Why RBI is coy about raising interest rates

For the 11th time in a row, the Reserve Bank of India (RBI) kept the headline interest rates (repo and reverse repo) unchanged in its April 8, 2022 monetary policy (MPC) statement, even while it revised its inflation projections for FY23 to 5.7% – from 4.5% in February 2022.

This (5.7%) is also higher than 5.3% for FY22 (as disclosed in the MPC report of February 2022). And a day later, on April 9, it released its latest consumer confidence survey to say that households expect inflation to reach 10.7% and 10.8% for the next three months and next one year, respectively.

The Russia-Ukraine war is still on and oil and commodity prices remain volatile with an upward bias. Domestically, retail oil (petrol and diesel) and cooking gas prices have gone up significantly in the past fortnight – which will have a cascading impact on food and transport, increasing inflation further. Interest rates were going up globally, even before the war began because of supply constraints in the post-pandemic recovery phase.

Why is the RBI coy to admit the inflation threat and use the two key instruments at its disposal – repo and reverse repo rates – to reduce liquidity and thereby control inflation? Why no questions are being raised about its continued "accommodative" stance (lower interest rates), rather than "neutral" (raising or lowering interest rates as the situation demands; in the present context, raising the rates) when the inflation threat is very real and may spiral out of control? Experts are happy that it may do so in June 2022 when the Monetary Policy Committee (MPC) meets. But that may be too late.

The short answer to all answered questions and doubts is that the RBI invoked the Standing Deposit Facility (SDF) – a new and additional tool created in 2018 to absorb excess liquidity in the banking system to control inflation. The SDF rate has been fixed at 3.75% – against the repo rate of 4% and reverse repo rate of 3.35%.

The SDF is collateral free (unlike the reverse repo), replaces the fixed reverse repo rate (FRRR) of 3.35% "as the floor of the liquidity adjustment facility (LAF) corridor". Since banks deposit their surplus/excess money daily in the RBI's reverse repo account (earning an interest of 3.35%) when they find no takers or unwilling to lend, the SDF is expected to mop up excess liquidity more easily than the FRRR instrument.

RBI's credibility at stake

On the face of it, the SDF may seem a more convenient tool but doubts linger about the subterfuge evident in it – multi-year timeframe, leaving repo and reserve repo untouched. There are many good reasons for the doubts.

As for the RBI's MPC, first set up in 2016, and its job of determining the "policy interest rate required to achieve the inflation target" (in which the current RBI Governor Shaktikanta Das played a role), it is by now well known that one of the main problems the government had with previous Governors Raghuram Rajan and Urjit Patel was about lowering of the policy interest rates – which both resisted. For this a senior central government official even accused Rajan of working to benefit "the white man" in "developed countries" and sought investigation into the "real purpose" not cutting down the interest rates that the government wanted. After an initial compliance, Patel too refused to play ball. These were revealed by a recent investigating report.

Finally, it was after Shaktikanta Das took over the RBI (December 208) that interest rates starting going down as per the government's wish.

Growth vs Inflation?

A facile debate has begun with the "accommodative" stance of the RBI's monetary policy of April 2022: growth vs inflation.

This debate is premised on RBI's balancing act between boosting private investment through cheap loans (keeping interest rates low) to boost economic growth and jobs creation and controlling rising inflation.

Only the very ignorant and naïve will fall for this. Here are some hard facts to explain why.

First, in 2021, Das and at least two RBI reports argued in favour of discontinuing the cheap interest regime, both warning that if continued further the liquidity infusion would create "macro-financial risks" as "unintended consequences". Apart from Das's statements to the media, the RBI reports which said so are: (i) Financial Stability Report (FSR) of January 11, 2021 and (ii) the MPC report of February 2021, which went to declare India "credit surplus". Das and RBI reports said liquidity infusion was leading to stock market bubble.

Second, what they didn't say is that the pandemic response of fiscal stimulus and cheap credit had also led to the billionaires' wealth to zoom when millions were dropping dead to the pandemic and millions more losing their jobs and livelihood. The global growth fell to -3.1% in 2020 in a long time. Global financial giants Swiss bank UBS and PwC said in their report of 2020: "the V-shaped equity market recovery from April-July 2020 propelled billionaire wealth to a new high" – from $8 trillion at the beginning of April 2020 to $10.2 trillion by end-July 2020. The reason being "billionaire wealth is loosely correlated with equity markets, due to holdings in listed companies" and "governments huge fiscal and quantitative easing packages drove a recovery in financial markets".

There are more facts.

Who needs liquidity infusion?

Third, if the RBI's idea of accommodative stance is to actually boost private investment, it should have first looked at its data which showed there are no takers:

• Credit growth to non-food sector plunged from 20% in FY11 to 5.5% in FY21.

• Credit to industry fell from 20.7% of the GDP in FY12 to -0.3% of the GDP in FY21.

• Credit growth to large industry fell from 23.2% of the GDP in FY12 to -1.7% in FY21.

The full FY22 data is not yet available. All that is known is that the growth in non-food credit has gone up from 5.5% in FY21 to 6.9% in FY22. But this hides more than it reveals as would be clear soon.

Fourth, analysis of RBI data also shows that it is the "personal loan" segment which is driving the credit growth. During the decade of FY12-FY21, "personal loan" grew at annual average of 15.3% – far outstripping that to agriculture (10.3%), services (11.6%) and industry (6.3%). Personal loan is more for low-productive consumption expenditure which has an indirect impact on the economy, while loan to industry has a direct impact, is more productive and generates more income in the economy.

Fifth, the RBI data further shows that private corporate investment has fallen drastically and consistently. From a high of 13.6% of the GDP in FY13 to 11.1% in FY20 (the last fiscal for which data is available), private investment is flailing.

The reason for the drastic and consistent fall in the credit growth to industry and investment by private corporates are not unknown: prolonged pre-pandemic slowdown due to multiple economic misadventures like the demonetisation and GST, followed by untimely and unplanned pandemic lockdown, supply-side solution (liquidity-heavy) to address demand-side problem that the pandemic shutdown caused.

What happened to all the cheap credit the RBI infused since early 2020?

RBI data shows it is getting parked in its own reverse repo account every day – because the banks are either reluctant to lend or the industry has no appetite for loans because the demand is low and so is the capacity utilisation and production. India has remained in a "liquidity trap" for about two years, although the reverse repo deposits are coming down slowly since October 2021.

What all the above facts show is that cheap credit or liquidity infusion was a futile exercise. Since all the data have been accessed from the RBI, it is unlikely that the RBI didn't know.

So, why the debate over the RBI's balancing act between growth impetus and inflation control?

Read on to find out.

Mounting central government debt

The MPC mandates the RBI to maintain CPI inflation at 4-6%. It also mandates that if the RBI fails to keep inflation within this limit, it has to provide written explanations to the government. But as the investigation mentioned earlier revealed, the RBI under Das failed to keep the inflation below 6% for three consecutive quarters between January and September 2020. This should have triggered a written explanation and roadmap to check the inflation. The RBI didn't do it, and the investigating report said the finance ministry, with the approval of minister Nirmala Sitharaman, gave the RBI a pass.

Further, the report revealed that the RBI is more focused on managing the government's debt – at the cost of inflation management.

Since the RBI happens to be the government's debt manager, it has to mind the interest rates taking the government's debt liabilities into consideration. The Economic Survey of 2021-22 reveals that the central government's debts from internal sources have ranged from 92.8% in FY15 to 94.2% in FY21 (PA). Besides, the central government's debt has mounted from 45.7% of the GDP in FY19 to 59.3% in FY21. Higher the interest rate, higher the government's liability and outgo.

The real problem here is with coming clean and transparency in the RBI's functioning, rather than hiding behind the facile growth-vs-inflation debate.

But that is far from comforting.

What if inflation goes through the roof – 10% as consumers fear (mentioned earlier) or touches 12-15%? Will the RBI act tough? And if it doesn't who will hold it accountable – since the finance ministry gave it a free pass after the inflation went over 6% for three consecutive quarters in 2020 (as mentioned earlier)?

That brings to the real danger in an altered electoral reality. If, indeed the failures of demonetisation, distress migration & job losses couldn't alter its electoral prospects, would high inflation (10-12-15%) matter for the government? If it doesn't matter for the government, would it matter for the RBI?

That is the crucial point to ponder over following the RBI's monetary policy statement of April 2022.