India in the world of (near) free money

The latest projection by the Organisation for Economic Co-operation and Development shows that the global economy will contract by 4.5 per cent in the current year. Although economic activity is expected to recover in 2021, the pandemic-induced uncertainty would be enduring. Across the world, policymakers are aggressively intervening to contain the economic damage. While it is reasonable to expect that governments and central banks would want to do everything possible to avert an economic meltdown and nurture a durable recovery, some of the interventions made by large central banks will increase policy complications in emerging market countries like India.

The economic projections of the US Federal Reserve indicate that policy rates in the world’s largest economy will remain near zero, at least till 2023. Further, the Fed has moved to an average inflation targeting framework. Consequently, the US central bank will allow inflation to moderately overshoot the target of 2 per cent for some time, following periods when it has run below the target. What this means is policy rates will remain low for an extended period. For instance, under this framework, the Fed would not have been able to increase interest rates starting in 2015. It would be interesting to see if the new framework actually affects inflation expectations.

Further, the new framework could create a fair bit of confusion when inflation is closer to the target. It may not be obvious to financial markets at what point the central bank will start raising interest rates.  Theoretically, if inflation overshoots the target considerably, the Fed might have to keep it below the 2 per cent mark to attain the average over a period of time and this would affect policy decisions. However, in the near term, the policy is likely to remain accommodative. 

The US Fed is not the only central bank making policy innovations. The European Central Bank (ECB) is lending to the banking system at negative rates, which are independent of policy rates. While the deposit rate for part of the excess reserves has been kept close to zero, the ECB’s lending rate to the banking system can go up to (-) 1 per cent, subject to certain conditions. It is being argued that there is no floor to this policy, and rates can go even lower. The obvious question is: Would the central bank not suffer losses by lending at a rate lower than the deposit rate, and will it not increase risks in the system? It definitely will, but that perhaps is a debate for another day. Curiously, the ECB’s policy moves have not attracted much attention. Meanwhile, the Bank of Japan will continue to target yields.

The stance of the large central banks and recent changes in the policy framework mean that the cost of money in the global financial system would remain low in the foreseeable future. While the objective is to push up economic activity, excessive policy accommodation could have unintended consequences. Stock markets, for instance, are now fairly disconnected from fundamentals. 

Monetary policy interventions by large central banks would also result in substantial capital inflows in emerging market economies like India. In fact, with the decline in import demand, India is already dealing with a large surplus, which has increased policy complications. The Reserve Bank of India (RBI) has added about $66 billion worth of reserves since the beginning of the financial year. But RBI’s intervention in the market to absorb excess foreign currency is adding rupee liquidity, which can affect inflation outcomes. Inflation is running above the central bank’s target for several months. 

There are other complications as well. Due to excess liquidity in the system, the RBI is not able to support the government’s borrowing programme through normal open market operations as it will further increase liquidity in the system. The RBI has indicated that it is comfortable with rupee appreciation, as it will contain imported inflation. But the Indian central bank will need to move with caution. A significant rupee appreciation and indications from the central bank that it is unable or unwilling to absorb excess flows can bring more speculative funds and increase the pressure on the rupee. A significantly overvalued rupee will not only affect India’s external competitiveness but can also increase risks to financial stability. 

Interestingly, the RBI’s position on currency is somewhat contradictory to the government’s position on trade. While the government is increasing tariffs to reduce imports, the RBI’s view to allow the rupee to appreciate will encourage imports. This is not to suggest that the government’s position is correct, but macroeconomic policies should be coherent. So what can the policymakers do? It is important to recognise that the policy setting will not change in a hurry. Therefore, India will need a more reasoned response. In the given context, since India has adequate foreign exchange reserves, it can review the flow of foreign debt funds. This would not only reduce inflows and risk to financial stability but also encourage Indian firms to raise equity capital which is of longer-term nature. It will also help Indian firms deleverage. But this may still not address the problem fully. Thus, the RBI will need to be extremely careful in managing the tradeoffs.

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