It's time to formalise the normalisation process: Part 2

MPC's stance should remain accommodative till growth is secured, and future actions should be data-driven. But for now, reverse repo rate should be hiked by at least 20 bps

The gross borrowing in FY23 is estimated at Rs 14.95 trillion (after the switch of certain papers, it’s Rs 14.31 trillion) -- a historic high. The current year’s gross borrowing has been Rs 11.65 trillion. So far, Rs 10.7 trillion has been raised. Net borrowing after redemptions next year will be Rs 11.186 trillion versus the current year’s Revised Budget Estimate of Rs 9.348 trillion -- again, a historic high. Then, there will be borrowing by the state governments. The state fiscal deficit will rise from 3.5 per cent to 4 per cent next year.

Going by the norms, the banks need to invest just 18 per cent of their net demand and time liabilities, a loose proxy for deposits, in government bonds. The Reserve Bank of India (RBI) data say the commercial banks’ share in the stock of government bonds was 37.82 per cent in September 2021; the next big bond buyers were the insurance companies (24.18 per cent share). The foreign portfolio investors’ holding was just 1.81 per cent.

The Budget is silent on getting India into the global bond indices, which would have encouraged foreign investors to buy Indian papers.

How have the interest rates moved across maturities during the current fiscal year? The 91-day treasury bill yield, which was 3.35 per cent in April 2021, rose to 3.49 per cent in December during the last policy; post-Budget, it is 3.88 per cent. The comparable move for the 182-day treasury bills is 3.59 per cent, 3.82 per cent and 4.4 per cent; and that of 364-day treasury bills, 3.74 per cent, 4.15 per cent and 4.66 per cent.

At the longer end, the 10-year yield was 6.17 per cent in April 2021; it rose to 6.35 per cent during the December policy; and just ahead of the Budget, it was 6.68 per cent. Last Friday, it came within kissing distance of 7 per cent – 6.97 per cent. After the RBI ca­n­celled auctions of two bonds – the last before the Monetary Policy Committee (MPC) meeting from February 8 to 10 – it dropped to 6.88 per cent.

Meanwhile, the overnight call money rate has surged to 4.5 per cent in the recent past. And, the one-year overnight index swap, an indicator of the trajectory of overnight money over the next one year, rose from 3.77 per cent in April 2021 to 4.51 per cent now.

Will the RBI spend its time and energy through FY23 to “manage” the yield by cancelling auctions and through other ammunition in its arsenal such as bond purchase under the open market operations (OMOs) and operation twists or will it allow the market to find its own level? Simultaneous purchase and sale of government securities under OMOs is known as operation twist. It involves buying long-term papers, while selling short-tenure bonds to keep the borrowing costs down.

In its December policy, the RBI expressed concern over the persistence of high core inflation (inflation excluding food and fuel) but kept its retail inflation projection uncha­nged at 5.3 per cent for 2021-22 – 5.1 per cent in the third quarter and 5.7 per cent in the fourth, with risks broadly balanced. In December, the headline retail inflation rose to its six-month high of 5.6 per cent from 4.9 per cent in November. Most analysts see higher retail inflation in the fourth quarter. Thereafter, it would depend on the crude price.

Achilles’ heel

India’s Achilles’ heel is its already weak fiscal position. It entered the pandemic with successive weak growth years, leading to a weakening of fiscal position – the ever-widening successive revenue and primary deficits. Following a shoddy GST implementation and demonetisation, we have seen continuous misses of revenue targets, a yawning gap between the Budget projections and achievements, and an anaemic credit growth.

The expenditure continued to rise for pump-priming the economy, while artificially suppressing the true fiscal deficit even as revenues sagged, killing the fiscal space. The pandemic was the perfect storm, which plunged revenues and further widened the fiscal deficit.

The borrow-and-spend Bu­d­get, without paying attention to the available domestic savings pool, will push up bo­nd yields and crowd out private investments. The savin­gs-borrowing gap is so wide now that the impact on dom­e­s­tic bond yields could be dramatic, which could hit the ent­i­re premise that borrowing can support spending – the fu­l­crum of the Budget. The pro­blem is more with the supply side than demand for bonds.

Main hoon na
 

At a closed-door discussion ahead of the Budget, a market expert nonchalantly said: All the governor would need to say is Main Hoon Na (I am there), a la Shah Rukh Khan in a 2004 Hindi film, Farah Khan’s directorial debut.

Will this policy be that easy? This is probably the most challenging policy for RBI Governor Shaktikanta Das and he needs to do more. Can Das just reiterate that the RBI has already started the normalisation process (by replacing reverse repo with variable rate reverse repo, or VRRR, leading to the rise in short-term rates) and continue with that?

It’s time to change the narrative and formalise the normalisation process. Indeed, VRRR has raised the rates but it creates uncertainty because the size and tenure of such auctions are not uniform. The stance should remain accommodative till the growth is secured and future actions should be data driven but, for now, reverse repo rate should be hiked by at least 20 bps. Another hike of an equal quantum will take it to 3.75 per cent probably in the first policy of FY23 to narrow the gap between repo and reverse repo rates. Then the repo rate hike should start. How many hikes in FY23? That’s anybody’s guess now.

Many are saying that tinkering with the reverse repo rate is not within the MPC remit and the RBI can do it outside the policy anytime it wants to. But if this is not done now, the RBI may lose its control over the narrative. The speed of action will then have to be faster in the future. With the general elections two years away, it will be difficult to counter fiscal dominance if the process does not start now. For Das, managing the cost of government borrowing is more challenging now than managing the monetary policy, particularly when the headroom on inflation vis-a-vis its target is limited.

(The first part of this two-part column on the RBI’s monetary policy appeared on Monday)

The writer, a consulting editor with Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd

His latest book: Pandemonium: The Great Indian Banking Story

To read his previous columns, please log on to www.bankerstrust.in

Twitter: @TamalBandyo