QE and other drugs: RBI must review liquidity enhancing measures

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By Rupa Rege-Nitsure

The massive financial shock induced by Covid-19 pandemic has prompted the central banks of many emerging market economies to use quantitative easing in a big way as a policy tool. Quantitative easing (QE) implies expansion of the central bank balance sheet via acquisition of government or private securities as an additional monetary management tool to stabilise financial asset markets or easing financial conditions.

With the unfolding of Covid-19 pandemic, Indian financial markets too witnessed severe stress and dislocation. The Reserve Bank of India managed to bring the situation under control using a slew of conventional and unconventional QE-like measures. There were frontloaded cuts in policy repo rate and large system-wide as well as targeted infusion of liquidity. Despite a significant increase in market borrowings of the central and state governments, persistently large surplus liquidity conditions ensured smooth resource mobilisation by the government as well as private sector entities at the lowest borrowing costs in a decade.

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While concerns over sticky inflation, fiscal slippage and the consequent increase in supply of government papers had impacted the market participants’ appetite for dated government securities, the RBI’s special open market operations and purchase of government securities in the secondary market helped soften the bond yields.

Besides the RBI’s open market operations, its other action that added to surplus liquidity in the system has been its continuous intervention in the forex market (purchase of dollars) to create good forex buffers and protect the competitiveness of Indian exports, given the widening inflation differential between India and its trading partners. This was indeed the need of the hour and RBI managed the challenge excellently.

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Notwithstanding the short-term benefits of QE and other monetary tools in terms of financial stabilisation, one cannot ignore its long-term structural impact. Every policy tool is beset with downside risks. As of today, surplus liquidity in the Indian financial system is closer to Rs 6 trillion and has distorted market dynamics. A combination of high inflation and low interest rates has given rise to negative real rates for savers, which is not a welcome phenomenon.

Money market rates have reached irrationally low levels. Even low-rated entities are availing funds at cheaper rates, which are not reflecting the appropriate credit risk or term premia. Competitive forces are driving banks too to lend at low interest rates. This doesn’t augur well for financial stability in the coming years.

READAvoid Excesses

Global investment firms are now warning that a prolonged stay of central banks as a market maker will impair the development of domestic financial sector. If pursued intensively, QE could cause serious problems such as inflation overshooting and debt distress. India along with Brazil, Costa Rica, Turkey and Hungary is classified into a group that will face risks of debt sustainability and inflation overshooting, going forward. It will help if RBI gives a clear framework on the size and length of its ongoing and planned QE operations in the forward guidance to the markets and come up with measures to control the irrational pricing of financial instruments.

Also, disproportionate creation of liquidity should raise concerns about fiscal dominance, or monetary financing of fiscal deficits. This will be self-defeating. Time has come to look closely at the side-effects of the treatment, which should not be more damaging than the disease.

(Rupa Rege-Nitsure is group chief economist at L&T Finance Holdings.)

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