Is India slipping back into bad habits?
Also published on Bloomberg/Quint, April 17, 2019
- In fiscal 2018/19, the RBI has been very active on the bond market, pumping more than INR 2800bn into the system
- The RBI stepped up its effort, partly because the more prominent risk of fiscal slippage made investors wary to buy government bonds
- The role of the RBI in total government debt holdings is still relatively small but there are reasons to suspect that the RBI will continue its buying spree in fiscal 2019/20 on the back of low inflation and an expected increase in spending
- India has a notorious reputation of debt monetization in the past, but introduced several reforms to phase out these practices
- The current developments are small compared to the quantitative easing programmes in the US, Europe and Japan, which came with substantial negative side effects
- It remains tempting to scale up these kinds of monetary operations and the distinction between fiscal and monetary policy is easily blurred
- What the government should do, however, is implement labor and land reforms to make government funding more resilient and robust
Addictions come in all shapes and sizes. They can range from watching soccer games, fishing, Facebook, playing cricket and video gaming to the more serious ones: gambling, alcohol, tobacco, work, sugar, food… Addictions can be a nuisance to countries and regions as well. In this context, our attention was drawn by the surprise move by the Reserve Bank of India (RBI) to launch a USD 5bn swap auction on 26 March. The auction was a success, which induced the RBI to use the liquidity tool again on 23 April. However, not everyone welcomed the move by the RBI. Markets and some economists are concerned that the new liquidity tool will go at the expense of open market operations (OMO) to buy back bonds, which has been the more traditional tool used by the RBI to provide liquidity to the system. The voices raised by criticasters more or less sound like an alcoholic that has been refused its drink.
In fiscal 2018/19, the RBI has been very active on the bond market, pumping more than INR 2800bn into the system by buying government bonds. This is as much as 70 percent of the total net government bond issuance over fiscal 2018/19. The intervention is clearly visible on the balance sheet of the RBI: see the light-blue bars in Figure 1.
The RBI also stepped up its effort since investors have become more wary to buy government bonds, given the more prominent risk of fiscal slippage. Although the role of the RBI in total government debt holdings is still relatively small (Figure 2), the share has breached 10% recently and there are reasons to suspect that the RBI will continue its buying spree in fiscal 2019/20. First, irrespective of the election outcome, every next government is in dire need of funding. Congress manifesto, for instance, wants to introduce a minimum income support programme, which would encompass a cash transfer of INR 72,000 to each family and will cost 1 to 2 percent of Indian GDP, roughly INR 3000bn. But the current government also expects to raise INR 4420bn via market borrowings in the first half of fiscal 2019/20, which is twice the amount compared to the same period in 2018/19.
Secondly, inflation has been surprising to the downside, which provides headroom to monetise government debt. We define demonetization as operations by the central bank to buy assets on the secondary market and replace them by highly liquid assets, such as money or bank reserves. This is different from ‘normal’ monetary financing, where the central bank directly buys newly issued government debt, which is prohibited in both India and Europe. From this perspective, QE can be perceived as (very) large scale variety of a regular open-market operation. It is questionable, however, whether the flexible inflation targeting framework that the RBI has introduced early 2016 has anchored inflation expectations on a permanently lower level. It is possible that the impact of incidental factors, such as productivity gains in certain food items (i.e. pulses and grains), have been driving down food prices. In this case, there is still a risk that debt monetisation on a large scale could trigger a substantial inflationary response, something that India is not unfamiliar with.
India used to be a heavy drinker
Since the ‘80s, India has shown four distinctive shifts in its monetary policy (Figure 3). In the 1980s, the economy was plagued by volatile and high inflation, which was the result of monetary policy being completely subservient to fiscal policy. In the following decades, India was sent to the AA and several reforms were implemented to phase out the fiscal dominance of monetary policy. In 1985, monetary targeting (MT) was implemented to contain the money supply. However, as fiscal metrics kept deteriorating, a balance of payments crisis emerged in 1990-91 which was followed by the implementation of a multiple-indicator targeting (MIA) regime. Afterwards, in 2003, the Fiscal Responsibility and Budget Management (FRBM) Act got signed to prevent the RBI from subscribing to primary issuances of government securities. And although automatic monetization of public debt has been phased out over the past years by implementing far-reaching reforms, large fiscal deficits continue to put pressure on monetary authorities to provide relief. A report by the RBI (2013, Chapter 3) explicitly mentions: “It is still hard to make a black-and-white distinction between what portion of the central bank’s purchases of government securities is for the purpose of the conduct of monetary policy and what proportion is in support of government’s borrowings.”
Europe, Japan and the US: difficulties in sobering up
Public debt monetisation in India is just a drop in the ocean compared to unconventional policy actions taken by several central banks in the past decade. In 2008, the US Federal Reserve started its quantitative easing (QE) programme, which encompassed the purchase of US securities and bolstered its balance sheet from USD 900bn in 2008 to 4500bn in 2017. The Bank of Japan (BoJ) and the Europe Central Bank (ECB) initiated their QE programmes at a later stage, but the magnitude of both programmes match that of the US. The large QE programmes in the US and Europe were deemed necessary to prevent the economy from ending up in a deflationary spiral in the aftermath of the global financial crisis and the European debt crisis. Deflationary forces have already been haunting the Japanese economy since the 1990s.
The problem with these large monetisation operations (see Footnote 1) has been that the huge amount of liquidity on banks’ balance sheets have barely resulted in an additional impact on the real economy, as there has not been much appetite for credit by the public. Think of this situation as serving free beers in a bar full of teetotallers.
What is even more worrying is that economies have become addicted to excess liquidity, which have been propping up various asset classes: equities, bond, real estate. This has complicated the unwinding of central banks’ balance sheets, as any hint towards normalisation by central banks have resulted in a fierce and volatile response by financial markets. Central banks have learned the hard way that taking liquor from a drunkard can result in aggressive behaviour and to go cold turkey on an addict can even result in cardiac arrest. Indeed, recent research shows that there is an inverted U-shape relationship between credit accessibility and productivity. In initial stages, higher credit results in higher productivity, but as credit becomes very cheap, Schumpeterian creative destruction is hampered and unproductive zombie firms can continue their operation, disturbing an efficient reallocation of resources.
Given the market’s addiction to QE, some economists believe that the balance sheet of central bank will remain large (here) and it will take some unconventional policymaking by central banks that have implemented QE to mop up the excess liquidity and sober up the markets.
Path of least resistance
As mentioned, India is not even close to the situation in many developed countries, but temptations remain strong and the distinction between fiscal and monetary policy is easily blurred. RBI governor Shaktikanta Das appears to put more weight on the output gap within the Taylor Rule, so we don’t expect much difficulty for the RBI to turn on the tap to aid the government in its funding needs to foster economic growth. Besides, other Emerging Markets are already actively debating QE as well.
What the government should do, however, is implement reforms to make government funding more resilient and robust. The policy measures proposed in the interim budget especially seem to be focussing on short-term popularity in the run-up to the upcoming elections, which increases the risk of fiscal slippage. This risk is mainly driven by the lack of revenue-boosting measures which are required to achieve the fiscal consolidation objectives of the authorities. In order to improve the revenue base, the government should focus on labor market and land reforms, as relatively strict regulations suppress productivity growth and the development of jobs in the formal sector. Land reforms play a vital role in facilitating an acceleration of infrastructure development, thereby supporting higher, more sustainable growth. Moreover, labor market reforms are important to reap the full benefits of the GST implementation in terms of promoting the formal economy and increasing employment of women, currently at levels far below other Emerging Markets (see Figure 5).
Reducing labor market rigidities will improve the allocation of resources and an increase of female labor participation within the formal sector, which broadens the tax base and supports more inclusive growth. Finally, the fiscal consolidation which could be achieved by a successful implementation of the reforms, reduces the high burden of interest expenses on total government expenditures (currently accounting for about 28 percent of total expenditures). This improvement on the expenditure side raises the government’s fiscal space to increase infrastructure investments and protect the economy against internal or external shocks.
So now we will have to wait and see which option the next government will pick with respect to its funding needs: monetisation or reforms. We already have a hunch what choice it is going to be… What would you choose in order to re-energise when returning home from work tired: 1) put on your running shoes and go to the gym or 2) grab a drink from the fridge and watch a Netflix documentary?