RBI's monetary and Centre's fiscal policy are moving hand-in-glove

Sameer Narang, Chief Economist, Bank of Baroda
Coming on the back of a historic Union Budget, Reserve Bank of India's (RBI) monetary policy is complementary to the fiscal policy. While policy rates have been kept unchanged, RBI has given forward guidance that it will continue to provide ample liquidity into the next financial year, as was the case earlier. This is essential to see through elevated borrowing of Rs 12 trillion by Centre and Rs 10 trillion by states in the next year.

 
RBI has done exceptionally well in managing government's extended borrowing this year when fiscal deficit has shot-up to 9.5 per cent of GDP. In fact, the glide path given by the Centre shows that fiscal deficit will now be at 4.5 per cent of GDP in FY26. Hence, the focus has to be to have orderly financial markets and financial stability. 

 
RBI did purchase (net) bonds worth Rs 2.5 trillion in the current financial year. Banks too have turned large buyers of government bonds at Rs 7.5 trillion. This has helped in clearing the elevated supply—Centre and states put together—of Rs 17 trillion in the current year (as of now). RBI also gave forward guidance that it along with market participants will see that supply of government bonds is absorbed. 

 
For the same, RBI had given leeway to banks that bonds bought after September 1, 2020 will qualify for held to maturity (HTM) segment. The HTM segment was itself raised to 22 per cent of net demand and time liabilities (NDTL) from 19.5 per cent and has now been extended till March 2023. Bond purchased next year too will qualify. With this, banks can buy bonds without worrying about mark-to-market losses.

 
In order to deepen government bond market and tap household financial savings directly, RBI will now give access to retail investors to government securities market—primary and secondary—through Reserve Bank (‘Retail Direct’). With this, India has joined a select few countries offering this facility.This will channelize financial savings into government securities when fiscal deficits are elevated.

 
Apart from forward guidance on liquidity, RBI has also given growth and inflation projections. MPC had communicated that it will see through transient uptick in inflation due to supply side disruption, higher domestic energy prices and gold prices. During the first nine months of this financial year, retail inflation has averaged 6.6 per cent led by food inflation at 9.2 per cent. Inflation did come down to 4.7 per cent in Dec’20 and is expected to bottom out in Jan’21. Hence, RBI has reduced its inflation forecast to 5.2 per cent in Q4FY21. However, the decline in inflation is led by food inflation. Core inflation or services inflation remains entrenched at 5.5 per cent or higher. Rising global commodity prices and normalization of economic activity implies inflation is unlikely to come down to RBI’s target of 4 per cent next year. In fact, MPC has raised its inflation forecast for H1FY22 to a range of 5-5.2 per cent instead of 4.6-5.2 per cent earlier.

 
The increase in inflation is in-line with improvement in underlying economic activity. MPC has revised its growth projection for H1FY22 to 8.3-26.2 per cent from 6.5-21.9 per centearlier. Accordingly, MPC now believes that growth will improve to 10.5 per cent in FY22 from a low of (-) 7.5 per cent in FY21. The trajectory of recent high frequency indicators and corporate results indicate there is a high likelihood that both the numbers may get revised upwards. A 35% jump in corporate tax collections in Q3FY21 is a testament to underlying sentiment visible in Indian equity markets. Thus in the coming year, RBI can do best to keep policy rates on hold.

 
RBI continues to channelize flow of resources to real economy. It will be giving CRR exemption for any fresh disbursal to unbanked small business borrower (upto Rs 25 lakh). NBFCs have been included in on-tap facility of RBI’s targeted long-term repurchase operations (TLTRO), which was announced for 26 stressed sectors and healthcare.

 
With growth normalizing next year, RBI is also reverting to normalizing its monetary policy operations. RBI had announced a 1 per cent reduction in cash reserve ratio so that banks have ample liquidity to lend. This is now being gradually revised upwards to 3.5 per cent in Mar’21 and 4 per cent in May’21. RBI had announced a variable reverse repo of Rs 2 trillion last month to absorb excess liquidity. Notably, banking system continues to see large liquidity surplus of more than Rs 6.5 trillion even now.RBI’s focus will be to gradually mop-up short-term liquidity while creating conditions to absorb supply of long-end government paper.

 
Last but not least, RBI batted for continuation of inflation targeting regime. In fact, the inflation targeting regime has been a resounding success in anchoring inflation expectations and monetary policy response. As India marches to a US$ 5tn economy, rule based monetary policy is the way to go.



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