In the current scenario of the Indian economy with a volatile bond market and an inflation level at the upper band of the inflation target, the RBI seems to be caught between a rock and a hard place.

The RBI’s Monetary Policy Committee (MPC), in its first policy meeting after the Union Budget, kept the repo and reverse repo rates unchanged at 4 per cent and 3.35 per cent, respectively.

This accommodative stance of the MPC implicitly shows that the RBI is putting more emphasis on taming the yield curve rather than containing the inflationary pressure in the economy.

The RBI’s decision of keeping the policy rates unchanged will have a beneficial effect by giving an impetus to credit formation in the economy.

Additionally, it will reduce the borrowing cost of the government.

The government plans to borrow a record ₹11.6-lakh crore from the market in 2022-23 to meet its expenditure requirement to revive the economy.

The expenditure requirement is nearly ₹2-lakh crore higher than the current year's Budget Estimate of ₹9.7-lakh crore.

The reduced borrowing cost because of the RBI’s accommodative stance will hopefully keep the fiscal deficit, which is already about 3 percentage points higher than as prescribed by the Fiscal Responsibility and Budget Management Act, at a manageable level.

But the RBI’s stance is at odds with the monetary policy decisions of other developed economies. Inflation has jumped to 5 per cent in Europe, and 7.5 per cent in the US; the highest in four decades, that has prompted their central banks to consider raising interest rates and withdraw additional liquidity. 

Pricier food basket

India is also facing a serious case of inflation as food prices have increased by 20 per cent year-on-year, as measured by the FAO Food price index. The increase in inflation will be priced in by the market in the form of higher bond yields far ahead of the RBI.

A classic illustration of this phenomenon is the current spike in the US 10-year treasury yield to 2.03 per cent after the Labour Department released data showing that the US inflation has reached 7.5 per cent.

If the RBI’s view on inflation is behind the curve, then higher market yield will have a cascading effect on both the asset and liability of the balance-sheet of banks. From the liability side, the continued accommodative monetary policy for the past two years has led to a slowdown in deposit growth. Deposits grew by 10.1 per cent at end-September 2021 as compared with 11.0 per cent a year ago.

The current accommodative stance will further depress the deposit growth rate, stretching the asset-liability mismatch in banks’ balance-sheet.

If the prevailing inflation scenario is priced in the yield curve, it will lead to a loss in equity in the balance-sheet of the banks.

Asset worries

From the asset side, scheduled commercial banks hold a large amount of G-Secs in their balance-sheet. Any increase in the bond yield will decline the value of the asset.

The RBI has placed a huge bet on inflation to create space for government borrowing. In its haste to accommodate the government, has it ignored the associated duration matching activity that banks will be exposed to? Managing interest rate risk has always been in poor in India.

A close look will show that all the interest rate derivatives market (interest rate swap, interest rate futures, overnight interest swaps) is illiquid.

Compared to an average daily bond market volume of ₹400-500 billion, the daily volume in the interest rate derivatives market is around ₹170-180 billion. Moreover, the participation of the banks in these derivatives markets is abysmally low.

A better alternative would have been to increase the policy rates to check inflation and use unconventional monetary policy to rein the yield curve.

Notwithstanding the various tools that the RBI can employ to manage the yield curve and inflation, unless the government moves towards a stronger fiscal consolidation policy, all its efforts will be futile.

Chakrabarti is Assistant Professor, Accounting & Finance Area, IIM-Ranchi; and Sen is Assistant Professor, Jindal School of Banking & Finance, O.P. Jindal Global University

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