April monetary policy a fine balancing act

It has been beaten to death by banking analysts and economists through intense discussion and dissection. Four days after it was announced, writing on the Reserve Bank of India’s (RBI’s) monetary policy is a predicament akin to that of Larry Fortensky’s, a US construction worker who was the seventh and last husband of Elizabeth Taylor (by her eighth marriage; she married Richard Burton twice).

Fortensky knew well what he was expected to do on their honeymoon in 1991 at Michael Jackson's Neverland Ranch but his challenge was how to be different from Taylor's previous husbands!

On a serious note, presented against a backdrop of falling crude prices, sliding US yield and the second wave of the Covid pandemic gripping India, the first monetary policy of fiscal year 2022 has been a fine balancing act by the Monetary Policy Committee (MPC), the rate-setting body of the Indian central bank.

There has been no surprise in RBI keeping the policy rates unchanged and continuing with its accommodative stance. The fact that this was a unanimous decision by all six MPC members is also no surprise. But there are at least a couple of initiatives that showcase Governor Shaktikanta Das’s knack for innovation in troubled times to steer the economy through and ensure that the cost of government borrowing is reigned in.

Till February, the RBI had been giving a long forward guidance — to continue with its accommodative stance as long as necessary. In fact, it had reiterated the time-based forward guidance in the last few policy statements, saying the accommodative stance would continue “at least during the current financial year (ie, 2020-21) and into the next financial year (ie 2021-22)”.

While that stance remains, there is a subtle but critical change. This time, the policy document says, “The stance of (the) monetary policy will remain accommodative till the prospects of sustained recovery are well secured while closely monitoring the evolving outlook for inflation.”

Clearly, the RBI is not committing to any timeframe; Das will start unwinding once the signs of economic recovery are firmly in place. In isolation, this could have run the risk of being interpreted as the RBI’s readiness to shift the stance anytime it was convinced of recovery and had an adverse impact on the bond market.

To neutralise that, it has smartly poured old wine from a new bottle on the bond dealers’ table.

In the last fiscal year, it had bought bonds to the tune of Rs 3.13 trillion from the secondary market through the so-called open market operations, or OMO. An Indian version of quantitative easing, or QE, it was done in phases looking at the liquidity conditions. This time, the RBI committed an upfront liquidity support, starting with a Rs 1 trillion bond buying from the secondary market in the first quarter of 2021-22.

At this point, inflation projection — even though it is at the upper band of the flexible inflation target — looks a bit conservative, while India’s ability to contain the fresh wave of the pandemic holds the key to growth

Starting this week with a Rs 25,000 crore bond purchase, this initiative is christened “secondary market G-sec acquisition programme”, or G-SAP 1.0.  The RBI is not explicit in its commitment on the size and continuity of this initiative but one could imagine that this will continue through the year, depending on the liquidity needed in the system. We will see G-SAP 2.0 and beyond.

Restoration of the old cash reserve ratio level of banks in two phases from March 27 and May 22 will drain around Rs 1.5 trillion from the banks’ kitty. The G-SAP will neutralise that. What’s the impact of this? Last Friday, the 10-year bond yield dropped below 6 per cent intra-day to 5.97 per cent but closed at 6.02 per cent, sliding some 18 basis points in the new fiscal year that started in April. (One basis point is a hundredth of a percentage point.)

In tune with its balancing act, the RBI also decided to conduct variable rate reverse repo auctions for a longer term to drain surplus liquidity on the shorter end but, allaying fears of tightening, Das promised “ample liquidity” in the system — “a level of liquidity that would keep the system in surplus even after meeting the requirements of all financial market segments and the productive sectors of the economy”. The amount and tenure of such auctions will be decided based on the evolving liquidity and financial conditions but “this is a part of (the) RBI’s liquidity management operations and should not be read as liquidity tightening”.

While the bond market cheered the policy, the currency slipped — more than 1.5 percentage points on the policy day. There were sell-offs in both offshore and onshore markets, indicating unwinding in the so-called carry positions. The carry traders borrow cheaply to invest in markets where they can earn handsomely. Simply put, they were borrowing in the US to invest in India and making money, taking advantage of the interest rate differential but the currency risk remains as they typically keep their positions unhedged. Going by one estimate, the size of the carry position reached $40 billion by February. Fear of rising inflation could be the trigger for the sell-off.

The RBI did not rush to intervene in the foreign exchange market, at least till Friday. With close to $577 foreign exchange reserves in its kitty (in January, it was over $590 billion), and no worry on the balance of payment front, the Indian central bank can afford to be confident at the moment. In the past year, a strong local currency had forced the RBI to buy dollars from the market, leading to infusion of rupee liquidity (for every dollar it buys, an equivalent amount of rupee flows into the system). A slipping rupee, to the extent of the RBI’s tolerance level, will close that liquidity tap.

The RBI has revised its inflation projection downwards to 5 per cent in the fourth quarter of 2020-21. For the current fiscal year, the projection is 5.2 per cent in the first and second quarters; 4.4 per cent in the third; and 5.1 per cent in the fourth, with “risks broadly balanced”. The projection for real GDP growth for 2021-22 has remained unchanged at 10.5 per cent — consisting of 26.2 per cent in the first quarter; 8.3 per cent in the second; 5.4 per cent in third and 6.2 per cent in the fourth.

Structurally, it’s a well-crafted policy. But like in cricket and politics, things can change dramatically for a central bank in a very short time — both for internal and external developments. At this point, inflation projection — even though it is at the upper band of the flexible inflation target — looks a bit conservative, while India’s ability to contain the fresh wave of the pandemic holds the key to growth.

The writer, a consulting editor with Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd | Twitter: TamalBandyo | His latest book is Pandemonium: The Great Indian Banking Crisis