The most general definition of macroeconomics is of spillovers between sectors and markets and from the system as a whole to its parts. A medical specialist focusses on a part of the human body and often does not understand that if a medicine given to heal a part hurts the health of the whole, it can harm the part she wants to cure as well. A sector specialist tends to neglect general equilibrium interactions.
When macroeconomic policy is run by specialists, it can harm the whole and therefore even the part they wanted to benefit. Something like this has happened in India over the past few years.
Inflation targeting and markets
Inflation targeting was among the hundred small steps recommended for India in a report on financial sector reforms. Low inflation and fiscal consolidation were seen as prerequisites for the development of corporate bond markets.
The Chair of the report subsequently became the RBI governor and implemented a version of Inflation targeting that was stricter than required, while his deputy put on the FRBM Committee imposed a similar path of fiscal consolidation towards a lower debt-GDP ratio. Unfortunately, the highest real interest rates India had ever seen reduced private investment.
The corporate bond market fell to new lows. Leveraged corporates are not in a position to raise money in a high real interest rate regime. They did not want to invest as demand was low. Can the corporate bond market develop if corporates are in trouble?
Similarly, a rise in government interest payments contributed to reducing the quality of government expenditure, lower growth reduced revenue growth, forcing the government to borrow even more. As an aggressively independent inflation targeting RBI bought too few government securities (G-Secs) in open market operations (OMOs), durable liquidity shrank and spreads rose. Credit creation in the economy as a whole slowed.
Again, the development of financial markets suffered. Inflation targeting did help to reduce inflation, but through falling inflation expectations and commodity prices. The rise in real interest rates only reduced aggregate demand and growth.
Lender of last resort
An RBI liquidity window for NBFCs, when viewed from the narrow lens of a financial sector specialist, implies exposing the RBI to unknown credit risk and creating moral hazard by rescuing people who have borrowed short and lent long and encouraging such inappropriate arbitrage in future.
But this neglects the necessity of a lender of last resort function whenever there are spillovers and systemic risk. In times of fear, institutions without access to such a lender hoard liquidity because they expect other participants to behave irrationally and not lend although fundamentals maybe strong. X factors in Y’s irrationality.
As everyone acts on such thinking, lending decreases if no substitutes are available. There is an externality — a slowdown is triggered. Borrowers are not able to repay and the quality of assets deteriorates further. A liquidity window removes the fear of not being able to repay if there is a demand. Lending rises, asset quality improves and the RBI is not stuck with large low-quality assets as the liquidity window is not actually used.
It only rebuilds confidence. The lending can be costly, based on excess good quality rated collateral. NBFCs without good assets would not be able to access it and so would continue to exit or merge. There would be no moral hazard.
The RBI’s own past experience bears out the above arguments. Indian stock markets crashed on May 17, 2004, labelled ‘manic Monday’. They were temporarily closed for trading. The RBI made a public announcement on its website that it was ready to sell foreign exchange to any foreign investor wanting to withdraw and to provide liquidity to any bank. This window was not used as calm returned. But a public notice ensured that each player knew that the other knew that liquidity was available. There was no need for a panic rush to be the first to draw a limited stock. In 2009, similarly a temporary window was made available to mutual funds on stiff terms. It was not used but markets settled down.
Post IL&FS in 2018, a blinkered view denied such a facility to NBFCs that were especially vulnerable since unlike banks they had no access to RBI liquidity, but had been encouraged to make up for the fall in banks’ lending. Lacking client knowledge, banks were not able to substitute for contraction in NBFC lending and were too afraid to lend to them.
Things were made worse by a squeeze on durable liquidity in just this delicate period. The stitch in time that could have saved nine was not made. Predictably, the nascent economic recovery was aborted and the economy slowed. Markets absorbed the shocks and were limping back to normal, but the DHFL default and problems in Jet and Reliance have triggered a climate of fear again. A liquidity window would still help.
Sovereign dollar borrowing
The suggestion on sovereign dollar borrowing made in the Budget shows a similar lack of appreciation of systemic interlinkages. Raghuram Rajan wrote that borrowing $10 billion abroad will not reduce pressure in the G-Secs market because the RBI would reduce its holdings of G-Secs to sterilise reserve accumulation from the $10 billion dollar inflow. As a past central banker he knows, because this is exactly what happened in 2017-18 due to raising caps on foreign inflows into G-Secs. In October 2015 bi-annual increases in limits were announced to reach up to 5 per cent of government bonds by March 2108. This cap was fully utilised at $19 billion by then. This was more than required to finance the current account deficit (CAD) so did not reduce the cost of government borrowing since the RBI decreased its holdings of Indian G-Secs and bought US treasuries at zero interest from the excess inflows it accumulated as reserves.
Despite the additional source of demand for them, the interest rate on domestic G-Secs shot up to 8 per cent almost 2 per cent above the Repo rate. Since the domestic G-Secs market is large even a low cap on foreign G-Secs holdings as a percentage of the domestic debt market (currently 6 per cent) can lead to excess inflows. Moreover, these are volatile flows.
If their share becomes too large in India’s total foreign liabilities that can affect the domestic interest rate cycle. Currently, this share is 11.36 per cent and with additional $10 billion government borrowing it will become 12.17 per cent. It should be kept below 10 per cent.
Capital flow management should adjust so that inflows are not in excess of the CAD and the share of G-Secs in the RBI balance sheet does not fall below 40 per cent. In 2018 it fell to 20 per cent.
Deepening and diversifying financial markets is a valid objective but the government would be better off finding ways to revive domestic demand to trigger a virtuous investment cycle than relying on fickle external suitors.
Public spending must be preponed and implemented vigorously even as the cost of borrowing comes down.
The writer is Professor, IGIDR, and Member EAC-PM