RBI's bond buys in current fiscal year can be inflationary, say economists

Not only do the bonds increase the balance sheet size of the central bank by infusing permanent liquidity into the system, the central bank runs the risk of stoking inflation in medium to long term

The Reserve Bank of India (RBI) now holds bonds worth Rs 9.08 trillion, much higher than its pre-demonetisation level of Rs 7.5 trillion, thanks to record open market operations (OMOs) done in the current fiscal year.

Not only do the bonds increase the balance sheet size of the central bank by infusing permanent liquidity into the system, the central bank runs the risk of stoking inflation in the medium to long term. The central bank witnessed such a spike in inflation after it committed to an OMO calendar in 2009. The RBI buys bonds from the secondary market under OMO to infuse liquidity, and the reverse is done to remove excess money from the system.

The central bank typically maintained rupee securities of Rs 7-7.5 trillion on its balance sheet, but this was not adequate during demonetisation in November 2016, when banks were putting record amounts with the central bank.

Lending and borrowing at the RBI’s liquidity window are done by keeping bonds as collateral, but the RBI did not have enough bonds to support this operation after demonetisation.

That time, the RBI had managed the increased liquidity flow from banks by increasing the cash reserve ratio (CRR) to 100 per cent for the money deposited after demonetisation. This meant that banks parked the money with the central bank free of cost, and without any security.

This time, though, it is problem of plenty for the central bank. “The very high bond share in the RBI balance sheet must have prompted the central bank to introduce the dollar swap. And other liquidity tools, something similar to the Standing Deposit Facility (SDF), where non-collateralised borrowing can be done, is the need of the hour now,” said Soumyakanti Ghosh, chief economic advisor to the State Bank of India group.

The RBI in 2009 had to adopt an expansionary monetary policy owing to the global credit crisis. This time, though, it had to do an OMO support due to liquidity crisis in non-banking financial companies (NBFCs).

Between April and September 2009, the RBI purchased Rs 80,000 crore through OMOs and a further unwinding of special bonds worth Rs 42,000 crore under the market stabilisation scheme. This was done in conjunction with massive stimulus packages by the government, and a handsome spike in income to government employees due to the Sixth Pay Commission recommendations.

The wholesale price index-based inflation (the key gauge of price rise then) rate was in negative territory in June 2009. It shot up quickly to nearly 11 per cent in April 2010 and remained high for three years, partly because of oil prices and also because of excess liquidity in the system.

“That prompted a whole lot of changes in liquidity management tools, with increased reliance on cash management bills and term repos and variable repos. Having said that, monetary policy works with a lag and balance sheet expansion leads to the creation of permanent and excess liquidity, which stokes inflation in the medium to long term,” said Amol Agarwal, assistant professor, economics, Ahmedabad University.

However, according to Saugata Bhattacharya, chief economist of Axis Bank, the inflation rate spiked in 2009 due to an “extraordinarily large fiscal stimulus post crisis, coupled with generous sixth pay commission payouts”. 

The liquidity injection now is durable, but still is a temporary arrangement, and shouldn’t matter much.

“In India, to a certain extent, fiscal expansion is more inflationary than monetary policy measures,” Bhattacharya said.

The RBI is mandated to keep inflation anchored at the central point of 4 per cent, within a standard deviation of 2 per cent. This means that as long as the inflation rate moves between 2 per cent and 6 per cent, the central bank can claim its monetary policy to be effective.

After the credit crisis, all major central banks’ balance sheets expanded because they bought bonds to infuse liquidity. The rise in a central bank balance sheet enables inflation, which developed markets want but developing markets like India try to avoid. Ideally, a central bank’s balance sheet should not increase more than the nominal GDP growth rate, but the recent OMOs (nearly Rs 3 trillion) mean balance sheet growth could be much more than that. 

The RBI’s assets expanded 9.5 per cent year-on-year in 2017-18 to Rs 36.17 trillion. The present OMOs alone account for nearly 10 per cent of the asset size of 2017-18.

According to the World Bank data, the central bank’s assets to GDP (gross domestic product) were at 4.51 per cent at the end of 2016. This is higher than most other peers, such as Indonesia (2.96 per cent), Korea (1.13 per cent), Russia (0.49 per cent), China (2.067 per cent), South Africa (1.43 per cent), Turkey (0.59 per cent), etc. However, Brazil had a very high central bank asset to GDP ratio (22.56 per cent), while the US and Japan central banks held huge assets in their books, 22.71 per cent and 65.78 per cent, respectively, mainly because of their continued quantitative easing exercise. The RBI’s assets to GDP ratio has certainly increased even further, economists say.

The swaps facility announced by RBI may try and prevent this expansion, but this facility works when the inflow is good, which some economists expect to be the case in the coming months. In March, the inflows in debt and equity combined have been a strong $4.6 billion.