In its October meeting, the monetary policy committee voted unanimously to keep interest rates unchanged. This was widely expected. But what was not was the RBI Governor stating that the central bank would consider open market operations in order to manage liquidity. This announcement drove the 10-year government bond yield up by 12 basis points to 7.34 per cent. The central bank views this policy as being “consistent with the stance of monetary policy”. But it raises the question: What was the objective of this de facto tightening? Are the actions of the RBI being driven solely by concerns over inflation? Or, are other considerations beginning to dominate?
The latest data available before the RBI/ MPC meeting did, in fact, show that inflation continued to remain well above the upper threshold of the central bank’s inflation-targeting framework. Retail inflation had surged in July, and remained elevated in August as food prices, especially of vegetables, soared. While inflation did fall sharply to 5 per cent in September as food prices corrected, the central bank did not have the luxury of this data point before its meeting in October.
However, the inflation forecasts accompanying the MPC meeting do suggest that the RBI had, in fact, anticipated this correction in food prices, as it did not materially alter its assessment of the trajectory of inflation. Similar to its forecast in the August meeting, the central bank continued to project inflation at 5.4 per cent for 2023-24 and at 5.2 per cent in the first quarter of 2024-25.
The underlying price pressures in the economy have, in fact, been weakening, as alluded to by the RBI Governor in his comments. Core inflation, which excludes the volatile food and fuel components, had eased by 140 basis points from its peak in January, falling to 4.9 per cent during July-August. The latest data shows that it has dropped further to 4.7 per cent in September. Thus, there is no indication of food inflation spilling over, of core inflation converging to headline inflation.
In such a situation, when a supply side induced food price shock is easing, when the underlying price pressures are weakening, when the RBI has not changed its inflation forecast, and when the MPC has maintained the status quo on rates, open market operations, which involve tightening financial conditions further, do not seem consistent with what the stance of monetary policy ought to be. If anything, it is suggestive of excessive tightening.
This then raises the question: Will open market operations be used more as a tool for addressing concerns over financial stability and defending the currency?
It is no secret that the sharp rise in retail and personal loans has taken many by surprise. More so, as it has occurred during a period of surging interest rates. Whether this credit growth is due to push or pull factors, whether it reflects pent-up demand or sluggish household income is debatable.
Either way, the concerns raised over the expanse and pace of credit growth to this segment, the quality of borrowers availing loans and the build up of stress in this segment do seem to have some basis.
As per a study on unsecured loans by UBS, the share of borrowers with more than five personal loans has risen to 7.7 per cent in March 2023, up from 1 per cent in 2018. The study pegs new personal loan disbursements to borrowers with weaker credit profiles at 22 per cent of disbursements and estimates the risk of defaults (unsecured retail loans) to rise as the share lending to already overdue borrowers (one plus days past due) has risen from 12 per cent in 2018-19 to 23 per cent in 2022-23.
As the RBI Governor has also expressed concerns over the sharp credit growth to this segment, squeezing out liquidity and de facto tightening, raising short and long-term interest rates, could be a way to slow down its growth. After all, one could well make the argument that it is best to constrain this exuberance in order to evade a blow-out down the line. However, liquidity conditions have been tight for several weeks now. Banks have, in fact, been scrambling for liquidity. As per reports, rates on certificates of deposits have been going up, as have those on commercial papers. Tightening financial conditions further will not only affect consumer credit, but could also impact industrial credit. And this comes at a time when there is uncertainty over the underlying momentum in the economy.
Then there is also the currency angle. The 10-year bond US yield is hovering around 5 per cent for the first time since 2007. The Dollar index has strengthened, notwithstanding daily fluctuations. Currencies of both developed economies and emerging markets have come under pressure. And India is no exception. However, the Rupee has dropped less compared to most other currencies as its fall has been cushioned by the RBI intervening in the currency markets.
Since the middle of July, the RBI’s foreign currency assets have fallen by around $25 billion. While part of the decline could be on account of revaluation of reserves, the balance does provide an indication of the scale of the central bank’s intervention in the forex markets. However, as rates in much of the developed world are likely to remain higher for longer, there are limits to drawing down reserves to defend the currency. In such a situation, OMOs serve as a useful tool to increase the spread between the Indian and US bond yields, helping ease the pressure on the rupee.
But, considering that the pressure on the currency is unlikely to abate quickly — it will probably show some signs of easing once flows start trickling in following the inclusion in the government bond index — it must be asked for how long and to what extent can the pressure be resisted? Such a defence of the currency will also make it difficult for the RBI/MPC to respond to the domestic inflation/growth trajectory.
Perhaps, a more appropriate question to ask is whether the pressure on the currency should be resisted at all?
ishan.bakshi@expressindia.com
