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View: The market may start asking if the next interest rate move depends on the state of GoI’s finances

What matters more when deciding rates — growth-inflation dynamics or govt finances? As of now, it's a blur.

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Last Updated: Feb 20, 2020, 03.27 PM IST
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The shift to a formal inflation-targeting framework in 2015, and the delegation of all authority regarding interest rate policy to MPC for the first time, separated monetary policy from RBI’s many other functions, including managing GoI’s debt.
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By Jahangir Aziz

The dust has finally begun to settle on this year’s budget and post-budget monetary policy review. With the immediate reactions of the market and analysts out of the way, it’s a good time to assess, with some detachment, the content of the two. Much of the equity market’s disappointment was that the budget, which aims to cut the headline deficit from 3.8% of GDP last year to 3.5%, was devoid of any material tax cuts or increased spending when GDP growth has dropped to its lowest since the 2008-09 global crisis.

The reality is, however, different. Most countries do not count privatisation as revenue, but as a source of financing fiscal deficit since it’s just a redistribution of savings from the private sector to the government. It does not change overall demand in the economy. Excluding privatisation from revenue, as it should be, a very different picture of the fiscal stance emerges. The underlying deficit in 2018-19 at 3.9% (headline deficit 3.4%) widened to 4.1% (headline 3.8%) in 2019-20, providing 0.2% in fiscal support.

For 2020-21, the underlying budgeted deficit is 4.5%, excluding the outsized 0.9% of planned privatisation. This implies a doubling of fiscal support of 0.4%. Of course, it is uncertain whether privatisation and tax collection targets will be achieved and modest fiscal changes are sufficient to put India back on its winning way. But, as of now, GoI intends to provide substantial fiscal support this year —not the other way around, as widely believed. While the Monetary Policy Committee (MPC) held rates citing high inflation, RBI announced a raft of new liquidity measures, including one and three-year repos with banks. While the market waxed eloquent about these inspired measures, they raise questions about India’s monetary policy framework.

The shift to a formal inflation-targeting framework in 2015, and the delegation of all authority regarding interest rate policy to MPC for the first time, separated monetary policy from RBI’s many other functions, including managing GoI’s debt. This, by far, has been one of GoI’s most effective and far-reaching structural reforms.

There’s a rate cut, there’s not

What happened on February 6? MPC revised higher its inflation forecast for the year on the back of the recent rise in food prices and kept policy rates on hold. At the same time, RBI announced the new long-term repo operations (LTROs) that effectively cut yields on medium-term government paper by about 25 basis points (bps). Thus, while MPC found the rise in inflation sufficiently disconcerting to keep policy rates on hold, RBI found it benign enough to effect a cut in interest rates.

To be clear, I am not questioning whether the decisions were appropriate or not, although I am puzzled by MPC’s inability to look past the transient rise in food inflation as implied by its own 2020 forecast and continue to cut rates. India’s real lending rates (deflated with core inflation) have risen relentlessly over the past 12 months. The hoped-for domestic recovery is likely to be delayed by the outbreak of coronavirus, substantially damaging near-term global demand and intensifying global disinflation.

Instead, my question is whether this is the new de facto monetary policy framework, whereby MPC decides the overnight rate and RBI the rest of the yield curve. Many will argue that the reduction in medium-term rates is an unintended consequence of LTROs, which aim to provide liquidity to improve monetary transmission and boost credit.

First, if there is one lesson the recent history of India teaches us, it is that policymakers need to be wary of inadvertent spillovers from their policy choices. Second, with excess interbank liquidity at 1.5% of GDP, it is doubtful whether further injection of liquidity will boost credit. On the one hand, demand for credit is low because of weak growth. On the other, banks have appropriately tightened lending standards, as it was hoped they would, after the painful restructuring of bad loans over the last 18 months.

Some will argue that there is nothing wrong with a central bank controlling the yield curve. After all, don’t all the G3 (US, EU, Japan) central banks effectively do the same? True, for the most part. But there is a difference. These central banks resorted to unconventional monetary policy only after policy rates had hit zero, not when they were above 500 bps as in India. In addition, economic efficiency demands that the central bank influence the interest rate structure with minimal control and allow the market to determine the price and allocation of credit. This implies controlling rates at the shortest horizon, not the entire term structure.

Separation of church & state

Separately, even if not intended, LTROs could well be misconstrued as ways to reduce government borrowing costs. For years, GoI has been urged to relieve RBI of debt-management responsibilities and entrust these to an independent agency, as in most developed and advanced emerging market economies. This is because the two objectives — monetary policy and debt management — can lead to contradictory choices about interest policy, as is the case now. It would not be surprising if the market starts to ask whether growth-inflation dynamics, or the state of government finances, will decide the next interest rate move.

While governments, both past and present, have shown little urgency in establishing an independent debt management agency, the formation of MPC and the formalisation of RBI’s monetary policy objective since 2015 had been providing some degree of separation between RBI’s two roles. This had helped to greatly clarify RBI’s communications and, in turn, deepen credibility. Alas, these old disconnects have now resurfaced.

The writer is Chief Emerging Markets Economist, JPMorgan Chase Bank
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)

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