What Should Be The Mandate Issued to The New Monetary Policy Committee (MPC)?

The end of the 4 year term of the Indian Monetary Policy committee (MPC), in Sept 2020, with a policy mandate of “flexible inflation targeting” (FIT) has spurred, rightfully, a debate if its is optimal especially when inflation (Price stability), growth & financial market stability, at varying degrees, are part of the mandates handed over to monetary authorities, in other countries. The proponents of both the structural & cyclical theories of GDP growth rate drop are, however,  largely are in agreement that the Indian growth rate, in potential output, has dropped, significantly, post the Global Financial crisis (GFC), 2008, opening up yet another debate on the efficacy of the current Fiscal Responsibility & Budget Management Act (FRBM) that defines fiscal policy in India.

A Brief History of the MPC:

The 6 member MPC, with voting rights, was an attempt at following an international best practice of making the RBI governor a first among equals; insertion of 3 non RBI members was an attempt at incorporating diverse opinion. A flexible inflation target of 2-6% was mandated with the RBI governor required to offer a written explanation if the target was breached, for 3 consecutive quarters.

There is an acknowledgement that inflation is a tax on the poor. The inflation mandate, in many developed markets, like the US is a tighter 0-4% but the greater leeway offered to the MPC was explained away as a necessity, for developing markets -despite countries like China, too, following the 0-4% mandate; others have argued for a more liberal inflation target to secure higher government revenues vide a higher nominal GDP growth rate. If India wants representation at the high table, 0-4% target should ideally be the aim even if it means short term pain.

Lower inflation & a real interest rate of 1 – 1.5% (say) would be a good compromise between the interests of borrowers & deposit holders. Indian savings rate dropped from a peak of 37.7% in 2007-08 to 29.7% in 2018-19 & negative real rates of interest, now,  prompts depositors to shift to riskier assets - gold or equities – with a potential for inviting asset bubbles & greater inequity thereof. Depositors assured of  1 – 1.5% real rate would help increase savings rate to fund investments of  borrowers who can then secure lower nominal risk adjusted interest rates comparable with the best in the world. However, it is likely that the COVID -19 headwinds shall be used to short-charge depositors. India banks have 185 cr. deposit accounts – more than 1 per person even if normalized for zero usage accounts - & 10 cr. Borrowers – writes Aarati Krishnan, in the Hindu Business line & ideally the regulator should protect the interests of the majority too.

RBI Data

The MPC has been successful in keeping inflation within the bracket assigned for a major part of their tenure. Critics have however panned, the MPC, for predominantly overestimating forecasted inflation figures & following a hawkish monetary policy, vide repo rate, impacting growth, conveniently obfuscating the “twin balance sheet” problem. A majority of Indian companies carry unsustainable levels of debt – either as a consequence of “phone banking”, a euphemism for crony capitalism or inadequate project appraisal & risk management frameworks adopted by the Public Sector Banks. Their failure to pay back banks led to rising NPAs (Non-Performing Assets) – impacting balance sheets of the financial companies. Banks resorted to ever-greening of loans, pushing the can down the road or did not allow transmission of a drop in repo rates to borrowers, forced as they were to show healthy financials with lower capital. RBI’s AQR (Asset quality review) of Banks in 2015-16 & the government's IBC (Insolvency & Bankruptcy Code) was a sincere attempt to remedy the situation. Unfortunately, the NBFCs & private sector banks like Yes Bank too are entangled, now, in the NPA mess. Therefore, the view that a drop in interest rates would prompt a rise in investment rate is an exaggeration especially when the capacity utilization rates are continuously dropping – to under 70% even pre COVID & assets are available at a grand discount under the IBC.

RBI Data 

This calls for evaluating other sources of finance & attracting supply chains taking advantage of the US – China trade spat. Though the idea of attracting Pension, insurance & sovereign wealth funds, to fund growth, is promising, it could fructify only in the medium term in the light of policy uncertainty; Free Trade Agreements & Bilateral Investment Protection Treaties (BIPT)  are being reviewed & protectionism induced vide “Atma Nirbhar Bharat” self-sufficiency program even as companies display COVID-19 investment caution. Thus,  in the short to medium term, the govt. has to do the heavy lifting dispensing with the post 1991 phenomena of envisaging the private sector as the principal engine of growth.

The Alternatives:

Prof. Anant Nageshwaran, of the Prime Minister Economic Advisory Council (PMEAC), argues that FIT was, perhaps, adopted because of proximate experiences of close to double digit inflation during the 2008-13 period. But Global Central Banks record on inflation management has been less than impressive. While US Federal Reserve, Paul Volcker’s hawkish monetary policy came “at the cost of engineering a severe recession” the abysmal failure, of Central Banks, at driving up inflation during the last decade- across US, UK, EU – or in Japan, over last 3 decades- despite its many “reckless” attempts reveals limited institutional capacity to influence outcomes. Neither should Central Banks be tasked with growth”for it is even less susceptible to their influence than the inflation rate.” He avers that the MPC should be mandated to focus on “credit growth” – through Banks, non-banks & external commercial borrowings (ECBs) on which it has control – through monetary & regulatory policies; else, mandate a “multiple indicators” approach as was the case earlier - during the period 1998-2016. Focusing on the mandate of “overheating” that manifests in credit growth in asset markets – financial & real - & in trade deficits is a recommended measure as it aids in financial stability too unlike an FIT regime. Govt. should be tasked, instead, to work on removing structural rigidities: legal, regulatory & compliance burdens & work on easing access to capital for SMEs. 

It is true that the RBI/MPC has limited control on imported inflation – commodities like oil/gold - supply side constraints in an economy – both labour & capital productivity – food shortages - of proteins like pulses, eggs, milk etc. - & the political economy- rise of prices of onions just after elections - or fiscal profligacy. Unlike developed markets, though, because of such structural issues – supply rigidities & food prices – it is easier, for central Banks, in developing countries, to push inflation up than control it downward. He concludes, therefore, that inflation targeting regime is ill suited for all countries – developed or developing – though for different reasons.

Some economists have argued that since monetary policy cannot effect food & fuel inflation due to supply rigidities, targeting core inflation – CPI (consumer Price Inflation) minus fuel (weightage 45.86%) & food (weightage 6.84%) inflation – instead of headline inflation makes sense. Madan Sabnavis, Chief Economist CARE Ratings believes that 85% of the CPI basket is not affected by interest rates. Furthermore, while headline inflation was higher than core inflation prior to MPC launch it got revered during 2016-19 due to depressed non-core figs; therefore had core inflation been the mandate, the MPC policy recommendations would have been different.

 

CMIE Data

Since the MPC has consistently given a commentary on output gap, Sabnavis recommends growth to be included as part of the mandate apart from savings rate. Instead of 3 academicians, as part of the 3 non-RBI representation, he suggests a banker – to put forward sector perspective, an industry representative - to highlight their concerns & a member to represent the public - to highlight savings.

Prof. Anant Narayan of SP Jain Institute of Management & Research (SPJIMR) opines that while monetary policy impacts the external sector, savings, investments & employment, they are absent from the MPC framework. Furthermore, relying on repo rate alone ignoring liquidity, term structure of interest rates, foreign currency  interventions & macro prudential regulations is bound to lead to sub optimal outcomes. The model of increasing interest rates to disincentivize borrowing & hence consumption leading to an aggregate  demand drop to force a price correction is more suited to a “borrow to spend” & not “borrow to produce” economies like India; household debt ,in India, incidentally, is low at 11% while that of private Sector is 51% of GDP. The interest rate – inflation premise on which the current framework rests, though simple -  to nudge the largest borrower, in India, the govt.to control inflation vide lower increase in administered food prices & keep fiscal deficit low -  is flawed, he avers & bats for an integrated model. The RBI’s currency markets policy is a black-box which needs to be opened up for greater public debate.

Sabyasachi Kar of National Institute of Public Finance & Policy (NIPFP), suggests an “augmented flexible inflation targeting” framework – an  unconventional  fiscal-monetary co-operation - to prime growth through a dynamic policy – with an exit strategy in place -  of RBI  offering a standing fiscal facility to fund capital expenditure “additional” to that budgeted by the state, at the beginning of the fiscal year, contingent of fulfillment of the following conditions, in a bid to maintain RBI’s independence:

(1)Inflation forecast is within the range defined by a flexible inflation targeting framework

(2)The Growth of potential output is below some well -defined long run value

(3)Underlying economic model predicts higher growth of potential output if govt. increases capital expenditure.

To prevent govt. from budgeting less/no capital expenditure & thrive on welfare expenditure alone to maximize political objectives, a “matching contribution” criteria could be introduced, he avers. By monetizing the capital expenditure in the primary market, bypassing the interest rate channel, the effectiveness of the standard monetary policy mechanism is maintained, he opines. Since the current FRBM Act precludes monetization – RBI buying govt. bonds in the primary market - modification of the Act essential; historically, while direct monetization did lead to problems, linking standing facility to the inflation targeting mechanism prevents indiscriminate monetization, restricting spends only to “capital expenditure” checking fiscal profligacy.

R Jagannathan, Editor, Swaraja Magazine, pumps for scrapping the MPC for “messing inflation estimates & growth climate” & “marginally damaging the balance sheets of Banks & borrowers”& enabling “governors to claim MPC backing for flawed policies”; as an example he cites External MPC member, Ravindra Dholakia’s vote for dropping repo rate being rejected repeatedly. Power comes with accountability he argues & claims that MPC diffused responsibility. He agrees with Anant Nageshwaran’s suggestion on RBI managing “overheating” & observes that multiple indicators can be monitored by an in-house RBI team rather than the MPC.

Conclusion:

Continuation of the MPC structure recommended to aid diversity of views; Madan Sabnavis’s view on having a representative each from banking, industry & public is debatable.

With an inability to control inflation or spur growth, mandating a FIT regime extension for the MPC shall lead to sub-optimal outcomes. "Multiple indicators" monitoring as suggested by Anant Nageshwaran including the opening up of the currency market black-box, as suggested by Anant Narayan, should be the way forward. With declining investment rates unlikely to be reversed, in the short term, due to private companies busy deleveraging, COVID-19 headwinds - leading to postponement of investment - & capacity utilization rate under 70%, govt. has no other option but to do the heavy lifting on investment.  Sabyasachi’s suggestion on capital expenditure monetization, therefore, has virtue.

The mirage of RBI’s independence was unmasked when the govt. invoked section 7, of the RBI Act, to force the institution into compliance. YV Reddy’s model of RBI’s independence on operational matters, consultation with govt. on policy & working in close co-ordination with the govt.  on structural issues is the suggested way forward. An RBI-Govt. tango to pull the economy out of trouble is the only solution.