India's monetary chakravyuha, and the calibrated exit we need
PremiumThe pace and priority-order by which RBI withdraws its extraordinary covid stimulus will influence economic outcomes
PremiumThe recent news from central banks across the world points to a simple story—moves towards withdrawing their extraordinary monetary stimulus have begun.
The US Federal Reserve has indicated that it will begin to reduce the pace of its balance-sheet expansion soon. The European Central Bank has also said it will begin to slow down its asset buying in the last quarter of this year. Some smaller central banks in countries such as Brazil, Iceland, Mexico, Chile, Russia and Hungary have been increasing interest rates. They have been joined by Columbia, Jamaica, Peru, Czech Republic, Paraguay and Kazakhstan. Norway recently became the first Western economy to actually increase interest rates rather than soak up excess liquidity.
Some like the central banks of Australia, New Zealand and Israel have postponed their exits from monetary expansion because of unexpected new outbreaks of covid, but the direction they are moving in is clear. China continues to be a big exception. Experience shows that central banks find it easier to embark on monetary expansion in response to a crisis; in contrast, exits are tricky. The coordination between central banks is even more complicated, as economies recover from a shock at different speeds, as in the case of the North Atlantic financial crisis a decade ago as well as the covid shock in these times. Former Reserve Bank of India (RBI) governor D. Subbarao had once said that central banks are like Abhimanyu in the chakravyuha—they know how to enter a system of monetary expansion but are less clear about how to exit.
All this is the backdrop against which the Indian monetary policy committee (MPC) will meet this week to decide its next move. Its six members will meet at a time when the public discussion has been focused on the nature of a monetary-policy exit. There are some straws in the wind. RBI has been pushing up the rate at which it is accepting offers under its variable rate reverse repos. It has also kept the net liquidity effect of its G-Sec Acquisition Programme at zero, by selling and buying government bonds in equal measure over the past two weeks.
In the August meet of the MPC, Jayanth R. Verma disagreed with his MPC colleagues and argued in his dissent note for a change away from the accommodative monetary policy stance as well as an increase in the reverse repo rate (which is technically outside the MPC’s control).
The coming days will show whether the MPC majority opinion has begun to shift in that direction, though an outright hike in the repo rate is not expected nor warranted right now. A growing number of private-sector economists are now anticipating the beginning of gradual policy normalization. A survey of 14 private-sector economists by Anup Roy of Business Standard shows a wide divergence of opinion on which button the Indian central bank will first press—a reverse repo rate hike, either a reduction or discontinuation of the G-Sec Acquisition Programme, liquidity normalization, a calendar for an Indian variant of the taper, forward guidance on monetary policy normalization, and higher duration variable-rate reverse repos.
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RBI took the lead in the policy response to the economic downturn after the pandemic reached Indian shores. The size of its balance sheet is now nearly 53% higher than it was two years ago, going up from ₹41 trillion on 27 September 2019 to ₹63 trillion on 24 September 2021. The RBI balance sheet is now about 28% of India’s estimated nominal GDP for the entire fiscal year ending March 2022. That is nearly six percentage points higher than the level before the pandemic, and at the higher end of the range over the past 35 years. It is important to remember that there are still six months left for the current fiscal year to end, so it is quite possible that further buying of local bonds as well as foreign exchange assets will take the Indian central bank balance sheet into uncharted territory. There is nothing sacred about the upper historical limit, but it is a useful marker at a time when inflation has been above the central point of the inflation target band for more than 20 months.
The first steps in India’s journey towards policy normalization will have to focus on removing some of the excess liquidity in the domestic money market, a shift in the monetary policy stance from accommodative to neutral, and normalization of RBI’s policy corridor through an increase in the reverse repo rate.
The final step would be a hike in the repo rate. That is likely to be done only in 2022, especially since domestic private-sector demand is still uncertain. In its September bulletin, RBI pointed out that the pace of monetary tightening across emerging markets depends on the situation on the ground. Countries that are commodity exporters, which have made terms-of-trade gains and have made good progress with vaccination coverage have generally been at the vanguard of monetary tightening.
Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics
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