Home / Opinion / Columns /  Monetary policy: Should it step back as fiscal measures kick in?

It will soon be a year since India went into a harsh lockdown to control the spread of the covid pandemic. Monetary policy led the tough battle to deal with the economic collapse that followed. Discretionary fiscal policy was more conservative in the early months. Much has changed since then. Fiscal policy is coming into its own to support the Indian economic recovery. Should monetary policy take a back seat? And can it?

The extraordinary policy response by the Reserve Bank of India (RBI) to the pandemic was based on four themes. First, there was a massive infusion of liquidity through expansion of the central bank’s balance sheet. It has grown by 12.25 trillion in the 12 months to early March 2021, thanks to aggressive asset purchases. Second, the Indian central bank intervened with a series of bond market operations in an attempt to control not just the overnight interest rate, but also longer-term interest rates. This was yield curve management of the sort that is practised in Japan.

Third, this past year has seen RBI use forward guidance as a part of its armoury, trying to reassure bond investors that it would do all it could to support the economy. The forward guidance has not just been about the direction of policy interest rates, but the availability of liquidity as well. Fourth, RBI brought in a host of temporary regulatory actions to prevent firms from failing or banks being hit by the shock. These have ranged from an interest moratorium to allowing lenders to restructure bad loans.

This column had asked at the end of December whether RBI should begin thinking about how to exit its extraordinary monetary policy, not immediately but sometime in the coming months. The central bank itself hinted in the middle of January that it would normalize its liquidity operations soon, in effect by bringing overnight interest rates back into the policy corridor (and perhaps closer to the repo rate rather than the reverse repo rate). The bond market reacted sharply. Yields jumped up. The central bank once again moved back to reassurances of providing plentiful liquidity.

The finance minister has signalled a very gradual glide path back to the fiscal deficit levels before the pandemic. The bond market is clearly uneasy about high levels of government borrowing in the coming years, especially once private sector demand for funds increases in tandem with an economic recovery. Six recent issues of government securities have devolved to primary dealers, as not enough bond investors were ready to buy at the prices that the central bank quoted in the auctions. Another risk on the horizon is that RBI’s cut in the cash reserve ratio (CRR) is scheduled to be reversed in April. That will suck out around 1.6 trillion from the money market.

The Indian central bank faces a policy conundrum. It can decide to clear the local bond market either through prices or quantities. The former means it will have to let market interest rates rise. The latter means that it will have to step in to buy more government securities. Each of the very different choices will have profound implications for the economy. Meanwhile, in its latest monthly bulletin, RBI has sharply criticized the “naive adventurism by some bond traders" who choose to ignore its forward guidance on liquidity management.

There have been two main ways in which RBI has poured liquidity into an economy hit hard by the pandemic—around 5.5 trillion has come from operations in the foreign exchange market and another 3 trillion from local bond purchases. The former has been driven by the desire to prevent an appreciation of the Indian rupee. The latter is the result of central bank support for the government borrowing programme as banker to the sovereign. These two are the usual sources of durable liquidity in the Indian money market.

The changing international situation may force RBI to tweak its liquidity creation strategy. The recent increase in international oil prices as well as episodes of turbulence in financial markets across the world could reduce some upward pressure on the Indian rupee. If that happens—and it is not yet clear whether it will—then dollar purchases by RBI could come down. The Indian central bank will then have to increase its purchases of domestic bonds to ensure adequate liquidity in the local money market, in effect providing greater support to the government borrowing programme.

The next fiscal year is likely to be a tricky one for monetary policy managers. Inflation has luckily been trending downwards of late, but the shadow of excess government borrowing is a long one. The 15th Finance Commission estimates that public debt as a proportion of gross domestic product will be around 85% even five years down the line. India has not yet reached a point where monetary policy is being overwhelmed by fiscal policy and the primary tasks of inflation control and financial stability suffer. Yet, coordination between fiscal and monetary policy promises to be one of the most thorny problems in the next few years, in terms of technical as well as political economy issues.

Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics

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