RBI's 'impossible trinity' of problems: rupee, inflation, bond yields

As the pandemic took hold, the last few months were tough. But the Reserve Bank of India (RBI) sailed through, almost making it look effortless. It supported the economy in every possible way – rate cuts, liquidity infusions and regulatory easing.

In terms of monetary policy, the RBI sought to balance two objectives: Not letting the rupee appreciate in the midst of a pandemic and providing enough liquidity to support a recovery. Luckily, the two were aligned. A shrinking trade deficit and large capital inflows enabled it to buy dollars, build up currency reserves and infuse rupee liquidity into the banking system. The large liquidity surplus helped the interest rate cuts filter through to the money, corporate and government bond markets.

But the next few months could get harder. In the first half of the year, the mere expectation of the RBI buying government bonds (known as open market operations, OMOs) later in the year to help the government fund a large fiscal deficit was enough to soothe bond market nerves. But it is now expected to “walk the talk”.

The fiscal situation is tight. The central government's fiscal deficit could rise to over 8 per cent of GDP in FY21, from 3.5 per cent budgeted at the start of the year. In May, it had already announced that borrowing will be Rs 4.2 trillion more than budgeted. Over and above that, it has been borrowing a little more at each bond auction, (and also issuing more treasury bills than normal, some of which can get rolled over). States, too, will have a considerable fiscal problem. Accounting for revenue losses – including the shortfall in the goods and services tax compensation from the central government – we believe the state fiscal deficit will rise to 4.5 per cent of GDP, from 2.4 per cent budgeted. And adding on the borrowings of public sector enterprises, the overall public sector borrowing could cross 16 per cent of GDP.

But, if the RBI helps out by buying a proportion of these bonds via OMOs, it would add to the already elevated rupee liquidity.

Meanwhile, large dollar inflows continue unabated. If the RBI does not want the rupee to appreciate sharply, as seemed to be the objective until July, it will have to continue buying dollars. That would increase domestic liquidity further.

Buying bonds and dollars at a time when banking sector liquidity is already elevated could raise eyebrows. But why fear surplus domestic liquidity?

It can be a double-edged sword. Ample liquidity is necessary to support and revive the economy after an unprecedented shock. But too much of it could stoke macro imbalances like inflation and a wider trade deficit, eventually hurting the very recovery it was meant to support.

Indeed, inflation can't be ignored. At 6.7 per cent in August, it has been outside the 2-6 per cent target band for several months. And inflationary pressures seem widespread across food, fuel and other core categories.

To cut a long story short, the RBI's challenges are rising. Not only is it expected to keep an eye on the exchange rate and domestic liquidity like over the last few months, but now it also needs to play a role in fiscal financing. All of this at a time when inflation seems uncomfortably elevated.

Will the RBI manage? Only if it strikes a fine balance between its various objectives (the rupee, inflation and bond yields), by doing a little bit for each.

But won't that stoke the classic “impossible trinity” problem for the RBI, whereby only two of the three are simultaneously possible – a fixed exchange rate, capital account convertibility and monetary policy independence?

How can the RBI keep the rupee from appreciating much, allow large capital inflows and still have monetary policy space for keeping liquidity loose?

Historically and globally, this has proven impossible. The main reason for this is as follows: Simply put, if a central bank is, say, buying dollars to keep the exchange rate from appreciating during a period of large dollar inflows, that will result in surplus domestic liquidity, which could stoke inflation. Something has to give.

So how will the RBI manage it all? We believe three things could make it possible.

One, as long as bank lending remains weak, excess liquidity may not slip out into the real economy, further stoking inflation.

Second, food inflation could fall towards the end of 2020, led by a favourable base effect, a new crop coming into the market and repaired supply chains.

Third, currency in circulation has been growing rapidly and if this continues, there will be organic demand for the RBI to replenish banking sector liquidity by buying dollars or bonds.  

But there are several risks involved. One, despite low credit growth, broad money growth is elevated. A small rise in credit growth could push it up to unsustainable levels. Two, while food inflation is likely to fall, core inflation remains surprisingly high.

All told, while we believe the RBI will just about manage the situation by striking a balance across its various objectives, it will have to be vigilant, looking out for turning points.

The biggest challenge will perhaps come later when pandemic fears recede, activity picks back up, and central banks begin to withdraw liquidity globally. The RBI will have to move quickly then, withdrawing excess liquidity so it does not become inflationary, and yet do it without hurting the recovery. That deft manoeuvering will perhaps be the RBI's toughest challenge of all. But that is a problem for another day.
The writer is Chief India Economist, HSBC Securities and Capital Markets (India) Pvt Ltd

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