RBI is getting its way on policy rates. But how long will this last?

It will be interesting to see if Shaktikanta Das can keep his political masters in good humor. Or if his relationship with the government - like that of his two predecessors - will also start to fray

Back in February, when India was still in denial about its brewing inflation challenge, economists at Nomura Holdings Inc. summarized the choices before the monetary authority into three neat boxes. First, they said, there was a 15 per cent probability that the central bank was right to ignore supply-side pressures. But their base case, to which they assigned a 50 per cent likelihood, was that the Reserve Bank of India was wrong and it would have to pivot to containing price increases. They did consider a third possibility to which they gave a fairly significant 35 per cent chance: that the RBI, although wrong about inflation, would simply go on to tolerate it. 

“This is a scenario of fiscal dominance, in which policy rates rise by much less than we expect in 2022, but macro risks — both inflation and external — could be much higher than our current baseline,” Nomura analysts Sonal Varma and Aurodeep Nandi wrote in a Feb. 25 note. “We see a potential stagflationary outcome in this scenario.”

Fiscal dominance occurs when the government’s finances — for instance, the cost at which it borrows — take priority and force the monetary authority’s hand on interest rates, hurting its power to fight inflation. That isn’t the case in India right now. In early May, when the fiction of transient inflation became impossible to keep up, the Indian central bank surprised the market with an unscheduled 40 basis point increase in the benchmark interest rate. It followed up Wednesday by raising the policy rate by another 50 basis points, though this time the tightening was widely expected. For now, it doesn’t look like the fiscal authority is keen to dissuade the central bank from doing its job.

At 7.8 per cent, the pace of annual price increases is at an eight-year high and still climbing. In other words, it’s early days in India’s battle against inflation, and the finance ministry might yet lose its nerve if, in the process of containing price pressures, the RBI pushes up bond yields too high, complicating the government’s plan to raise money by selling a record 14.31 trillion rupees ($184 billion) of notes this year.

So far, the administration of Prime Minister Narendra Modi doesn’t seem to be rattled. If anything, New Delhi has announced a $26 billion package, which includes tax cuts on fuel, to help the RBI keep a lid on inflation. That package is unlikely to be a substitute for more rate increases; it might even enlarge the public borrowing plan. To this, add Wednesday's increase in prices for monsoon-sown crops — including rice -- that the government will pay farmers to procure their harvests for public distribution. Money will have to be found for this, too.

RBI Governor Shaktikanta Das has to assure New Delhi that its borrowing program would get completed without pushing the 10-year yield much higher than the current level of around 7.5 per cent, a three-year high. The question is, can Das really hold the line on long-term bond yields? And will the government change its carefree tune if he can’t. Luckily for Das, so far there’s been nothing of the 2015 bluster when, according to a recent Al Jazeera expose by The Reporters’ Collective, the top bureaucrat in the finance ministry had internally sought an investigation into then Governor Raghuram Rajan’s decision to keep interest rates high, by which he was allegedly helping “the white man” — shorthand for investors in rich nations — at the cost of domestic investment and growth.

After Rajan’s 2016 decision to return to the University of Chicago, the friction carried over to his successor. Governor Urjit Patel came under pressure on everything from interest rates — which by now were being decided by a monetary policy committee — to his management of surging corporate bad debt and, finally, the question of whether the RBI had more capital than it needed. Patel’s deputy was mocked for warning the government of the consequences of raiding the RBI’s coffers. Following Patel’s abrupt resignation in December 2018, his job went to Das, a former finance-ministry mandarin who had executed Modi’s draconian currency ban in late 2016. A new period of peaceful coexistence between the fiscal and monetary authorities began, and gained momentum during the pandemic when such cooperation became the norm globally. 

But now, the pandemic is over, and new sources of friction are cropping up. On rate increases, the central bank and the finance ministry may be singing from the same hymn book, but the question of the RBI’s capital is beginning to simmer, thanks to the lowest dividend the ministry has received from the RBI in a decade: a little less than $4 billion, or a third of last year’s payout.

Crucially, even this reduced dividend has been made possible by the central bank simultaneously selling $97 billion from its foreign-currency reserves in the spot market and buying $114 billion. Ignore the purchases. Each dollar that’s sold is valued its weighted average cost of acquisition in the past. Since that figure is lower than the current exchange rate, selling dollars for around 78 rupees today means a profit, which is then shared with New Delhi. Without this “active conversion of revaluation gains into realized profits, the RBI would have required a net capital injection from the government,” according to Observatory Group analyst Ananth Narayan. 

A reduction in the balance sheet also helped rein in the RBI’s capital requirement, and prevented its dividend from going to zero, Narayan says. That tug of war — whether RBI would give money to the government or tap it for funds — might remain in check once again if the central bank’s assets don’t swell this year, either. That may well be the case since there’s hardly any dollar inflow into India now, only outflow. Still, the RBI’s economic capital, which according to Narayan’s calculation has already dipped below the minimum 20.8 per cent of assets set by a 2019 committee, is a mindless constraint. It would never have come about if the finance ministry didn’t in the past lust after the RBI’s capital. To have to depend on politicians for money isn’t a good outcome for an institution that has to project its autonomy to make its war on inflation credible. 

India’s fragile government finances mean that the risk of fiscal dominance of monetary policy always lurks in the background. Right now, it isn’t a big threat because inflation is giving an unexpected boost to the tax revenue. But as Nomura’s Nandi says, monetary tightening is “far from the finishing line.” Barely two months into the job, Das cut rates in a surprise stimulus ahead of Modi’s May 2019 re-election bid. That was then. Now that the cycle has turned, it will be interesting to see if the RBI chief can keep his political masters in good humor. Or if his relationship with the government — like that of his two predecessors — will also start to fray.