The Indian economy has become more integrated with global capital, trade and financial markets. This is directly impacting the market dynamics in India. Monetary policy is no exception. India’s monetary policy is no longer the subject of one market, but is being shaped in three markets. In reality, it never was. The money market, foreign exchange market and bond market have been shaping India’s monetary policy simultaneously.
This is not new at all. Rather, it is old economics but with new numbers. Money is never neutral in the short run. Too much of it leads to asset bubbles. Too little brings stagnation. India is now in the middle of this dilemma. Despite the RBI absorbing over ₹8 lakh crore through multiple VRRR auctions, there remains about ₹7 lakh crore of surplus liquidity. This surplus money has to be managed in such a way that it improves operations in the money market and monetary policy transmission. Basically, liquidity is a policy variable now.
The impossible trinity, as suggested by the Mundell-Fleming model, is a real situation. The RBI is dealing with that impossible trinity, where it needs to choose between capital mobility, exchange rate stability and monetary autonomy. India has chosen capital mobility and exchange rate stability through capital inflows under the USD-INR swap facility and FCNR (B), and by defending the rupee against the US dollar. The RBI has now constrained monetary autonomy.
The OMO sales announcement has forced the 10-year bond yield to hit 7 per cent after three months. This will affect long-term investment decisions and the cost of capital for the government while affecting the entire yield curve. Interest rates should respond to inflation and output gaps, but exchange rates and capital inflows do have a role to play in the monetary policy transmission story. The WACR is the operating target, and OMOs and FX swaps can be used to manage durable liquidity.
The trilemma is real in an open economy like India. India has chosen its position. Now India’s macroeconomic management should ensure that the surplus liquidity from forex inflows is drained without spiking bond yields, while the exchange rate remains stable without sacrificing monetary policy autonomy and credibility. Growth must be protected while keeping inflation within the threshold.
The future policy challenge for India is to successfully manage these markets together without allowing one instrument to undermine another. This is not today's inflation number or forex reserves but the next decades.
At this hour, India needs to do a few things. First, the RBI must ensure that monetary policy does not chase food inflation. This job should be left to the government to use fiscal policy instruments to manage food inflation rather than to tame it. Food inflation simply cannot be tamed through interest rates. Second, India must prepare a plan for the coming decades rather than for a quarter or year. High food inflation in India is a structural problem, as it has become a regular phenomenon at intervals. This doesn’t need a tactical but a structural response.
Third, the RBI should integrate the three markets into one policy framework and publish a quarterly financial conditions index integrating liquidity, exchange rates and bond yields. This will shift the central bank’s vision from one dimension to three dimensions. Fourth, the RBI must coordinate with the government on forex management. The swap facility and FCNR (B) deposits succeeded beyond imagination but created domestic liquidity problems. The RBI must plan for the consequences before they happen, as this will now become a regular occurrence at intervals.
India's financial integration is a strength. But the monetary policy must now integrate the three dimensions along with the fiscal policy. In such times, when fiscal policy focuses on growth and demands low interest rates and monetary policy is forced to increase interest rates to stabilise prices, the chances for stand-off between fiscal policy and monetary policy increase. History is replete with such incidents. Here lies the national interest.
The Money Market
Liquidity is the real policy variable. RBI's operating framework is designed in such a way that it keeps the weighted average call rate (WACR) close to the policy repo rate to avoid any liquidity mismatch. This looks good in the textbooks, but the reality is almost always different. When bank system has surplus liquidity, the repo rate alone does not tell the full story. In early September, banking-system surplus liquidity rose to about ₹11.6 lakh crore. The RBI first responded with Variable Rate Reverse Repo (VRRR) operations and then moved to outright bond sales. The message is clear. Liquidity itself has become one of the monetary policy variables.This is not new at all. Rather, it is old economics but with new numbers. Money is never neutral in the short run. Too much of it leads to asset bubbles. Too little brings stagnation. India is now in the middle of this dilemma. Despite the RBI absorbing over ₹8 lakh crore through multiple VRRR auctions, there remains about ₹7 lakh crore of surplus liquidity. This surplus money has to be managed in such a way that it improves operations in the money market and monetary policy transmission. Basically, liquidity is a policy variable now.
The Foreign Exchange Market
The second market that directly affects monetary policy is the foreign exchange market. The special USD-INR swap facility, including $127.23 billion through FCNR(B) deposits, has mobilised $136.38 billion by August 31. These inflows have strengthened India's external position, and forex reserves have increased to about $781 billion. But these inflows through the USD-INR swap facility and FCNR (B) deposits also create rupee liquidity. The RBI received these dollars and released rupees into the banking system, overloading banking system liquidity. Here foreign exchange management enters the domain of monetary policy. Here is the irony. A weaker rupee leads to increased import costs, including oil and other inputs, resulting in worsening inflation and the trade balance. On the other hand, surplus liquidity normally softens the short-term market rates.The impossible trinity, as suggested by the Mundell-Fleming model, is a real situation. The RBI is dealing with that impossible trinity, where it needs to choose between capital mobility, exchange rate stability and monetary autonomy. India has chosen capital mobility and exchange rate stability through capital inflows under the USD-INR swap facility and FCNR (B), and by defending the rupee against the US dollar. The RBI has now constrained monetary autonomy.
The Government Bond Market
The third market is the government bond market, which is subject to monetary policy. The RBI is selling government bonds worth ₹1 lakh crore in Open Market Operations (OMO) sales. The response to the first tranche of OMO sales of ₹50,000 crore on September 17 was overwhelming, with bids of ₹66,590 crore. This response by financial institutions itself tells the story of surplus liquidity in the banking system. Government securities are not another asset class on the balance sheets of banks. Rather, these government securities are the indicator of confidence and benchmark price of rupee money for the wider economy. However, OMO sales are tricky too. Through OMO sales, excess liquidity is easily absorbed, but yields also rise, impacting monetary policy transmission. The 10-year government bond yield is part of the monetary transmission story.The OMO sales announcement has forced the 10-year bond yield to hit 7 per cent after three months. This will affect long-term investment decisions and the cost of capital for the government while affecting the entire yield curve. Interest rates should respond to inflation and output gaps, but exchange rates and capital inflows do have a role to play in the monetary policy transmission story. The WACR is the operating target, and OMOs and FX swaps can be used to manage durable liquidity.
The Integrated Framework: One Policy, Three Dimensions
RBI cannot treat the repo rate, the rupee and the bond yield separately. They are on the same plate and have to be dealt with together, and this is the biggest monetary policy question RBI is facing. India needs a more integrated operating framework in which capital mobility (liquidity) management, foreign exchange management and bond-market conditions are assessed together. This is necessary to keep financial conditions stable enough to protect growth, while preventing external shocks from becoming domestic inflation or financial instability. This is going to become a regular situation as India grows economically and becomes more integrated with global markets.The trilemma is real in an open economy like India. India has chosen its position. Now India’s macroeconomic management should ensure that the surplus liquidity from forex inflows is drained without spiking bond yields, while the exchange rate remains stable without sacrificing monetary policy autonomy and credibility. Growth must be protected while keeping inflation within the threshold.
The future policy challenge for India is to successfully manage these markets together without allowing one instrument to undermine another. This is not today's inflation number or forex reserves but the next decades.
The Way Forward: Policy Coordination and Credible Communication
India is in a spiral of high food inflation. WPI in August was around 10%, and it will reflect in CPI numbers in September. It is now a tricky situation for India's aspirations. The possibility of the RBI raising policy rates in the October MPC is very high. The difference between policy rates and inflation has narrowed enough to breach the RBI’s threshold limit in the inflation numbers for September. Even a few-point rise in inflation will make real interest negative. So pressure on the RBI to increase interest rates is very high to avoid a situation of negative divergence between interest rates and inflation. At present, the Indian economy requires a low interest rate regime to sustain its growth and allowing inflation to eat that growth would prove costly for the economy.At this hour, India needs to do a few things. First, the RBI must ensure that monetary policy does not chase food inflation. This job should be left to the government to use fiscal policy instruments to manage food inflation rather than to tame it. Food inflation simply cannot be tamed through interest rates. Second, India must prepare a plan for the coming decades rather than for a quarter or year. High food inflation in India is a structural problem, as it has become a regular phenomenon at intervals. This doesn’t need a tactical but a structural response.
Third, the RBI should integrate the three markets into one policy framework and publish a quarterly financial conditions index integrating liquidity, exchange rates and bond yields. This will shift the central bank’s vision from one dimension to three dimensions. Fourth, the RBI must coordinate with the government on forex management. The swap facility and FCNR (B) deposits succeeded beyond imagination but created domestic liquidity problems. The RBI must plan for the consequences before they happen, as this will now become a regular occurrence at intervals.
India's financial integration is a strength. But the monetary policy must now integrate the three dimensions along with the fiscal policy. In such times, when fiscal policy focuses on growth and demands low interest rates and monetary policy is forced to increase interest rates to stabilise prices, the chances for stand-off between fiscal policy and monetary policy increase. History is replete with such incidents. Here lies the national interest.
Rajeev Upadhyay
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