America’s $1.9 trillion rescue package could throw a spanner in RBI’s recovery plans

The government will soon give the Reserve Bank of India (RBI) its inflation target for five years beginning April 1. The RBI, which is an inflation-targeting central bank, is currently tasked with keeping retail inflation at 4%, with an upper and lower tolerance limit of 2 percentage points. The central bank has indicated that it would prefer to continue with that target for the next five years as well.

The new target will become operational at one of the most critical periods in the history of not only Indian, but also the global economy. The Covid-19 pandemic has introduced tremendous uncertainties into forecasting models. Governments and central banks are trying to tailor fiscal and monetary policies to help create jobs and pull economies out of deep slumps, even as they are forced to pour resources into fighting the contagion that is proving to be hydraheaded.

In India, the government is following a borrow-to-grow strategy but the RBI, while helping keep the government’s borrowing cost low, is geared to keep inflation under control. The contradictory impulses would be tough to balance.

“Monetary policy will need to lean against the wind to keep interest rates low to the extent possible,” Mridul K Saggar, a member of the monetary policy committee (MPC) and RBI’s executive director, said at a February 3-5 MPC meeting that decided to hold key interest rates steady, according to the minutes of the meeting.

“If central bank open market operation purchases are moderate, it entails the risk of crowding out of private investment; if they are large, it carries risk of reengineering inflation,’’ Saggar reportedly said, articulating the dilemma.

To be sure, the RBI had correctly anticipated in October that food prices were about to fall. The bank had successfully kept inflation under control until December 2019 when high food prices whacked it out of its upper tolerance range. A postlockdown demand surge, coupled with supply disruptions, ensured it averaged 6.6% in 2020.

The pandemic forced the Centre and states to borrow heavily from the market and spend to support their populations and industry. A comfort for the government was a sharp surge in savings in April-June 2020. Household savings swelled to 21.4% of gross domestic product (GDP) from 7.9% a year-ago period. This was more than doubled from the preceding quarter’s 10%, RBI data showed. It helped fund the Centre’s borrowing programme which shot up by 64% from the budgeted Rs 7.8 lakh crore in 2020-21.

The RBI lent a hand by cutting key interest rates and injecting liquidity into the system. Nearly half of the initial `2trillion Aatma Nirbhar Bharat Package announced by the Centre in May included liquidity enhancing measures and regulatory forbearance of the central bank. The GDP shrunk nearly 24% in the first quarter of 2020-21 but surprisingly contracted only 7.5% in the subsequent quarter, raising hopes of a faster recovery. It entered positive territory in the third quarter, growing marginally by 0.4%.

But the National Statistics Office, which publishes the data, said it now expected the economy to shrink 8% in the whole year, slightly more than the earlier predicted minus 7.7%.

World over, governments are under pressure to prop national economies, which is leading to large-scale borrowing and consequent monetary expansion. US President Joe Biden and the US Congress are fine-tuning a $1.9 trillion rescue package that aims to put money in the hands of Americans to counter the coronavirus economic slump and revive the country’s economic activity. This scheme has raised concerns of runaway inflation and massive economic disruptions at a later stage. Former treasury secretary Lawrence Summers wrote in a Washington Post op-ed that the package might cause “inflationary pressures of a kind we have not seen in a generation, with consequences for the value of the dollar and financial stability”. While the House of Representatives has passed the scheme, it is yet to reach the Senate. The rescue plan has implications for India.

As excess dollars chase assets worldwide, the domestic currency could weaken. “That liquidity is going to go into assets,” says Pronab Sen, economist and former chief statistician of India. “Left to itself, it will put upward pressure on the rupee making India’s exports costly.” The alternative, he says, is for the RBI to monetise the inflows which will put pressure on prices.

Portfolio flows have already topped $6 billion in 2021, according to an Economic Times report based 0n Bloomberg data that was published on February 24. The government’s borrowing programme could soak up that liquidity.

Sen says it could lead to a situation where the prices of assets — equities, gold, commodities and others — bloat while the real economy stays subdued.

The liquidity from excess dollars is going to go into assets. Left to itself, it will put upward pressure on the rupee making exports costlyThe liquidity from excess dollars is going to go into assets. Left to itself, it will put upward pressure on the rupee making exports costly

The difficulty in making a policy decision in uncertain times was evident in the MPC discussions. The central bank had a tough choice to make in its October monetary policy review. Inflation was persistently staying above the upper tolerance limit and had clocked 7.27% in September, which demanded a rate hike.

But the economy needed easy monetary policy to aid recovery. An increase in the rate could have badly affected businesses. “Had this happened, India’s growth trajectory would have been pulled down for a long time to come,” Saggar said, according to the minutes.

The RBI held rates steady on the assessment that the spike in inflation was transient.

It was a good call.

The International Monetary Fund’s Chief Economist Gita Gopinath wrote on February 19 that inflation was an unlikely worry despite liberal economic support packages.

Among the structural factors she pointed out were automation and high profit margins of dominant firms that could absorb rising costs without raising prices. “This crisis could likely increase the market share of such firms, as smaller firms have been harder hit than large businesses by the pandemicrelated downturn,” Gopinath wrote, largely to assuage US worries. A bond selloff in the US in the past weeks, triggered by inflation fears, has been roiling global markets. Fed Reserve chairman Jerome Powell brushed aside inflation concerns but the markets did not pay heed.

Advanced economies may be able to ramp up production or quickly import if demand rises sharply but India has bigger supply constraints and tariff barriers. The micro, medium and small enterprises (MSME) sector, which accounts for 30% of GDP and 48% of exports, has been struggling and many have gone out of business.

High input costs and rising fuel and freight rates are already affecting export competitiveness and it would hurt more if the rupee strengthens owing to surging dollar supply.

Research firm IHS Markit said input cost inflation accelerated to a 28-month high in January. Maritime research firm Drewry’s Composite World Container Index stood at $5,121.04 for a 40 ft box on March 4, up over 185% from a year ago. The condition is said to be so bad in some segments that two small businessmen in the MSME hub of Coimbatore allegedly killed themselves due to business troubles.

Former chief statistician Sen says the source of inflationary pressure in India would likely be demand shifting to large corporates.

It is evident in the stickiness of core inflation and rising capacity utilisation, he points out. A central bank survey in January showed capacity utilisation rose to 63.3% in the second quarter of 2020-21 compared with 47.3% in the first quarter. The RBI pointed at rising fuel and industrial raw material prices for the firmness in core inflation. International crude oil prices have been rising and have topped $65 a barrel, up 28% from the beginning of the year. More than half of retail fuel prices are made up of taxes.

RBI Governor Shaktikanta Das said on February 25 that fuel price hike has a costpush factor and there was a need for coordinated action between the Centre, states on reduction in taxes on fuel prices. “We realise that states and Centre have their revenue pressures and require high sums of money to enable the country and people to come out Covid-19 stress. I am sure state and central governments will take a positive decision in a coordinated manner,” he said.

The full impact of the fuel price rise is still not being felt evenly across the country. Rural fuel inflation rate since February 2020 averaged only about 1% but urban fuel prices rose at a rate of about 7%.

The RBI’s ability to support the government borrowing programme could affect its monetary operations, says Niranjan Rajadhyaksha, research director and senior fellow at IDFC Institute.

Long-term bond yields, whose movements indicate market expectations of interest rates in the economy, have been hardening after the Union Budget was tabled in Parliament.

The 10-year bond yield was at 6.2% on March 5. The gap between the repo rate — the rate (4% currently) at which the RBI buys bonds in the market — and the 10-year government bond has continued to widen.

The five-year bond yield was around 5.8%, or about 180 basis points more than the repo rate. To keep interest rates from rising, the RBI is expected to buy government debt to the tune of about `3 lakh crore in 2020-21 leading to its indirect monetisation. Price stability was “the foundation on which the economy can strive to reach its potential”, the RBI said, while declaring its intention to continue with an easy monetary policy well into the next financial year.

“Balancing fiscal and monetary policies will be the biggest challenge in the next 3-5 years,” says Rajadhyaksha. “It will be a very tricky technical and political-economy problem.”