The need of an exit strategy from monetary expansion

This has been an extraordinary year for the world—a pandemic, an economic collapse, human suffering. The technical conundrums of monetary policy may seem trivial in comparison to the profound upheavals over the past 10 months. However, they are still worth thinking about. The Indian response to the economic shock has been led by monetary expansion rather than fiscal spending. As the economy normalizes over the next few quarters, the Reserve Bank of India (RBI) will have to work out a credible exit from its monetary strategy.

The scale of monetary expansion this year has not been matched since the middle of the 1980s, when Indian monetary policy began to come into its own. The size of the Indian central bank’s balance sheet has increased by ₹14.2 trillion since December 2019—from ₹42.6 trillion to ₹56.8 trillion. As a proportion of nominal gross domestic product (GDP), this is close to the highest level seen over the past 35 years.

The RBI balance sheet has ranged between 18-30% of GDP since 1985. The average has been 22%. It is right now at the higher end of the range, having increased by about eight percentage points since December 2020. The consequences of this are unclear—more about that later in the column—but it is a fact that 2021 could be unlike any other in recent history as far as monetary policy is concerned.

The need to soak up excess dollars from India’s balance-of-payments surplus, as well as to partially support the government borrowing programme, will likely add to the size of the RBI balance sheet over the next few quarters. Money supply will also increase rapidly. What this means is that a sustained increase in the size of the RBI balance sheet will take monetary policy into uncharted waters next year.

However, the assets of RBI are still modest compared to the central bank balance sheets in other large economies such as the US (34%), China (38%), the Eurozone (67%) and Japan (138%). These large economies have seen massive increases in their balance sheets in recent years. The pace picked up further in the pandemic year. The assets of these big four central banks had collectively increased by an annual rate of 52% by November, with $8 trillion added to their books over 12 months. The big difference is that Indian inflation is far higher than inflation in these countries, and has been above the upper end of the official target range for eight months in a row.

The rapid expansion of money supply this year has been driven by an increase in RBI’s foreign exchange reserves and a rise in government securities held by the central bank. The former has been far more important than the latter. This means that the Indian central bank has not had to support the fiscal deficit to the extent that many, including me, had expected in the early months of the pandemic, when it seemed that RBI would have to aggressively monetize the government’s fiscal deficit.

The most likely reason that the fiscal deficit has been funded by financial markets rather than the central bank is that time deposits in banks have shot up by ₹ 10 trillion since April, as people saved more either as precaution or because they could not spend during the severe lockdown. With a surge in bank deposits combined with weak credit growth, risk-averse bankers were happy to lend to the government. That took some pressure off RBI. The sharp increase in time deposits as well as the demand for currency have been important drivers of money supply growth when one thinks of its components.

What are the implications of this record increase in the balance sheet of the country’s central bank? The traditional view is that it will add to inflationary pressures in the Indian economy. The current bout of inflation being witnessed in India is driven by the supply side rather than excess demand. And the impact of monetary expansion on prices has been muted because of lower velocity of money, but that may not be a permanent feature of the landscape.

The other concern is financial stability. The expansionary monetary policy has led to surplus liquidity in the Indian money market. The weighted average call money rate—which is the operating target of monetary policy under flexible inflation targeting—has been below the reverse repo rate since the last week of October. Collaterized rates have slid below the call rate as well, especially for short term borrowing.

Many companies have taken advantage of low borrowing rates. Much depends on their financial soundness. Data released by RBI shows that corporate bond spreads have come down for companies with the best credit ratings, while they have actually increased for companies with lower credit ratings. This is seen most starkly in the movement of corporate bond spreads between 28 February and 27 November. The spreads have actually widened for borrowers with credit ratings of A-, BBB+, BBB and BBB-.

Indian monetary policy has quite rightly prioritized growth over inflation in the aftermath of the pandemic, with rate cuts as well as liquidity support. Former Reserve Bank of India governor D. Subbarao had pointed out that it is easier to enter the zone of expansionary monetary policy than to exit it, which could prove difficult. He had compared this to the chakravyuha that Abhimanyu entered in the Mahabharata.

Will Shaktikanta Das face a similar challenge in 2021?

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