Inflation or growth? RBI must choose one

During the pandemic outbreak, like its central bank counterparts around the world, the Reserve Bank of India (RBI) printed and pumped money into the financial system to drive down interest rates.

By then, taxes collected by the central government had dropped dramatically. As the government’s public debt manager, RBI drove down interest rates, helping the government borrow money at significantly lower rates.

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Dried up

At the same time, the interest rates at which banks lent money also fell. The hope was to encourage individuals to borrow more and spend, for businesses to borrow more and grow, and stimulate economic activity in the process. On the other hand, it has led to excess money or liquidity in the financial system. There was more money circulating than there was adequate use. It lasted more than two years. At the beginning of April, excess liquidity amounted to more than 8.1 trillion. On September 20, the excess liquidity came to an end. So what caused this drastic change?

One of the main reasons was that the RBI tried to keep the value of the rupee below 80 per dollar. India imports a significant portion of its energy needs. Therefore, a weaker rupee fuels retail inflation, which RBI is responsible for controlling. To do this, the RBI sold dollars from its reserves and bought rupees. The RBI’s foreign currency holdings stood at $550 billion as of March 25. As of September 9, this amount had fallen to $490 billion, implying that the RBI has been massively selling dollars and buying rupees. In doing so, he managed to reduce excess liquidity in the financial system.

Given the excess liquidity, defending the value of the rupee against the dollar at all costs has worked so far. However, things will get difficult. The dollars sold so far sucked up money that hadn’t been used by banks and other financial institutions. However, the days of excess liquidity are now over. At the same time, the growth of bank loans accelerated. As of August 26, non-food credit growth was solid at 14.8%. This type of non-food credit growth was last seen in December 2018, almost four years ago.

Banks lend money to the Food Corporation of India and other government procurement agencies to purchase rice and wheat directly from farmers at the minimum support price imposed by the government. This is called food credit. Once these loans have been subtracted from all bank loans, only non-food credit remains.

So two things happen. Non-food credit growth is accelerating at a good pace as the economy recovers. At the same time, the RBI sells dollars and buys rupees. This means that the RBI and the banks are competing for the money. The impact of this must be higher interest rates. It is already happening.

The weighted average interest rate in the overnight money market, where banks lend and borrow from each other, reached 5.47% on September 20. It was at 4.41% on August 20. This also explains why banks have raised interest rates on fixed deposits. At the same time, credit rates are also rising.

This shows us how intertwined the economy is. If the RBI continues to intervene in the foreign exchange market, interest rates will continue to rise and could reach a level where they begin to impact credit growth and, in doing so, economic recovery. However, higher interest rates are needed to control high inflation. Interest rates are more or less the only tool the RBI has to control inflation. Therefore, all things being equal, at some point the RBI will have to sacrifice some growth or let some inflation run. It is difficult to aim for both at the same time.

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