The RBI’s Quadrilemma
A one-time Rubik’s Cube world champion is pictured solving the puzzle. (Photograph: Mark H. Milstein/Bloomberg)

The RBI’s Quadrilemma


India is simultaneously confronting an unprecedented hit to growth, a pandemic-induced adverse supply-shock that has kept inflation much above target, an unrelenting flood of capital inflows, and a trade-weighted exchange rate that still appears expensive. With more objectives to target than instruments at hand, how can policymakers navigate this ‘quadrilemma’?

A foundational underpinning of open economy macroeconomics is the notion of an ‘impossible trinity’ or the ‘trilemma’, an upshot of the seminal contributions of Robert Mundell and J Marcus Fleming from the 1960s. Put simply, it postulates that no country can simultaneously maintain an open capital account, fix its exchange rate, and still conduct independent monetary policy. It must choose but two of these three poles.

This is, of course, an extreme, corner-solution illustration of a more graded, real-world trade-off: the more open (closed) a country’s capital account, and the higher (lower) the proclivity of policymakers to intervene in the foreign exchange market, the lesser (greater) the autonomy of monetary policy.

As G3 central banks have put their foot down on the quantitative easing pedal since the global financial crisis, and slammed it further during the current pandemic, the trade-offs confronting emerging markets have only become more acute. As walls of capital have episodically surged into emerging markets searching for yield, policymakers in these economies have either had to risk currency appreciations that render their economies uncompetitive, lose monetary policy control or throw sand in the wheels of capital inflows, thereby occasionally depriving their economies of foreign savings.

These trade-offs, however, typically begin to bind when economies are hit by idiosyncratic shocks, forcing monetary policy cycles to become asynchronous across economies. One wouldn’t expect this during a global pandemic when the entire world has been hit by a similar shock, albeit to different degrees. Fiscal and monetary policy should be easing in concert around the world, right? Why then would concerns about independent monetary policy and the trilemma emerge?

In India’s case, it’s the recent upsurge of inflation that has complicated macro management, and brought the trilemma to the fore. But because the inflation upsurge is accompanied by a dramatic hit to growth – symptomatic of an adverse supply shock – the policy trade-offs have only become acute.

In fact, as we argue below, this has caused the ‘trilemma’ to morph into a ‘quadrilemma’.

First Leg: A Wall of Money

With capital inflows typically a function of growth differentials, and India’s growth both slowing discernably pre-Covid-19 and challenged further in the Covid year, one would have expected inflows into India to abate, right? Au contraire, capital has been surging into the economy.

India received almost $85 billion of net foreign capital in 2019-20—the highest in five years—on the back of very strong FDI and ECB flows. While the former reflects a combination of liberalisation across sectors and strong inflows into services, the latter is likely symptomatic both of India’s domestic credit crunch, and the easing of global financial conditions. This, in conjunction with weakening domestic demand that compressed the current account deficit, meant the balance of payments was in a large surplus of $60 billion last year.

The pandemic has only accentuated these trends.

Lower oil prices and a further weakening of domestic demand is taking the current account into a surplus (as we had postulated back in April), even as strong capital inflows continue unabated, reflecting lumpy FDI flows into India’s telecom sector, Indian banks’ raising capital from abroad, and a sharp resurgence of equity portfolio flows ($6 billion in August alone).

India’s balance of payments is therefore on course to registering another hefty surplus this year. 

Furthermore, with expectations that India may enlist in a global bond index in the foreseeable future, which would attract passive bond inflows, India’s ‘problem of plenty’ may only get more acute.

The RBI’s Quadrilemma

Second Leg: Rupee Competitiveness And Forex Intervention

Faced with a large BoP surplus, the RBI has been confronted with two options:

  • Intervene to absorb the surplus and accumulate more forex reserves;
  • Or step back and let the Rupee appreciate.

Before the inflation upsurge, it chose the former. We believe this was the right strategy, because India’s trade-weighted, real-effective-exchange-rate or REER had appreciated almost 15% between 2014 and January 2020. While some of this may reflect an equilibrium response to lower crude prices, it’s harder to make the productivity-induced-equilibrium-appreciation argument given India’s sharp slowdown in recent years. Unsurprisingly, therefore, we find Rupee strength has hampered exports (see What Drives India’s Exports and What Explains the Recent Slowdown? New Evidence and Policy implications) while also making imports cheaper, thereby impeding the tradable sector’s competitiveness.

The RBI’s Quadrilemma

Preventing sharp and sustained appreciation of the trade-weighted rate is therefore important from a competitiveness and growth perspective.

The case becomes more compelling in the throes of the pandemic, when monetary policy was otherwise being eased. Letting the Rupee strengthen constitutes a de facto tightening of monetary conditions and militates against domestic interest rate cuts and liquidity injections.

For all these reasons, we were not surprised the RBI intervened to an estimated tune of almost $45 billion between January and August.

In fact, by preventing Rupee appreciation when other EM currencies were rebounding, the RBI effectively engineered a trade-weighted depreciation of about 3.5% between January and July.

Furthermore, because most of the forex intervention was not sterilised, it created Rupee liquidity of about Rs 3.5 lakh crore in the first half of the year. But there was no tension in this approach because the RBI was simultaneously slashing interest rates and adding liquidity through other sources to ease monetary conditions.

Monetary policy was being eased all over the world and India was no exception. By generating liquidity, forex intervention was enabling, not impeding, monetary policy.

Third And Fourth Legs: An Adverse Supply Shock

However, the recent upsurge in inflation significantly changes the policy calculus.

Recall, headline CPI was already above 6%—the upper band of the inflation targeting corridor—in the quarter before Covid-19. The expectation globally was the large demand shock from the pandemic would overwhelm any supply shock and therefore be disinflationary.

In India, however, the opposite has manifested. CPI inflation accelerated from 6.2% in June to 6.9% in July, and appears to be tracking close to 7% in both August and September. To be sure, some of this is on account of elevated food inflation, with the expectation that a strong monsoon and above-average sowing will exert disinflationary forces later in the year.

The bigger puzzle is why core inflation has jumped from 4% in March to above 5.5% over the last two months?

The RBI’s Quadrilemma

At the heart of the issue is an identification challenge. Is the recent jump in core prices on account of the adverse supply shock from the pandemic – with the implication that it will progressively abate as supply normalizes but the demand weakness lingers? Or, more ominously, is food inflation, which has averaged 8% over the last year, generalising into core prices, in concert with rising inflationary expectations?

The answer to this will be key to the future inflation trajectory. While the timing of the core surge appears to suggest it’s more pandemic-induced, more data is needed to confirm this hypothesis.

But even as inflation remains elevated, growth is on course to register a record contraction this year.

So while the RBI will be wary of easing financial conditions further given worries about inflation, they will be equally wary of letting financial conditions tighten much, given worries about growth.

This reflects the classic conundrum that monetary policy confronts when faced with an adverse supply shock of uncertain duration.

The Quadrilemma

Therein lies the policy quadrilemma.

How should policy respond when faced with an unprecedented hit to growth, inflation much above target, an unrelenting flood of capital inflows, and a trade-weighted exchange rate that still appears expensive?

Any attempt to address all objectives simultaneously is likely to be futile given that there are potentially more objectives than instruments.

For instance, until the RBI is worried about inflation, it will understandably be reluctant to inject more liquidity into the system and further ease monetary conditions – especially with the interbank liquidity surplus still above a hefty Rs 5 lakh crore. This, in turn, precludes unsterilised forex intervention, because the latter creates liquidity. How then can the central bank prevent Rupee appreciation in the face of a continuing large BoP surplus?

To be sure, the RBI can intervene in the forex market and then sterilise the intervention in the forwards market—thereby making it liquidity-neutral—a strategy undertaken, with some scale, over the last two months. But there is no free lunch. Forward premia have already begun to rise and sustained forward purchases are likely to push this premia up further. This, in turn, risks disincentivising economic agents from hedging their foreign currency exposures, potentially creating financial stability concerns down the line. A significant increase in forward premia can also induce more speculative ‘carry-flows’, though arguably less so than letting the spot rate appreciate.

The RBI’s Quadrilemma

The RBI could also sterilise by intervening in the spot market and then selling short-term paper to soak out Rupee liquidity. However, by adding to supply, this risks pushing up yields and tightening financial conditions, which policymakers would understandably want to avoid given current growth concerns.

The RBI’s Quadrilemma

These are not the only trade-offs.

Fiscal deficits around the world are expected to rise to record levels as large growth shocks result in large revenue losses while simultaneously triggering higher spending. Against this large bond issuance, central banks in several emerging markets have taken it upon themselves to buy government bonds (QE) to ensure bond markets don’t get unhinged and financial conditions don’t tighten too much.

There is an expectation in some quarters that the RBI may have to do the same through OMOs in the secondary market later this year. But doing so would inject liquidity, which could create a challenge if inflation remains elevated.

But not intervening has its own costs. Without explicit intervention, we saw bond yields quickly harden 40-70 bps between July and August, which prompted the RBI to announce a fresh set of measures last week. These dynamics may be indicative of some bond market pressures if the RBI were to sit on the sidelines. But how willing and able will the central bank be to provide support if inflation remains a concern?

This, then, is the quadrilemma, fundamentally reflecting a mismatch between (more) policy objectives and (fewer) policy instruments. Operationally, this translates into two objectives (exchange rate management and bond market management) but with two important constraints (not increasing system liquidity, and ensuring forex forward premia don’t rise too much).

Policy Options, Trade-Offs and Constraints

Given the aforementioned objectives and constraints, what options does the central bank have?

  1. The RBI could let the Rupee appreciate modestly—as it has over the last fortnight—to let off some steam. To be sure, Rupee appreciation will be disinflationary, but the impacts are estimated to be small. The RBI’s Monetary Policy Report estimates a 5% change in the USD/INR rate impacts headline CPI by just 20 basis points. Furthermore, once the Rupee is seen to appreciate, the risk is it will catalyse more capital inflows in the hope of further appreciation, thereby compounding the BoP challenge. This, along with the concern that Rupee appreciation will further hurt competitiveness in an environment of weak growth, suggests the risk-return from meaningful appreciation may not be favourable.
  2. Policymakers could contemplate liberalising more capital outflows to offset some of the inflows and potentially take the pressure off the balance of payments.
  3. On the bond market, the RBI could continue with Operation Twist, selling short end paper (T-Bills and short bonds) to preventing further steeping of the curve – without injecting fresh liquidity. However, this has distributional implications. While long-end yields (where the government predominantly borrows) may get some support, short end yields could eventually rise (which could affect corporates that tend to borrow shorter). That said, preventing a very steep yield curve is important for financial stability reasons, because a steep curve incentivises economies entities to take on more roll-over risk – the impacts of which were visible during the 2018 NBFC crisis.

More generally, it’s not clear the RBI may have to do as much QE as is being projected. Recall, India is on course to registering a current account surplus this year. By construction, this would mean the private sector’s savings-investment surplus would be higher than the public sector’s savings-investment deficit.

Put simply, there will be excess savings in the economy, both for precautionary motives as well as if economic agents perceive the shock to be quasi permanent and downshift medium-term consumption/investment. This is being complemented by strong capital inflows, adding to the pool of savings.

All this is manifested starkly in the banking system, through strong deposit growth but weak credit growth. With banks reluctant to lend to the real economy, they have invested meaningfully in government bonds, and may be further emboldened to from the lower mark-to-market risk after the recent increase in HTM limits.

To the extent that domestic savings rise this year, the QE need from the RBI may be less than envisioned, especially if it can allay fears of a disruptive sell-off in yields.

Distributing Pressures Over Instruments And Time

All told, navigating the trilemma will be more art than science, and relative priorities may have to change in real time:

  • While the MPC is worried about inflation, the near-term imperative would be to avoid injecting more liquidity and easing financial conditions. Consequently, interventions in any market would need to be sterilised: forwards in the foreign exchange market, and Operation Twist in the bond market. If forward premia rise to uncomfortable levels, the Rupee could be allowed to modestly appreciate. If liquidity gets drained, space for more spot intervention will open up. The approach will have to be nimble.
  • Over time, if the inflation scare turns out to be a head-fake—as the supply shocks fades but the demand shock lingers—the RBI may be more emboldened to support the bond market and prevent forex appreciation without worrying about sterilisation.
  • Furthermore, as domestic demand begins to recover more fully later in the year, imports and the current account can be expected to progressively normalize, which should take some of the pressure off the BoP and the Rupee – thereby rendering the trilemma less binding.
  • All that said, if India’s supply shock lingers or inflation becomes entrenched, both the fiscal and monetary strategy will have to be re-thought, complicating macro management.
Finally, it’s important that, post-pandemic, the exceptional monetary and regulatory support be gradually but progressively withdrawn to preclude financial stability, financial repression and macro imbalance concerns down the line.

In the near-term, however, pressures will have to be distributed across instruments and across time to prevent any one market from getting overly distorted.

There is no panacea to avoid the trilemma, which is why it has bedeviled policymakers for decades on end, and forced a rethink on the capital account orthodoxies of the past. The sooner markets internalise this, the less they will be surprised.

Sajjid Z Chinoy is Chief India Economist at JPMorgan.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint.

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