Consider the broader impact of policy instruments

(The following article appeared in Cogencis on December 5, 2018:

http://www.cogencis.com/newssection/columnananth-narayan-why-keep-it-simple-norm-wont-work-for-rbi/  )

Consider the broader impact of policy instruments

The RBI has access to a variety of market and policy tools. These include Open Market Operations (OMOs) and repos in government bonds, intervention in currency markets, and setting of policy interest rates through the MPC.

The current approach of the RBI to restrict certain instruments for certain outcomes may be creating unintended vulnerabilities and distortions. This is visible in our monetary policy framework, and increasingly in our liquidity management as well.

We may need a more considered approach to policy diagnosis and responses.

Man-to-man marking and the Tinbergen principle

Using a soccer analogy, RBI uses a man-to-man marking approach that links each of its policy instruments to a specific objective. Policy interest rate, for instance, under the monetary policy mandate of the MPC, targets CPI inflation – and not currency markets or capital flows. Government bond OMOs are supposedly used to manage system liquidity, not to manage the borrowing program of the government. Currency intervention is ostensibly used to manage some unstated measure of currency market volatility, not to target any particular currency level or directly manage INR liquidity.

Some experts laud this approach and quote the Tinbergen principle, which they say argues for the central bank to use only one instrument to target one objective.

I believe that is an incorrect read of this principle. The principle simply states that we need at least as many instruments as we have objectives. It cannot and does not call for ignoring the overall impact of each instrument – no principle can do that.  

Medical diagnosis, monetary policy, effects and side-effects

Doctors diagnose the ailment (not just to check for the ‘flu – there could be other illnesses as well!), prescribe appropriate medication, take note of their possible side-effects, and if needed, prescribe additional treatments to manage them. If the side-effects are unacceptable and cannot be controlled, the medication itself needs would be questioned – no doctor would want to address a problem only to create a larger one.

This can sound complicated, unclear and messy – but simplifying this for the sake of simplification can be very dangerous.

Our monetary policy framework does not follow the good doctor’s approach.

First, we focus solely on CPI – ignoring any other addressable vulnerability that may require attention. Next, we use policy interest rates to control this CPI, without considering the actual effect and side effects of these policy rates.

As with medication, every policy instrument has multiple effects. Interest rates impact currency markets, capital flows, aggregate demand, growth, inflation, investments, savings, and asset prices.

Sadly, it simply doesn’t matter that there was no intent to cause any side-effects – the side-effects will still ensue. In fact, under certain conditions, the side-effects of the instrument could be larger than any impact on the intended objective.

As an example, the vulnerability in the INR currency markets built up in the years 2014-2018 in part because high real rates, intended to target CPI, attracted reversible inflows, encouraged a build-up in unhedged exposures, and caused significant rupee overvaluation.

Liquidity, OMOs and bond prices

RBI’s liquidity management is another area where the debatable interpretation of the Tinbergen principle may be causing significant, under-appreciated side-effects.

By the end of this month, RBI would have net purchased INR 1.76 tn worth of government bonds through its Open Market Operations (OMOs) in FY19. That is a staggering 69% of the INR 2.55 tn net issuance by the central government in FY19 so far.

Interestingly, the Urjit Patel monetary policy report of 2014 had taken exception to the sizeable OMO buybacks by the RBI during 2008-13 (when total RBI OMO purchases ranged between 20% to 40% of the net market borrowings of the government), hinting that they may have been conducted to manage down yields on government securities.

The ongoing recent OMO bond purchases have certainly achieved the intended objective of durably replenishing the liquidity outflow from RBI’s sale of an estimated US$ 22-25 bn in the spot market in FY19 so far.

There are side-effects, of course. This relentless purchase of bonds by the RBI, with the promise of more from today’s post-MPC press conference, has helped 10Y GOI yields drop from 8.25% earlier this year to 7.45% today. For the government, bond market participants, and Non-Banking Finance Companies (NBFCs) facing liquidity challenges, this is very, very welcome news.

While this is near-universally welcomed, is this truly desirable in the medium run?

Divorcing bond markets from fundamentals

As the Governor confirmed today, RBI buys GOI bonds purely to inject durable liquidity into the market. It makes no assessment of its impact on bond prices, nor does it profess any view on bond prices.

The presence of such a large buyer of GOI bonds, agnostic to price levels, considerably distorts the market.

Otherwise, the market would ideally reward a prudent government that runs a sustainable, quality fiscal balance with lower borrowing costs. On the flip side, any government that increases its revenue deficit and deploys its borrowings unproductively would face higher costs.

This is not a question about the creditworthiness of the sovereign – with the ability to print domestic currency, that risk is non-existent. This is simply the market’s assessment of the sustainability of the government borrowing, and its likely impact on inflation and other parameters.

Given governments bonds have captive buyers in banks, bond prices are already distorted. This magnitude of current RBI intervention, however, increases the distortion manifold.

The whole point behind the Fiscal Responsibility & Budget Management Act (FRBM) was precisely to reduce distortions that arise from monetization of the fiscal deficit. The current liquidity management framework, with its blinkered see-no-side-effects approach, could be taking us back to pre-FRBM days.

An alternative approach to managing liquidity

This is worth a larger debate, but an alternative method to replenish liquidity drawdown arising from foreign currency outflows could be for the RBI to provide liquidity through the term repo window, for longer tenors of 6-months and beyond.

This would provide sufficient term – but not permanent - liquidity to banks. This would give ample time to the financial ecosystem to explore sensible ways of bringing in permanent liquidity – either by attracting currency in circulation back into the banking system, halting foreign currency outflows, and attracting fresh durable foreign currency flows into the country.

Much as they are painful, higher interest rates might be one way to open these medium-term taps. They might also reduce import consumption demand and thus improve the external balance. They could also ensure that both the government and the corporate sector manage their debt appropriately – helpful to instill overall confidence and draw in durable savings.

The repo window would come less in the way of higher rates than the market-distorting outright purchase of GOI bonds.

The point is not that this is the best solution – the point is that we have to encourage a framework where we debate the consequences of using different policy instruments, and choose the one with minimal undesired side-effects.

Summary

Like medication, policy prescriptions and instruments could have wider consequences than just the intended policy objective. In policy making as in healthcare, we need to move beyond pithy, simplistic formulations that ignore the complexities of the real world.