RBI's taper and tantrums

If quantitative easing (QE) comes, can taper and tantrums be far behind? Percy Bysshe Shelley's enduring lines, albeit paraphrased, resonated with the Reserve Bank of India governor Shaktikanta Das' statement after the monetary policy review meeting on Friday.

Following the global financial crisis of 2008, the central banks of developed countries pumped in liquidity in the system at various points by purchasing assets during a period of stress to revive economic growth. This policy is popularly known as quantitative easing (QE). But such policies could not continue for long, so central banks have to slow down the pace – or taper the large-scale asset buying.

So, when in 2013, the US Fed formally said that tapering will start, the shockwaves hit many developing countries, including India, as investors began to pull out. The taper tantrum of the US Fed in 2013 is mainly responsible for India's currency crisis at that time (fragile macroeconomic parameters accentuated the magnitude of the situation).

Indian QE

Back home, in April this year, the Reserve Bank of India started India's version of quantitative easing (QE) by introducing government securities acquisition programme (G-SAP) – to pump in liquidity by buying government bonds so that interest rates stay benign. QE is introduced when the central bank has no room for rate cuts, so liquidity is infused to keep interest rates low.

After five months of the G-SAP announcement, the economic growth prospects started to look brighter, albeit durability remains uncertain. April was when the country was fighting with the deadly second wave of the Covid-19 pandemic, which prompted many states to announce lockdowns – a situation that prompted the G-SAP.

As a result of the bond-buying, coupled with muted credit growth of the banking system and slow government spending, the banking system currently has excess liquidity of around Rs 10 lakh crore at this point. At the same time, retail inflation stayed above the central bank's tolerance zone of 6 per cent in May and June.

Normalcy returning

While the RBI's priority was to boost growth since the onset of the pandemic, and while it continues to remain a priority, there is an acknowledgement by the monetary policy committee (MPC) that such a situation of excess liquidity needs to be addressed.

In the policy review, the central bank announced that it would double the amount of liquidity it mops up through the variable rate reverse repo (VRRR) auctions from Rs 2 lakh crore to Rs 4 lakh crore by the end of September. "These enhanced VRRR auctions should not be misread as a reversal of the accommodative policy stance," RBI governor Das said, almost in the same breath after announcing the liquidity mop on Friday.

"The RBI governor stated that this should not be interpreted as policy normalisation, but we and the markets disagree," analysts at Nomura said in a report. Observing the MPC of the RBI faces a trade-off between growth and inflation and has prioritised growth, the report said, "We believe that the liquidity manoeuvres suggest, at the very least, that the RBI is uncomfortable with the large amount of floating liquidity. As such, allowing bond yields to gradually rise and more VRRR issuance are a first step towards liquidity (and policy) normalisation, in our view."

Tantrum woes

There is a reason why the Indian central bank is worried about its taper tantrums.

The demonetisation exercise, announced in November 2016, resulted in the banking system getting flooded with liquidity as Indians queued up in bank branches to deposit their Rs 1000 and Rs 500 currency notes. Around 87 per cent of the existing currencies by value were rendered invalid by the demonetisation exercise. The objective of demonetisation was to eliminate black money. It was expected that unaccounted money would not be returned. But as it was evident later on, the demonetised currencies came back into the system.

The excess liquidity started to evaporate when the RBI began a gradual withdrawal of liquidity in 2017. This resulted in a liquidity shortage by the middle of 2018. According to bankers, the end of easy money started hurting the non-banking financial companies (NBFC), and IL&FS became the first casualty as the shadow bank started defaulting. The liquidity crisis then went on to engulf the entire NBFC sector, barring a few.

The RBI is worried, and rightly so, about the fallout of a liquidity crisis to the real sector, at a time when there is no surety the nascent growth revival would be sustained amid a threat of a third wave of the pandemic, central bank watchers said.

"RBI continues to highlight that any pre-emptive tightening can kill the nascent and hesitant recovery that is taking shape," said Indranil Pan, Chief Economist of Yes Bank. "In cognisance with an extremely uncertain growth climate, we think that the RBI will maintain its accommodative policy and not move on any form of tightening – be it on the rates side or the liquidity side – till the end of the current financial year," Pan said.

Rate hike: Sooner than later

This normalisation indication by RBI, though not being admitted, signals that the interest rate from here onward will not go down any longer. Interest rates have bottomed out; it is a matter of time before it starts inching up. Before the Indian central bank hikes the repo rate – the policy rate – it is likely that the reverse repo rate (the rate RBI offers to banks for parking money) will be increased. A repo rate increase would follow.

Commenting that the six-member MPC decision to maintain status quo on interest rate was along expected lines, Anagha Deodhar, Chief Economist, ICICI Securities, said "…the VRRR decision and one committee member voting against accommodative stance were early signs of normalisation. It upped the inflation forecast for FY22 to 5.7 per cent, a tad higher than our expectation and retained the growth forecast at 9.5 per cent." "We expect the normalisation to continue with the RBI hiking reverse repo rate in two steps starting early next year," she added.

The ultra-easy money policy – characterised by low-interest rates and excessively high liquidity – will end sooner than later. The beginning of the end has just started.

(The writer is a journalist)