Why Present Monetary Policy Models are Inappropriate for Developing Countries – An Illustration from Indian Central Bank’s Latest Monetary Policy Stance

 

The objective of this short article is to highlight the inappropriateness of interbank liquidity control-based monetary policy models for developing countries, especially, in view of lasting pandemic risks to these economies, based on present monetary policy model of the Reserve Bank of India (RBI) as reflected in its latest policy decision on 7 October 2021.

Its latest decision was to continue with the present monetary policy stance as long as necessary to revive and sustain growth on a durable basis and to mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target of 4 per cent with a band of +/- 2 per cent.

RBI’s Present Monetary Policy Model

The model is primarily based on inter-bank liquidity management by the RBI carried through open market operations (OMO) at three policy rates (at present).

• repo rate (overnight) at 4.0 per cent
• reverse repo rate (overnight) at 3.35 per cent
• marginal standing facility rate and the bank rate at 4.25 per cent.

Accordingly, the RBI lends funds overnight at the repo rate to deficit banks and accepts funds overnight at the reverse repo rate from surplus banks so that the interbank overnight lending rate remains within the two policy rates (policy rates corridor). These repo and reverse repo operations are conducted on government securities as collaterals. RBI earns interest income on repo operations and pay interest on reverse repo operations where the net interest is the risk-free profit to the RBI. Depending on liquidity conditions, short-term repo and reverse repo auctions (variable rates) also are conducted in order to keep interbank interest rates strictly within the policy rates corridor. 

In addition, auctions are conducted to purchase government securities in the secondary market on term basis to pump money to the government securities market so that the government is able to borrow money at lower interest rates to fund the fiscal expansion. However, levels of government securities yield/price controlled by the RBI through such auctions are not based on transparent targets. However, some central banks in developed countries such as Bank of Japan and Reserve Bank of Australia announce such yield rate targets in addition to policy interest rates.

Accordingly, the monetary policy model is the interbank overnight interest rate target or control which is a price control in the money market. Unlike price controls by the government in commodity markets, the RBI can do this as it is the money printer at its wish. The underlying hypothesis here is that this monetary policy model will get transmitted across the economy through bank credit flows where the monetary growth of the economy will be aligned to keep the inflation running at the central bank target (known as inflation targeting monetary policy). Accordingly, policy rates will be raised when the inflation is in a rising trend above the target and vice versa in line with the belief of the monetarist school. Many developing countries follow this policy model imitated from developed countries who have dynamic markets, financial and real markets.

At the onset of the global Coronavirus shock, the RBI between March and May 2020 cut the repo rate by 1.15 per cent from 5.15 per cent to 4.0 per cent and reverse repo rate by 1.55 per cent from 4.90 per cent to 3.35 per cent in three instances. Since then, the accommodative policy stance has remained for more than 16 months. Accordingly, as the price in the money market (interest) is lower, the volume of demand and supply (credit and money) is expected to rise to facilitate the economic growth out of Coronavirus. This is the accommodative monetary policy presently followed throughout the world.

Interim Outcome of the RBI’s Pandemic Monetary Policy Stance

In the present monetary policy model, the money printed and created by the central bank primarily through purchase of government securities and credit to the government will immediately flow to the banking system/interbank liquidity pending subsequent credit flows to the private sector over time based on risk-taking of lending banks. As a result, the interim surplus bank liquidity will be parked at the central bank at reverse repo rate (3.35 per cent) enabling banks to earn a risk-free income.

Therefore, the daily average reverse repo volume has increased significantly from ₹ 5.7 tn. in June to ₹ 9. tn. in September 2021. The potential surplus liquidity overhang is estimated to be more than ₹ 13 tn. RBI has cut the reverse repo rate faster than the repo rate to discourage banks from parking surplus funds at the central bank so that credit delivery to the economy can be raised. Central banks in developed countries maintain close to zero or negative interest rates payable on excess reserves in this regard. However, the intended objective is not served in any case due to excessive risks involved in bank credit granted to the private sector due to Pandemic concerns and, therefore, parking of surplus funds at central banks continues.

Therefore, credit and money growth in the economy comes primarily from the expansion of bank credit to government for pandemic fiscal expansion where the private credit growth stays low due to underlying high risks and non-repayment arising from Pandemic uncertainties. As of September 24, 2021, money supply (M3) and bank credit grew by 9.3 per cent (lower than 10.8 per cent in July) and 6.7 per cent (slightly higher than 6.5 per cent in June).

Money printing has increased by 20.8 per cent by 1^st of October 2021 since the end of March 2020 (from ₹ 30.3 tn. to ₹ 36.6 tn.), mainly through credit to the state and purchase of foreign exchange. In August 2021, foreign exchange reserves increased by US$ 17.4 bn to US$ 637.5 bn primarily due to new allocation SDR by the IMF. The increase in the foreign exchange reserve in 2020-21 so far is US$ 60.5 bn. The reserve level is high at 14 months of imports and US$ 458 reserve per capita (Lower than US$ 2,213 per capita in China and higher than US$288 per capita in Bangladesh).

The CPI inflation has reduced to 5.3 per cent in August as compared to 6.3 per cent in June 2021 (the target range 2-6 per cent). Therefore, inflation is primarily driven by non-monetary factors including Coronavirus uncertainties. The GDP growth (20.1 per cent in the first quarter) shows strong rebound of the economy from the Pandemic despite the devastating second wave.

Comments on the Suitability of the Policy Model to Developing Countries

As inflation runs within the target range with rising GDP growth, the RBI continues with the present policy stance although the surplus liquidity in the banking system is high showing a potential buildup of inflationary pressures in the future as monetarists believe. Central banks in developed countries also continue with prevailing accommodative policy stance even with highest inflationary pressures reported in the past decade due to supply side disruptions arising from the Pandemic uncertainties. They believe that such inflationary pressures, though high, are transient upon pandemic progress and, therefore, do not warrant any policy tightening on account of inflation control at targets around 2 per cent.

Although monetary policy models adopted by developed countries also are interbank liquidity control based, those central banks have initiated direct credit channels targeted to various sectors such as private bond markets with asset purchases and SME credits with term refinance to fight the pandemic impact on the economy and societies. However, for this purpose RBI mainly resorts to directed lending regulations to promote priority sector lending from banks’ funds. Therefore, risks to banks are high as such credit is highly risky (illiquid assets) funded by short-term retail deposits (sight or liquid liabilities). Therefore, directed lending practices reflect forced credit intermediation which is unfair to banks. In fact, such credit in national interest should be facilitated by national credit policies under the monetary policy. Therefore, Indian monetary policy model stays inactive on the private sector economy with surplus liquidity in the banking sector. This is true for many other central banks in developing countries. These models facilitate only speculation based money dealing games overnight or near term while productive sectors of the economy including the state struggle in liquidity and credit crunches.

Indian balance of payment surplus and foreign reserve are built up through foreign investment and borrowing as the current account or real resources trade has been a deficit. Therefore, the level of foreign reserve to gage the strength of the economy is a misleading indicator. Further, this foreign reserve model may not be sustainable, given the conventional thoughts of domestic wealth and business and competitive capacity. 

Therefore, export promotion through specific credit schemes is necessary to support the general public from the global economy similar to the policy model adopted in China, given a large number of lagging sectors and majority population living in poverty and primitive living standards in India. The low cost of production, abundance of natural resources and high IT environment also are adding to the comparative advantages. Therefore, innovating the monetary policy to cater to credit delivery on term basis across the economy, businesses and households, is crucial to mobilize productive resources and improve living standards of the general public.

Further, inflation as measured by the cost-of-living index (mostly representing low-income households) whose prices and cost are largely controlled by the government is not responsive to the interbank interest rates and liquidity operations of the central bank.  Therefore, inflation targeting-based monetary policy has no relevance to countries with controlled markets. 

Accordingly, what is more appropriate for these countries is to target sectoral credit distribution for economic activities to uplift the living standards of the general public while reducing grave distributional disparities as credit drives modern monetary societies. Therefore, the monetary policy is not a textbook based monetarist formula for inflation control but a ground exercise to uplift the living standards of the general public through economic activities. Green credit is the latest addition to address grave socio-economic concerns on environment pollution and global warming. 

Otherwise, societies would be seeking fiscal deficits and public debt to support the living standards as they are not aware of the hypothetical monetary policy models. In this perspective, the emergence of modern monetary theory will crowd out the prevailing monetary policy models in the next decade mainly due the need to reconstruct social and economic systems from the Coronavirus. In fact, central banks also are urging fiscal authorities to use their taxing and spending powers for this purpose as the present monetary policy models are not inclusive enough.

Views in this article are based on the author’s hands-on experience on relevant subjects. Readers may refer to two books of the author “Innovating Central Banks with New Mandate & Governance to Promote Safer Money and Banking in Open Economies” and “ මූල්‍ය ආර්ථික විද්‍යාව: මුදල්, වාණිජ බැංකු සහ මහ බැංකුව” (Sarasavi Bookshop) for technical discussions.

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka