  • Objective – The aim is to influence long-term interest rates and also to provide a boost to the economy by making the cost of capital or funds cheaper for business and industry and other borrowers.
  • Such programmes were launched in the US first during a recession and later during a prolonged slowdown.
  • Reason – Even after aggressively cutting its policy rate by 135 basis points this year, monetary policy transmission has been weak. Banks are not lowering rates significantly given the state of their balance sheets.
  • Need for complementary support – for such a programme to have an impact, there should be a well functioning market for government securities with depth. 
  • Poor financial sector – the link between India’s bond market and the real economy has been relatively weak and making it worse is a half functional financial sector now.
  • Fiscal performance – the large fiscal slippage — the fiscal deficit at the end of April-October this year at above 100% of the budgeted target — the spike in inflation and toned down projections of GDP growth. 
  • Lessons from the US experience – a programme aimed at reducing long-term bond yields will only have limited impact as long as the government runs a large deficit.

Way ahead

  • There is a growing recognition that central banks are running out of ammunition. 
  • The government should get to work on a credible fiscal deficit reduction plan.
  • It should fix the broken financial system along with unveiling a roadmap for state-owned banks.
  • The divestment programme should get going.
  • The packages for sectoral issues, especially real estate, should be operationalised swiftly.

Back2Basics

Open Market Operations

Economics | Monetary Policy Explained with Examples

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] Trouble with credit

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Slowdown of credit in the economy

Context

The Monetary Policy Report of the RBI paints a worrying picture of credit flows in the economy. 

Status of credit flows

  • Between April and mid-September this year, the flow of funds to the commercial sector collapsed to Rs 90,995 crore, down from Rs 7.36 lakh crore over the same period last year. 
  • Non-food bank credit has declined
  • Flows from NBFCs have declined. 
  • Foreign flows have picked up during this period. 
  • Typically, credit flows in the first half of the year tend to be subdued and pick up in the second half. The decline this time around compared to the previous year is staggering.

Reasons behind this decline

    • It appears to be due to a combination of two factors 
      • a collapse in demand
      • risk aversion

Corporate investments

    • An over-leveraged corporate sector is in the midst of a much needed deleveraging exercise. 
    • In the current environment of subdued demand and low capacity utilisation rates, there is little incentive to launch fresh investments.

Banks

    • On the other hand, banks appear to be reluctant to cut rates to boost lending.
    • They are parking more funds in government securities and with the RBI.
    • RBI report notes that banks have increased their SLR portfolios, holding excess SLR of 6.9% at the end of August 2019 indicating a reluctance to lend.
    • In the face of growing economic uncertainty, banks have tightened credit norms, reducing those eligible for credit.
    • The shift in the liquidity stance from deficit to surplus mode has also not helped boost credit flow to the larger economy. 

Crisis in the NBFC 

      • This has only deepened. 
      • Bank credit and the commercial paper market remains shut for NBFCs.
      • Credit flow from NBFCs to the larger economy has suffered and the fallout is visible in the decline in household debt fueled consumption.

Conclusion

  • A slowdown in economic activity will increase stress on the repayment capacity of borrowers and increase the rise of default, making lenders even more cautious. 
  • The first step towards rebuilding trust, and addressing the stress in the financial sector in order to get credit flowing, should be to ensure a quick and orderly resolution of stressed NBFCs.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] A welcome move, but it’s unlikely to spur demand

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Monetary policy rate cut

Context

With the 25 basis points (bps) rate cut, RBI returned to the conventional wisdom of a rate change in multiples of 25bps.

RBI statement

    • MPC decided to continue with an accommodative stance as long as it is necessary to revive growth while ensuring that inflation remains within the target.
    • RBI’s decision to increase the household income limit for borrowers of NBFCs and MFIs is welcome. It will enhance credit delivery to a larger customer base at the bottom of the pyramid.
    • There is an attempt to boost the domestic forex derivatives market. RBI has decided to allow domestic banks to offer foreign exchange prices to non-residents on a 24-hour basis. 

Efficacy of rate cuts

    • This may push the debt markets to take a cue from the second-generation policy signals and yields may soften from the current level.
    • Efficacy of rate cuts is questionable against elevated household leverage, deteriorating company fundamentals, and weak demand
    • The number of downgrades in H1FY20 grew by 66% vis-à-vis a 20% de-growth for the number of upgrades. The pace of downgrades has been increasing. 
    • Financial flows to the commercial sector in H1FY20 are significantly lower due to a decline in funding from banks and non-bank sources. 
    • Despite a rising interest scenario, credit had expanded by over ₹1.65 trillion but contracted by ₹93,700 crores even as we are in an aggressive rate cut cycle. This indicates credit risk aversion continues to play center stage for the non-bank sector.

Fiscal policy

    • Centre has done a remarkable job in maintaining fiscal consolidation.
    • We are increasingly concerned about the fiscal position of the states. 

Way ahead

    • More clarity is needed to crystallize the KYC requirements for off-shore entities as also their tax implications.
    • In the current context, an only monetary policy rate cut would not work in isolation. It must be complemented by fiscal expansion.

Back2Basics

Foreign exchange derivative

A foreign exchange derivative is a financial derivative whose payoff depends on the foreign exchange rate of two currencies.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] Fiscal wheels must also roll in order to make monetary policy effective

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Monetary policy transmission

CONTEXT

Through four successive reductions in this calendar year, RBI has reduced the repo rate by 110 basis points to 5.4%.

Status of the rate cut

  1. The economy has been slow to respond to these incremental monetary stimuli. 
  2. Quarterly growth data show a continuing slowdown, mainly driven by sluggish demand, due to both external and domestic factors.
  3. There is substantial excess capacity in the manufacturing sector.
  4. With unutilized capacity, temporary and casual employees are being laid off and wage hikes are being postponed, reducing levels of aggregate disposable income, which is further reducing demand, particularly for consumer durables.
  5. Unless capacity utilization improves, investment demand from the private sector is not likely to improve. 

Repo rate reductions only provide enabling conditions to reduce the cost of borrowing. To be effective, adequate transmission needs to take place.

Limitations of Monetary Policy

  1. Demand for investment and consumer durables has to increase, which is a function of income, much more than the cost of borrowing. For this, momentum has to be generated at the fiscal side.
  2. Due to revenue constraints and legislative limits on borrowing, suitable countercyclical fiscal measures have not yet been taken.
  3. Public sector investment has been showing signs of stagnation for some time. The central government’s capital expenditure to GDP has stagnated at 1.6% for 2018-19 and 2019-20 as budgeted.
  4. Without a demand push from the public sector, monetary policy alone would not be effective.

What the government should do

  1. The countercyclical policy is primarily the responsibility of the central government. 
  2. A one-year departure from the budgeted fiscal deficit of 3.3% of GDP for 2019-20 can be justified at the current juncture.
  3. It should be ensured that the entire additional borrowing above the budgeted level is spent on capital expenditure.
  4. It is established fact that increases in government capital expenditures have much larger multiplier effects, as compared to increases in government revenue expenditures.
  5. State governments and the central and state public enterprises should come on board and undertake additional investment spending on infrastructure.
  6. This will push investment from the private sector, uplifting the infrastructure and construction sectors, and later spreading out to other sectors.
  7. This will trigger a virtuous cycle focused on the employment-intensive infrastructure and construction sectors -> private disposable incomes would increase -> reversing the ongoing demand slow down.
  8. As the magnitude of private borrowing grows, the transmission would improve.

Together, the joint impact of the fiscal and monetary stimuli is expected to uplift the country’s growth from its present low level to levels comfortably above 7% and, eventually, closer to 8.5-9%. Sustaining growth at these levels is required if India were to become a $5-trillion economy by the end of FY25.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] The capital adequacy norms for banks could do with revision

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Nothing much

Mains level : Problems with monetary policy transmission


Context

The monetary policy committee of RBI will announce its monetary policy decision. RBI is widely expected to cut rates.

Challenges in Monetary policy transmission

  1. Irrespective of the magnitude of a rate cut, the question of transmission is a big one.
  2. Interest rate cuts take much longer to be passed on.
  3. It is not even clear if interest rates matter in the current uncertain environment. 

Risk weights

  1. In the credit boom years up to 2007, RBI had proactively adjusted risk weights to dissuade banks from lending excessively to certain sectors and businesses.

Why reverse now

  1. According to data published by the Bank for International Settlements (BIS), India’s credit-to-GDP gap has been negative since 2013 and is now running well below trend.
  2. Banks are unwilling to lend and businesses are not keen to borrow either. The caution of banks should not starve creditworthy borrowers.
  3. In the post-2008 phase, regulators around the world have embraced counter-cyclical capital buffers and macroprudential norms to better regulate credit creation while interest rates hit new lows. RBI could use the mechanism of countercyclical capital buffers to ease credit conditions.
  4. Act in concert with owners of banks in enforcing lending discipline.
  5. Central bank prescribing the MCLR-based lending rate as the floor in a liberalized interest rate environment is incongruous.
  6. The government must use the crisis to legally enshrine non-interference in the operational decisions of banks
  7. The government must incentivize banks to augment their assessment of creditworthiness and risk assessment of loans on a continuous basis.
  8. Capitalization support and operational autonomy must be made contingent on skill up-gradation and other quantifiable performance measures.
  9. As economic conditions normalize, countercyclical capital buffers must and will move in the opposite direction.
  10. The bigger question is whether the capital adequacy norms prescribed under Basel III should be made uniformly applicable to all banks in India or only to internationally active banks. It will not only reduce the capitalization burden on the government but will also free up lending capacity.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] The misplaced faith in an easy money policy

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Monteary Policy basics

Mains level : Limitations of monetary pollicy

CONTEXT
The reaction of global markets to the US Federal Reserve’s monetary stance suggests investors are vesting too much faith in easy money to promote investment and growth.

Why the emphasis on monetary policy

  1. RBI does have more leeway to reduce its repo rate now that the Fed has lowered its own lending rate in the US by a quarter percentage point
  2. An RBI rate cut may stem the slide in stock prices, but this can be rationalized only by virtue of the signal it sends of RBI’s intent to aid a sluggish economy, not for a quick revival

Limitations of monetary policy

  1. There is evidence to suggest that the efficacy of monetary policy is diminishing.
  2. In the West, this is largely because the cost of capital is already very low by historical standards
  3. Much cheap credit goes into chasing higher-paying assets around the world instead of spurring business activity
  4. In India, monetary policy is even less potent in spurring investment. Various other factors beyond the cost of capital act as a drag.
  5. Of the three- quarters of a percentage point reduction in RBI’s repo rate this year, banks have passed on barely half
  6. With consumption on a downtrend, the will of companies to borrow and invest is weak

Way ahead

  1. What might restore market sentiment are renewed inflows from abroad into Indian shares and securities set off by the Fed’s move
  2. Infrastructure spending spree
  3. Implementing a set of major reforms that allow market forces to play an effective role in most of the arenas
  4. Easing land acquisition rules and turning the country’s labour market flexible could have a dramatic effect on India’s appeal as an investment destination
  5. Reversal of some income tax rules seen as extortionary by rich investors 
  6. LTCG tax could be given a rethink

It is a good time for reforms. Let’s not over-rely on monetary policy.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

RBI has cut lending rates for the third consecutive time

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Repo and Reverse Repo

Mains level : Monetary policy decisions

  • The RBI has reduced the repo rate by 25 basis points (bps) to 5.75 per cent in the second bi-monthly monetary policy meet of the financial year 2019-20 (FY20).
  • It was a third straight interest rate cut by the RBI’s monetary policy committee (MPC).

What is Repo Rate?

  • REPO denotes Re Purchase Option – the rate by which RBI gives loans to other banks.
  • In other words, it is the rate at which banks buy back the securities they keep with the RBI at a later period.
  • Bank gives loan to the public at a higher rate, often 1% higher than REPO rate, at a rate known as Bank Rate.
  • RBI at times borrows from banks at a rate lower than REPO rate, and that rate is known as Reverse REPO rate.

Why has RBI cut repo rate

  • The RBI was widely expected to go for an interest rate cut amid dismal gross domestic product (GDP) growth, subdued investment and slowdown in consumption space.
  • Last week, government data showed GDP growth slowed to a five-year low of 5.8 per cent in the fourth quarter (Q4) of FY19.
  • Weak growth amid benign CPI inflation had created room for the Monetary Policy Committee to cut the repo rate by 50-75 bps through FY20E, beginning in June 2019.

Concern over the cut

  • The big concern is whether the transmission of the cut takes place adequately, in the sense of banks passing in the rate cut to customers.
  • This has not happened sufficiently in the case of the previous cuts.

Back2Basics

Monetary Policy Committee

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] No surprises

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Repo Rate

Mains level : RBI through rate cut is trying to address slowdown in growth as well as keeping inflation in check.

CONTEXT

There was 25 basis points cut in benchmark interest rates by the Reserve Bank of India in its first bi-monthly policy statement of the financial year announced on Thursday.

Need for Cut and basis of cut

  • The market had anticipated such a cut and the only question was whether the central bank would surprise with a deeper 50 basis points cut.
  • In the event, the Monetary Policy Committee (MPC) seems to have decided to hold its horses and settle for a conservative approach given the divergent sets of data that it was confronted with.

1.Fluctuating Inflation Rate

  • On the one hand, inflation, despite the mild spike in February, is well under control at 2.6% and is projected to average 3.2% to 3.4% in the first half of 2019-20.
  • This is below the 4% target set for the MPC.

2.Factors influencing Inflation

  • But there are some factors that could spring a surprise on the upside, such as the behaviour of the monsoon and the trend in global oil prices, both of which feed directly into inflationary expectations.
  • Early forecasts indicate a strong possibility of a below-normal monsoon due to El Niňo. Such an event would cast a shadow on agricultural output, and consequently the food prices.
  • Similarly, global oil prices are now edging close to the $70 a barrel mark on the back of production cuts by the OPEC cartel.
  • While the soft growth trends in the global economy could act as a check on any runaway increase in oil prices, the chances of a sharp fall in the next few months appear remote at this point in time.
  • If these are points of upward pressure on inflation, on the other side growth has been faltering in the last few months, going by both data on industrial output and overall GDP.

Slowdown in growth rate

  • The Central Statistics Office has revised the GDP growth for 2018-19 downwards to 7% while the RBI has projected a lower growth of 7.2% in 2019-20 compared to the 7.4% estimated in the last policy.
  • The 25 basis points cut is, therefore, an acknowledgement by the MPC of the slowdown in growth.

Policy Shift

  • It also signals a shift in policy since Shaktikanta Das assumed office as Governor of the RBI, whereby the MPC is not solely focussed on inflation but also takes into account growth trends with equal seriousness.
  • The MPC’s neutral policy stance is prudent given the uncertainties ahead as it gives the central bank the flexibility to tailor policy to emerging data sets.

 

Conclusion

Meanwhile, New Governor has sent out a welcome, clear signal on the central bank’s commitment to the framework for resolution of stressed assets in the backdrop of the Supreme Court striking down its circular issued on February 12, 2018. While underlining that the RBI’s powers have not been compromised, he has indicated that the central bank will soon reissue the circular taking into account the apex court’s observations. This is as it should be.

 

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

RBI cuts Repo Rate

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Repo and Reverse Repo

Mains level : Monetary Policy of the RBI

  • The RBI cut its repo rate, or the rate at which it lends to banks, by 25 basis points to 6 per cent.

What is Repo Rate?

  • REPO denotes Re Purchase Option – the rate by which RBI gives loans to other banks.
  • In other words, it is the rate at which banks buy back the securities they keep with the RBI at a later period.
  • Bank gives loan to the public at a higher rate, often 1% higher than REPO rate, at a rate known as Bank Rate.
  • RBI at times borrows from banks at a rate lower than REPO rate, and that rate is known as Reverse REPO rate.

Why a cut?

  • The key consideration for the RBI has shifted from inflation to growth and analysts are betting on the lower inflation rate as well as slower growth in the economy to spur the decision to slash rates.
  • In its last policy review in February, the MPC had shifted the monetary policy stance to ‘neutral’ from ‘calibrated tightening’.

Implications for Consumers

  • For retail consumers, a cut in rates could have a two-pronged impact. For depositors, new deposits will earn a lower rate and thereby lower returns.
  • For borrowers, though, a downward movement of interest rate would bring down the interest outgo in the near future.

Back2Basics

Monetary Policy Committee

Monetary Policy Committee

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap]Ease the flow

Note4Students

Mains Paper 3: Economic Development| Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.

From UPSC perspective, the following things are important:

Prelims level: Basic knowledge of RBI’s open market operations.

Mains level: The news-card analyses the reasons for high interest rates its implications over the economy, in a brief manner.


NEWS

CONTEXT

RBI’s tight monetary policy has kept real interest rates high, impacting investment flow and job creation.

High Interest Rates

  • Between January 2018 and January 2019, India’s consumer price inflation has fallen from 5.07 per cent to 2.05 per cent, year-on-year.
  • Yet, the State Bank of India’s MCLR or marginal cost of funds-based lending rate for three years has gone up from 8.10 per cent to 8.75 per cent.
  •  ICICI Bank, likewise, has raised its MCLR for one year from 8.2 per cent to 8.8 per cent.
  • Even yields on 10-year government of India bonds have fallen only marginally from 7.67 per cent to 7.37, despite inflation sliding so sharply.

Impact on Growth

  •  We have today are very high “real” rates of interest.
  • If businesses are borrowings at not less than 9 per cent — micro, small and medium enterprises would obviously be paying much more — when inflation, whether based on the consumer or wholesale price index, is below 3 per cent, it is something serious.
  • During 2012-13 and 2013-14, consumer price inflation averaged 9.7 per cent, whereas benchmark prime lending rates ranged at 9.75-10.25 per cent.
  • Average consumer inflation has come down to 3.6 per cent in 2017-18 and 2018-19 (till January 2019).
  • High real interest rates for a prolonged period is why investments have slowed down and very few jobs are being created.

Reasons for high interest rates

  • The source of it has been the RBI’s tight monetary policy. 
  • A firm commitment to low inflation and macroeconomic stability helped restore investor confidence badly dented during the loose fiscal and monetary policies.
  • But the tightening has gone on for too long.

Way Forward

  • The RBI should cut its overnight lending or “repo” rate in the next policy review meeting in April.
  •  It can even go in for a 0.5 percentage point reduction, instead of the usual 25 basis points.
  • The central bank could also consider more open market operations to bring down bond yields across all maturities. 
  • The government, too, should slash interest rates on the Employees Provident Fund, small savings and other administered schemes.

 

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] Growth prop On RBI repo rate cut

Note4Students

Mains Paper 3: Economic Development| Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.

From UPSC perspective, the following things are important:

Prelims level: Basic knowledge of RBI’s open market operations.

Mains level: The news-card analyses the recent rate cut by RBI and its implications over the economy, in a brief manner.


Context

  • The RBI has recently cut the benchmark repo rate.
  • However, concerns over the fiscal deficit remains.

Change of stance

  • Barely four months after the Reserve Bank of India switched its monetary policy stance to one of ‘calibrated tightening’, signalling interest rates were set to trend higher, it has reversed direction.
  • Not only did the RBI’s monetary policy committee unanimously opt to revert to a ‘neutral’ posture, but the rate-setting panel unexpectedly decided, by a 4-2 majority, to cut the benchmark repo rate by 25 basis points, to 6.25%.

MPC’s reasoning has been fairly straightforward

  • With Consumer Price Index-based inflation having continued to slow and projected to stay well below the medium-term target of 4% till at least the October-December quarter, the MPC saw an opportune moment to pivot to a growth-supportive stance.
  • That there is a need to bolster economic momentum is evident from the RBI’s downward revision of the forecast for growth in the first half of the next fiscal year.
  • The projection has been lowered to a range of 7.2-7.4%, from 7.5% posited in the RBI’s December statement, as moderating global growth and slowing overseas demand add uncertainties to the prevailing domestic imbalances.
  • Specifically, production and import of capital goods, which is a key gauge of investment demand, contracted in November/December and credit flows to industry remain muted.
  • With an overall shortfall of 4% in rabi sowing across various crops, and storage in major reservoirs at just 44% of the full level, the slowdown in farm output growth may end up being more protracted.

Weakening of demand

  • The less-than-sanguine outlook for the rural economy is also reflected in the high-frequency indicators of the services sector.
  • Data on sales of both motorcycles and tractors in December underscore weakening demand in the hinterland.
  • This weakness in the farm sector is undergirding the unprecedented softness in food prices.
  • The December CPI data showed continuing deflation in food items.

MPC’s acknowledgment

  • While the RBI’s inflation calculus clearly benefits from the ongoing trend in price gains, the MPC is justifiably cognisant of the tenuousness of the assumptions it has made for its forward projections.
  • Importantly, while it has assumed a normal monsoon this year, the central bank acknowledges that any variation in geographic spread or uneven distribution in terms of time could roil the inflation outlook.

Way Forward

  • However, the RBI’s policy statement fails to make any mention of its hitherto abiding concern about fiscal prudence.
  • With the Interim Budget showing some slippage from the fiscal roadmap and projecting a budget deficit of 3.4% for both the current financial year and the next, the risk of government borrowing crowding out private investment demand remains tangibly real.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

Monetary Policy Committee Notifications

[op-ed snap] No easy transfer

Note4students

Mains Paper 3: Indian Economy| Issues relating to planning, mobilization of resources, growth, development and employment.

From UPSC perspective, the following things are important:

Prelims level: fiscal stimulus, fiscal policy

Mains level: The newscard discusses impact of easing — fiscal, monetary, and regulatory, on the Indian economy, in a brief manner.


Context

  • Rising agrarian distress and the (chronic) headwinds confronting small and medium enterprises (SMEs) have taken center stage.
  • Extrapolating from this, some are fearing a more generalised and sustained slowdown.
  • This has inevitably led to calls for some easing — fiscal, monetary, regulatory.

Background

  1. The economic narrative in India has rapidly evolved. As recently as October, the policy was focused squarely on preserving macroeconomic stability as external imbalances rose to unsustainable levels and the rupee came under relentless pressure.
  2. With global crude prices collapsing since then and domestic food prices remaining exceptionally benign, stability concerns have receded.
  3. The agrarian distress has already resulted in 10 states announcing farm loan waivers over the last two years.
  4. Now, there is a growing clamour among commentators to introduce unconditional cash transfers to serve as income support for distressed farmers nationally, as has been attempted in Telangana and Odisha.

Dangerous path to tread

  1. First, fears of a growth slowdown are overstated. Near-term prospects have meaningfully improved, as crude prices have collapsed, monetary conditions have eased, and banks have quickly stepped in to fill any void left by non-bank-financial-companies (NBFCs).
  2. Second, bond yields have fallen by almost 70 bps from their highs and, even accounting for some increase in NBFC spreads, monetary conditions have eased to a two-year low.
  3. Third, non-food bank credit growth has picked up sharply, accelerating to a four-year high of 14 per cent, suggesting banks are quickly and increasingly stepping in to fill some of the NBFC voids.
  4. Finally, while the collapse in food prices hurts farmers’ purchasing power and rural consumption, it helps urban consumption.

Amid rising capacity utilisation and the firming of core inflation recently, easing would simply exacerbate underlying imbalances and sow the seeds of future macroeconomic instability.

  1. Fiscal exhaustion
  • The total public sector borrowing requirement (Centre, state, off-balance sheet, central public sector enterprises) was still a hefty 8.2 per cent of GDP in 2017-18.
  • Although, the Centre has been bringing its deficit down, but this has been completely offset by state deficits, off-balance sheet borrowing, and central public sector-enterprise borrowing rising commensurately.
  • Unsurprisingly, this has led to fiscal exhaustion among markets. The slope of India’s government yield curve has continuously risen in recent years.
  • The implication is clear: Any fiscal relaxation at this point will become counter-productive, pushing up borrowing costs and crowding out economic activity.
  1. Fiscal imbalances vis-à-vis external counterpart
  • The current account deficit (CAD) is simply an economy’s investment-savings gap. Public dis-savings remain elevated. Therefore, the main reason the CAD narrowed is because private investment slowed so sharply.
  • If the private investment cycle picks up — as we all hope — the CAD would balloon, unless the public-sector imbalance reduces.
  • In other words, without more fiscal consolidation, we will always be choosing between a sustainable CAD and higher private investment.

The policy challenge

  1. There is absolutely no space for new unfunded liabilities. The pace at which farm loan waivers have been proliferating is worrying, even though budgetary allocations have been much lower than announcements.
  2. As is well known, loan waivers are a particularly blunt instrument suffering from the familiar pitfalls of vitiating credit culture, addressing the symptom, not the underlying cause, and disproportionately favouring larger farmers who rely on institutional credit.

Impact of Proposed direct, unconditional, cash transfers as income support for farmers

  1. A variety of proposals have been mooted from paying farmers the difference between market prices and minimum support prices (MSPs) in cash, to a broader quasi-universal basic income that covers 25-50 per cent of the population, costing anywhere from 1-5 per cent of GDP based on their expansiveness.
  2. The question is how will this be paid for, given that India’s fiscal cup runneth over? The policy challenge, therefore, is to either find the fiscal space for cash transfers by reducing existing subsidies and welfare programmes, or to offer either existing product subsidies or equivalent cash transfers, but not both. In the current environment, both options look politically daunting.

Could the RBI’s excess capital pay for income support?

  1. RBI special dividend will either be one-off or staggered over a few years, whereas any new farm-income-support creates a perpetual liability.
  2. Second, from an accounting perspective, the fiscal deficit will not widen because the additional expenditure will be paid for by the transfer of capital from the RBI.
  3. If the transfer, for example, is spent on cash transfers — instead of retiring public debt — the “effective fiscal impulse” will increase by the full quantum of that spending tantamount to a fiscal stimulus, with the attendant implications on pressurising macroeconomic imbalances.

Will the pressure on the fiscal be accompanied by monetary and regulatory easing?

  1. There is growing market/bank clamour for some regulatory easing towards banks. Policymakers must eschew this.
  2. NPAs appear to have peaked, the IBC has changed the debtor-lending balance of power, the government has injected more capital, and credit growth has increased smartly in recent months.
  3. Lowering lending standards through any regulatory easing at this stage, risks undoing accruing gains and triggering a fresh wave of NPAs down the line.

Way forward

  1. India cannot get complacent in this environment and inadvertently indulge in any excesses. India’s growth prospects have improved, and there is no case, or space, for an inadvertent confluence of fiscal/regulatory/monetary easing.
  2. Resolving the stress in agriculture and SMEs is imperative but requires well-known supply-side reforms to improve scale, productivity and viability.

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

To read about the basic concepts of economics at play here:

  1. Economics | Fiscal Policy Explained
  2. Economics | Monetary Policy Explained with Examples

By Dr V

Doctor by Training | AIIMSONIAN | Factually correct, Politically not so much | Opinionated? Yes!

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