RBI Monetary Policy: How Long Will The Impossible Trinity Last?
A clock sits on a wall. (Photographer: Krisztian Bocsi/Bloomberg)

RBI Monetary Policy: How Long Will The Impossible Trinity Last?


In July 2007, I wrote an article titled, ‘Learning to live with the Impossible Trinity’. The then Reserve Bank of India governor, YV Reddy, had admitted that “dealing with the impossible trinity of fixed exchange rates, open capital accounts and discretion in monetary policy has become more complex than before”.

I was hoping we would hear something similar from Governor Shaktikanta Das in the December monetary policy review. There were a few passing mentions of the excess capital flows due to the global recovery. However, it does not yet seem to be an issue which is keeping the RBI awake at night.

What Is The Impossible Trinity?

On a sustained basis, the central bank can manage only two of these three aspects. The trilemma is when the central bank is forced to manage all three and is unable to prioritise.

RBI Monetary Policy: How Long Will The Impossible Trinity Last?

This issue comes to the fore in periods of excess foreign capital inflows. As capital inflows increase, the currency appreciates – capital mobility. If the central bank deems these inflows as excessive, it buys up the supply of dollars from banks and resists the appreciation – exchange rate management. The buying of dollars increases its foreign exchange reserves. The resultant printing and sale of Rupees increase the liquidity in the banking system and drives down interest rates – monetary policy. Banks then use this new liquidity to buy bonds and give loans.

If it deems the capital inflows to be short-term hot money, it will prioritise exchange rate management and capital controls over inflation and domestic liquidity, as happened in 2007.

If it wants to control inflation, it has to stop printing excess money and suck out the excess liquidity. This means it cannot buy the excess dollar inflows and has to allow the currency to appreciate. We may be entering this scenario.

Challenges On Multiple Fronts, Will Persist For A Long Time

India is being swamped with foreign capital flows along with Covid-19. Initially, it was Reliance Industries’ breathtaking fundraise. Now, in the last two months, foreigners have bought around $11 billion of Indian equities.

The RBI under Governor Das has resisted rupee appreciation. It has been buying up dollars and bulking up the foreign exchange reserves. The resultant money printing along with other measures during the pandemic has taken banking system liquidity to an unprecedented surplus.

The banking system’s ‘core’ liquidity now stands at around Rs 9 lakh crore. Short-term money market rates (treasury bills, CP,CDs) are below the Reverse Repo Rate of 3.35%. The policy Repo Rate is at 4%.

CPI inflation is at 7.6% and is forecasted to average above 5% until September 2021. RBI targets CPI at 4% with a threshold band of 2-6%.

The RBI has pledged that it will remain accommodative into the next financial year. This means they will not increase the interest rates and will continue to keep the system liquidity in surplus. Thus, at the Reverse Repo rate at 3.35%, even if we take the low band of the inflation forecast for H1FY21 of 4.6%, average CPI inflation will remain above the policy rate for close to two years.

Betting On Vegetable Prices To Fall: Is This Time Different?

We have been here before. The 2008-2010 period was similar in respect to low rates, high liquidity, and a hope and prayer for inflation to fall. In the winter of 2009, the RBI was expecting vegetable prices to normalise and delayed its policy normalisation. Food prices kept rising making RBI begin its rate hiking cycle.

The MPC’s inflation forecast expects a decent fall in vegetable prices in the next two-three months. That becomes a key variable to watch. If it does not, it will put RBI in a bind.

Of course, economic conditions today are different. Growth remains a priority and needs to be nurtured. Given, how weak growth was prior to Covid-19, it requires time for this nascent recovery underway to get established. Low and negative real interest rates for a period of time is supportive of investment and physical asset creation.

The other thing they could do to buy time is to allow the rupee to appreciate, soften some of the global commodity prices rise, and thus cool inflation.

If global excess liquidity finds its way into India, RBI won’t be left with much choice but to allow the rupee to appreciate.

The Global Liquidity Glut

The situation seems similar to the post SARS epidemic 2003-2004 period. Global interest rates are at zero, the central bank balance sheets have expanded beyond imagination and the fiscal deficits are wide. The world is sloshing with liquidity looking for returns. Will India get a large share of global liquidity?

India’s Capital Markets Are Open – Intervention Cannot Be The Only Strategy

The developed world’s central bankers are likely to create more than $10 trillion of new money. Most of it is deployed in the government bond markets earning next to nothing. As risk falls and things settle, investors move money out of safe assets and look for higher return sources.

Even if 1% of this liquidity finds its way into Indian assets over the next one-two years, the RBI will have to deal with a problem of plenty.

The RBI needs to start thinking and developing strategies to accept these large amounts into the Indian equity, fixed income, and real estate markets.

The Indian capital market is very open. Foreigners have unutilised limits of more than $150 billion in Indian government and corporate bonds.

Indian equity inflows are capped only based on individual companies’ foreign shareholding limits.

Indian real estate, struggling as it is with high debt and unsold inventory, will heartily welcome these large inflows.

Learning To Live With The Impossible Trinity

  1. The RBI cannot use capital controls to control the flows.
  2. It does not want the rupee to appreciate much as it impacts the Atma Nirbharta policy.
  3. It does not want to suck out the liquidity from the markets as it wants to keep rates low to revive growth.

For now, the heavy hand of the RBI will be felt in the foreign exchange markets. The RBI will continue to intervene, prevent the appreciation and add in liquidity.

We should expect short-term interest rates to remain low. The government bond yield curve will remain steep. The absence of Open Market Operations to support the longer end of the bond market may make it steeper. It will wait till February for the government borrowing programme to end before it begins to suck out the excess liquidity.

It is not clear how long can we continue in this situation. Something has to give, something always does.

Arvind Chari is Head - Fixed Income & Alternatives at Quantum Advisors. Views expressed are personal. Disclaimer.

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

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