VIEW: Navigating liquidity, money supply, interest rates and currency markets

RBI and the MPC face a complex policy context.

Unlike much of the world, India is grappling with a high headline and core inflation, despite a contraction in income.

At the same time, while the current pace of economic recovery is indeed gratifying, our economy is battle scarred, weak, and needs delicate handling.

In the midst of all this, we are seeing strong and persistent foreign currency inflows.

Our monetary policy chant – thou shall control inflation by use of policy interest rates while keeping in mind the objective of growth – isn’t a very useful guide in the current context.

What should policy makers now do about the interconnected issues around banking liquidity, money supply, interest rates and currency markets?

Banking liquidity refers to the Rs 6.5 lakh crore of surplus funds the banking system currently holds with the RBI, over and above statutory CRR requirements (see here).

These surpluses are not available to directly spur domestic consumption or asset purchases. However, liquidity surpluses do push banks to lend more. In turn, bank lending increases money supply, which can lead to higher economic activity and inflation if domestic output does not keep up with the increased demand.

India’s bank credit is currently growing at a very tepid 5.7 percent year-on-year. To that extent, high banking liquidity is not of immediate concern from an inflation standpoint.

High liquidity surpluses have also pushed down short-term interest rates, with some money market instruments dealing well below even the RBI reverse repo rate of 3.35 percent.

Low interest rates at a time of high retail inflation short-change savers.

In today’s context, however, higher short-term rates could draw in additional carry-seeking foreign currency inflows, add to our money supply, and exacerbate the risk of inflation.

On balance, given the lack of credit demand and the risk of carry-seeking inflows, short-term interest rates should continue to stay low.

Savers however do need a solution, which we discuss separately.

Rather than banking liquidity, it is a rising money supply that entails risks of retail and asset inflation.

At Rs 43.5 lakh crore, India’s M1 (zero-yielding currency notes and bank demand deposits) has grown 19 percent year-on-year. Rising M1 is a global phenomenon – but the rest of the world isn’t battling high inflation as yet. At a time of high inflation, rising M1 can be a harbinger of more retail or asset inflation.

India’s money supply has grown on the back of bank funding of fiscal deficits (banks and RBI have financed nearly Rs 10 lakh crore of deficit), and foreign currency inflows ($90 bn this fiscal year). Tepid credit growth is not yet a major contributor.

Money appears to have flowed into our rural economy and stoked some welcome consumption. Unfortunately, inflation could be a sign that domestic productivity is for now struggling to keep pace, even as our non-oil imports approach the levels of last year.

The real debate now has to be about channeling our money supply into productive investments, rather than into imported consumption or into risky asset purchases.

One way to achieve this would be for the government to directly borrow from savers, perhaps via a Corona Bond, rather than from banks and the RBI. Such borrowing and spending would recycle existing money supply, provide adequate return for long-term savers, and allow the government to spend on productive investments.

The RBI has purchased over $90 bn of foreign currency this fiscal year, comprising current account surpluses on the back of collapsed consumption, foreign direct investments and huge portfolio flow into equity markets.

The RBI has also prevented excessive appreciation of the INR against the USD, at a time when the USD itself has weakened significantly against its trading partners.

This is a sound strategy. Already, non-oil imports have recovered back to pre-Covid-19 levels. Inflation suggests that domestic productivity remains a challenge – a strong rupee could further hurt. The 36-country trade weighted real effective exchange rate (REER) suggests that rupee still remains overvalued.

High currency reserves now give us welcome breathing space to repair our economy and bring back jobs and productivity via ongoing reforms, in a very uncertain macroeconomic context. In the past, during FY08, RBI had purchased $93 bn. Over the next six years to FY14, RBI had to sell it all back and more.

Banking liquidity surpluses arising from currency inflows are not yet a problem. In any case, whenever RBI does decide to withdraw liquidity surpluses, it has an array of instruments to choose from, especially the use of MSS bonds.

As an aside, the RBI practice of purchasing foreign currency in forward markets to curb liquidity has pushed up the implied rupee rates in the currency market (1-year MIFOR is at 4.6 percent well above money market rates). This could foster domestic carry trades of excessive exporter selling, and of ECB borrowers staying unhedged.

We have argued that given low credit growth and the risk of carry-seeking inflows, short-term rates should remain low. What about long-term interest rates?

Left to the market, large government borrowings would have actually taken longer-end interest rates much higher than now. Rather than the curve being too steep, the longer-end yield is repressed, on account of RBI verbal, regulatory, and market action.

Repressed long-term interest rates have benefitted financial institutions (with treasury profits) and the borrowing governments. They have brought down mortgage rates below 7 percent, offering some chance of economic revival. However, they have short-changed savers with negative real returns, and has pushed them into risky asset classes.

As a via media, we link back to the earlier suggestion that the government should directly borrow from savers through a ‘Corona Bond’ that offers appropriate and acceptable post-tax returns, and channel the money back through productive investments.

As long as credit offtake remains tepid as it is now, high banking liquidity does not pose any immediate threat to inflation. Banking liquidity does keep short term rates low – and that is useful to stave off carry-seeking currency inflows.

Nevertheless, analyst commentary suggests that the market will countenance some withdrawal of surplus liquidity now. The RBI should perhaps grab this opportunity and withdraw some of the surpluses – eventual withdrawal of the liquidity punchbowl will never be easy anyway.

Rising money supply – on the back of bank funding of government deficits and currency inflows – does pose a problem for retail and asset inflation. Government issuance of a Corona Bond directed at savers may be one way to curb growth in money supply, offering meaningful yields to long-term savers, while channeling money into productive investments.

RBI’s strategy of accumulating foreign currency and preventing excessive INR appreciation offers us significant and welcome buffers in a very uncertain macroeconomic context.