The small rate cut by the Reserve Bank of India (RBI) was a positive move, and will help system-wide interest rates decline. Since RBI started aggressively cutting rates in October, liquidity in the system has improved, financial conditions have eased, and corporate bond spreads have returned to pre-crisis levels. If banks continue to reduce lending and deposit rates, and there is little reason why they shouldn’t, we could see a pick up in economic activity as early as the second half of FY10.
The real issue is no longer monetary policy induced short-term rates, but fiscal policy provoked long bond rates. The government’s large and growing deficit is creating both a flow and a stock problem. The flow problem is the funding of the deficit. The market is finding it difficult to absorb the amount of bonds the government is issuing, leading to higher long bond yields. This is increasing the cost of financing for the private sector.
There is also a stock problem—the size of the government’s debt at 80% of gross domestic product (GDP) and rising. As the government issues substantially more bonds, the interest costs—already 5.5% of GDP—are rising at an alarming rate, and will lead to more debt issuance.
If left unchecked, the debt burden can spiral out of control, leading to sovereign downgrades, capital outflow, and may be even a debt crisis with a sharp slowdown in growth. This is putting an additional risk premium on bond yields.
Therefore, the focus of RBI policy has to be to ensure that government bond yields at the long end do not ratchet up sharply. It can do so by expanding its balance sheet by purchasing government securities and releasing liquidity into the system, i.e., quantitative easing.
The balance sheet of RBI has actually shrunk since the onset of the crisis in October, primarily due to foreign outflows, and therefore it has space to buy government bonds and expand its balance sheet.
Limited quantitative easing can maintain adequate liquidity, provide temporary financing, and keep long bond yields from ratcheting up.
There is a trade-off between financing the government deficit and inflation.
According to our estimates, RBI can provide roughly Rs1.5 trillion as credit to the government, in addition to the unwinding of Market Stabilization Scheme Bonds without compromising its inflation target of 4%.
Ultimately, the fiscal deficit has to come down, otherwise it will crowd out the private sector, increase the stock of debt, and India’s ability to fund its growth.
The priority for the next government should be to announce a medium-term plan to get government finances back on a sustainable level. Until then, there is a valid case for RBI to expand its balance sheet.
Tushar Poddar is vice-president, Asia Economic Research, Goldman Sachs.