As the policy response to the Great Financial Crisis of 2008 showed us, when the going gets tough, central banks get going. Predictably, this year has not been different. The pandemic has led to a shift in monetary policy priorities and has forced central banks to adopt measures, in both scale and type, that they would shy away from in more normal circumstances. Take liquidity. In aggregate, G20 countries have injected liquidity to over 7 per cent of their cumulative GDP this year. Their taps are far from running dry.

RBI’s response

In India, the RBI’s policy response has also been unconventional. The central bank, at least temporarily, seems to have moved beyond the constraints of its Flexible Inflation targeting framework. The RBI has kept the repo rate unchanged at 4 per cent, after a 75 bps reduction in March 2020 and further 40 bps in May, and has provided constant liquidity support despite inflation running above its upper band of 6 per cent for almost eight months now. It has justified this by describing inflationary pressures as being primarily a supply side issue and emphasizing the urgency to support growth.

Another implicit addition to the RBI’s policy objectives has been the management of the yield curve to push through a massive government borrowing programme at low rates. In fact, the weighted average cost of government borrowing is now at a 16-year low, despite the likelihood of the consolidated fiscal deficit of the centre and states printing at 11-12 per cent of GDP in 2020-21, compared to a pre-pandemic target of 6.5 per cent.

However, this is not a new page in the policy playbook. Yield curve control has been used in Japan as a policy tool since 2016. The Bank of Japan has since set the short-term policy rate and the 10-year government bond yield at -0.1 per cent and 0 per cent, respectively. In recent months, other central banks have also debated the idea, with Reserve Bank of Australia (RBA) setting a target of 0.25 per cent on its three-year government bonds in March 2020.

A much softer tone

That said, unlike Japan or Australia, yield curve management adopted by the RBI has had a much softer tone with no clear upper bound defined for yields across maturities. The RBI has conducted both plain vanilla open market operations (OMOs) and US like Operation Twists. For the first time ever, the Indian monetary authority also decided to conduct OMOs of state loans to manage the spread of SDLs over government securities.

The impact of this is visible in the 10-year benchmark yield which has fallen by 40 bps since March, despite the record high supply of government paper and rising inflation.

Lastly, the quantum of foreign exchange intervention and the explicit communication of the RBI’s intention to keep the rupee fairly valued has been unprecedented. Central banks are usually known to keep mum on their views on the exchange rate and make vague statements when currencies come under pressure. The RBI has chosen to speak and act instead.

Policy imperatives have undergone major change across the world. In August, the US Fed changed its policy framework, pledging to keep interest rates “lower for longer”, and is willing to tolerate higher inflation beyond its target of 2 per cent in the medium-term.

No more fiscal frugality

Across the Atlantic, European countries moved away from decades long attitude of fiscal frugality and approved the common issuances of bonds moving towards a quasi-fiscal union. The region has seen a move towards a more cohesive fiscal and monetary response to the pandemic. The common bonds issued by the Eurozone would be supported by the €1.8-trillion bond buying program by the ECB, enabling it to anchor the yield curve.

These ultra-loose monetary policy measures that are likely to stay put throughout 2021 are likely to lead to an increase in the flow of funds towards higher yielding assets. This rotation of funds has already been underway over the last few months and has led to a 9 per cent decline in the dollar index since April. The consensus now seems to be that the slide in the dollar could morph into a “secular decline”. This would encourage the so-called “carry-trade” and ensure sustained dollar liquidity into other markets. This could keep global bond yields in check.

However, India might have a problem attracting bond flows. High inflationary pressures, coupled with continued low nominal rates, have sent real bond yields crashing. The real yield in India stands at -1.0 per cent compared to 4.6 per cent in Indonesia, 3.8 per cent in China, and 1.6 per cent in Thailand. The rise in divergence between India and its emerging market peers in terms of real returns could weigh on flows into its fixed income markets. Were this to continue, the upside to the rupee could be limited in 2021.

While policymakers have done it all to cushion the impact of the pandemic for now, the critical issue going forward would be what happens to all these unconventional measures once the economic tide turns. Will inflation make a comeback as the centre of monetary policy as commodity prices rise and easy liquidity conditions fuel demand side pressures? Will there be tsunami of bad loans? Exit from unconventional policy is just as difficult as entry.

Sakshi Gupta is a Senior Economist at HDFC Bank; Abheek Barua is Chief Economist at HDFC Bank. Views are personal

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