Without saying so, the Reserve Bank of India (RBI) has embarked on quantitative easing (QE). He gave it a fancy new name: the Government Securities Acquisition Program (GSAP), which promises to become worthy of being remembered if pronounced like G-zap. What exactly does RBI hope to zap or destroy? Well, he wants you to perish at the idea that the yield on government securities exceeds, say, 6.25%. He wants to cap the expectations of market players. It might be more difficult than imagined. You cannot put a limit on a thinkable thought, nor tame the sentiment of the market, even if you are RBI. It is like the case of a teacher telling students, “Don’t think of a pink elephant.” Bond market players will be determined to test that cap, and RBI will have to keep coming back to zap its greedy intentions. For now, RBI says the GSAP promise is to buy ₹1 trillion government securities in the secondary market in the first quarter of this fiscal year. But the market has already interpreted this as a guaranteed buy of ₹4 trillion in four quarters. This would therefore mean financing a third of the annual budget deficit of ₹12 trillion via GSAP. While this is not outright monetization of the deficit, it does come down to it. The GSAP also aims to reduce the yield spread between short and long term securities, also known as term premium. By guaranteeing to be the buyer of last resort for government bonds, RBI crossed a mental “Lakshman Rekha”, a line thought to be impassable under normal circumstances. But these are anything but normal times. The deficit is huge and the second wave of covid threatens to block economic recovery. RBI is now just following a precedent set by the US Federal Reserve, followed by the European Central Bank (ECB) and the Bank of Japan. Over the past 12 years, we have seen several versions of QE in the Western world, resulting in interest rates close to zero. The Fed and the ECB went even further, buying blue-chip corporate bonds and later bad bonds, exemplified by Mario Draghi’s slogan of “doing whatever it takes” to keep rates low and revive growth.
Last year, RBI did a lot of unorthodox things to combat the impact of the pandemic. It allowed a moratorium on loan repayments. He also announced a massive long-term repo operation, essentially providing low-cost overnight loans for a period of three long years. This was in addition to a rate-cutting frenzy that has been going on for almost three years. Yet that did not revive credit growth, which, after all, is the main focus of this exercise. Currently, credit growth is barely 6% overall, of which the industrial credit component is much lower. To support high gross domestic product (GDP) growth, we need credit growth closer to 20% per year. India’s own experience since the 1990s is that high interest rates have not deterred animal spirits and robust investment growth. Conversely, it is not low rates that induce industries to plan large capital expenditures or increase their plant capacity. Thus, if the GSAP aims to keep the cost of capital low for businesses, including small and medium-sized enterprises, by anticipating a higher credit drawdown, this will not be enough. Worse yet, some large, well-rated companies may simply refinance their loans and pocket a nice payoff with no new investment in sight. Stimulating new investment requires political stability, renewed consumer and business confidence, the success of India’s universal vaccination campaign, and reduced regulatory and tax burdens. What low rates can do is inflate asset markets, especially stocks and housing. It would be another headache as it began to threaten financial stability. For now, it seems the only real beneficiary of GSAP is the central government, which is the economy’s biggest borrower. The impact of a slightly higher cost of borrowing is huge on the treasury, especially when the mountain of government debt alone is huge. ₹100 trillion. Therefore, even a 1% increase in the average cost of borrowing this year can increase its interest expense by ₹1 trillion, or 0.5% of GDP. Not to mention the additional burden of servicing the public debt.
Is there a different way to reduce the sovereign cost of borrowing? Yes. As this column has repeatedly suggested, why not opt for a bilateral loan for a share swap between RBI and the Union government, completely bypassing the bond market? This could be accompanied by dribbling sales of shares promised by public sector companies.
Is there a downside to the early days of QE in India? Yes. On the one hand, a central bank cannot control both bond yields and the external value of its currency. The rupee’s slide after the RBI announcement is proof of this maxim. Be prepared for a currency slide. Second, it is like entering a “chakravyuh” from which an exit path is unknown. It has implications for financial stability, as it could lead to a stock market and real estate bubble. Third, it could also lead to inflation (after all, that’s what too much money in circulation does). This will further erode the real returns of bank depositors and other savers. This, in turn, will put pressure on the RBI’s monetary policy committee to raise short-term rates. Fourth, how will a rate cap imposed by the GSAP reconcile with excess demand for loans? Even though deposit growth is optimistic ₹15 trillion this year, central and state deficit needs will swallow up all loanable funds. Unless interest rates go up, how can this circle be squared?
Ajit Ranade is Chief Economist at Aditya Birla Group.