Several theories explain why India’s new central bank governor took his boldest step yet. Little attention has been paid to the consequences.
Last week, Governor Shaktikanta Das made an unexpected tweak to the Reserve Bank of India's traditional management of longer-term liquidity in the banking system: by buying and selling government bonds. India’s currency, sovereign-debt and credit markets were all caught off-guard by the announcement of a three-year, dollar-rupee swap.
The RBI will buy $5 billion from banks for its reserves by giving them rupees, and reverse the trade in 2022. This preemptive move would prevent the currency's appreciation, according to one theory.
The central bank may want to scoop up incoming dollars from ArcelorMittal’s long-awaited $5.8 billion check for Essar Steel India Ltd., lest the rupee strengthens from an oversupply of greenbacks. That payment should be coming in now that the Ruia family, former owners of the bankrupt asset, is almost out of legal options to prevent the sale. (Footnote: I remain skeptical of a resolution before the next general elections are over, and a new government is formed.)
Another hypothesis ties the swap to elevated funding costs for non-bank financiers. The real economy, which is already slowing, could be in trouble if shadow lenders are forced to turn off the tap for builders amid a glut of unsold apartments. In this line of thinking, the RBI’s move aims to ease financial conditions.
That’s not far-fetched, with the biggest arranger of Indian corporate debt warning of a crisis in credit markets. However, there’s a third view, which sees the swap spurring demand for lackluster government bonds.
Long-term yields continue to be stubbornly high. Banks could use the rupees they get by selling dollars to buy sovereign notes. To the extent their purchases push yields lower, they get to book mark-to-market gains — or cut losses — on their asset portfolios by March 31, the end of their financial year.
However, it doesn’t matter whether the RBI had currency, credit or interest rates in mind. What’s more relevant is how the new liquidity-management tool will shape expectations of what comes next.
Now that that the central bank is buying dollars to create domestic liquidity, will it continue to snap up as many Indian government bonds? The purchases in the current financial year have topped $42 billion. Traders expect these to be dialed down, starting April 1. If the reduction is large enough to offset the $5 billion infusion, bond investors get nothing in the net. They may remain cautious about buying 10-year government bonds, given the risk of fiscal slippage next year is high. Much of the massaging of the headline fiscal deficit — for instance, by pushing a chunk of the government’s borrowing off-budget — will be reversed once the poll results are in.
The bond market hasn’t failed to notice that a state-run telecom company has delayed salaries; hard-to-privatize national carrier Air India Ltd. is on perpetual life support; and that state-run banks’ balance-sheet repair job is proving longer and more expensive than the government expected when Prime Minister Narendra Modi took office in 2014.
Put another way, the benchmark 10-year bond yield may remain sticky even if inflation doesn’t accelerate. To that extent, the dollar swap may be ineffective in the government-bond market, though it could help ease the private sector’s worsening credit crunch.
Where the swap could do damage is the currency market. A steeper yield curve might attract foreigners to tactically buy into high long-term yields. Now that Das is acquiring dollars in bulk via long-term swaps, the market may expect him to purchase less in the spot market. A one-off swap to stanch rupee appreciation could thus end up being foreign investors’ invitation to push the rupee uncomfortably higher on a daily basis.
But what is the alternative to the “Das put"? If the RBI keeps buying government bonds, it surrenders its power to teach the government a lesson in fiscal arithmetic. Regardless of who wins on May 23, the next administration is expected to take a hard left turn. More unfunded programs will be unveiled.
Aficionados of modern monetary theory may say deficits don’t matter, but unlike the US, India’s private and public sectors together can’t borrow all they need in their own currency. Besides, inflation – which MMTers accept as the only constraint on government borrowing – isn’t as well-anchored as in developed nations. Volatile food and fuel prices still dominate consumers’ price expectations.
On the other hand, if the RBI stops resisting day-to-day rupee appreciation, and steps in only periodically with bulk dollar buying via swaps, an overvalued rupee will usher in a short-lived asset-price boom, followed by a bust. After all, fiscal and monetary policies can be coordinated locally, and politicians longing to reclaim their power to freely print money can be ignored. But how does Das ask Federal Reserve Chairman Jerome Powell to guarantee that the dollar won’t resume its upward march?
A $5 billion swap is harmless enough. Any more and Das would become as villainous, in the eyes of the politically dominant Indian nationalist thinking, as his two immediate predecessors for turning India into a stooge of America. The RBI’s new boss is stuck between a rock and a hard place.