Monetary policymaking is not only about analyzing economic conditions and devising appropriate responses. It is equally if not more important for the central banker to correctly communicate the policies and their rationale in order to build investor confidence. Market participants closely watch and listen to monetary policy makers. They pay attention to the central bankers’ confidence or lack thereof while communicating. They try to unearth the hidden messages under each sentence spoken and what they imply for the market. The market’s verdict is immediate and most often it is unforgiving of gaffes and missteps.
In December 1996, then Federal Reserve Chair Alan Greenspan asked a seemingly innocuous question during a banquet about irrational exuberance, escalating asset prices and appropriate policy action. Over the next few days, stock indices across Japan, Europe and US sold off. Or let’s recall a more recent incident involving ECB President Christine Lagarde. In March 2020 and in response to a journalist’s question, Lagarde rashly stated that “we are not here to close (sovereign debt) spreads”. Bond yields across European economies rose in reaction to this alarming statement.
Emerging market central banks are under even greater scrutiny given the lack of equivalent confidence in their institutions compared to developed markets. In this context, it is interesting to examine the Reserve Bank of India (RBI)’s communication with the market in recent years.
India entered the Covid-19 crisis on a relatively weak footing, with an elevated fiscal deficit, government debt and inflation. Foreign portfolio debt inflows had been declining since 2015 on the back of market concerns around deteriorating fiscal finances. With the government restricted in its actions, the RBI was responsible for much of the heavy lifting to steer the economy and market through this crisis. And while it did a good job of boosting systemic liquidity, offering credit guarantees to small businesses and suppressing bond yields, its communication was somewhat lacking.
This or that?
The RBI’s mandate is price stability while keeping in mind the objective of growth. In certain instances, the market was unsure about the RBI’s priority. For instance, in December 2019, the RBI decided to maintain the policy rate given high inflation. Simultaneously, it revised down its growth forecast to the lowest in over a decade. The market had been expecting further easing from the RBI, taking cues from its tone in the past meetings. Throughout 2019, the RBI had expressed concern over weakening industrial activity, service sector output and investment. Additionally, it had cut the policy rate by 135 basis points that year to support growth. The sudden switch to inflation control surprised the market as investor confidence building necessitates consistency of messaging.
The RBI is under a similar dilemma this year. CPI inflation exceeded its 2-6% target band in May and there are signs of further price pressures. RBI Governor Das brushed aside inflationary pressures in June by arguing that demand pull inflation is lacking. He reiterated the RBI’s accommodative monetary policy stance to revive and sustain growth. However, market participants continue to remain wary of the RBI’s next move. The money market is already pricing in 99 bp hike to the policy rate over the next year, indicating that the market does not buy the RBI’s commitment. The other aspect to note here is the lack of clarity over what the RBI is prioritizing. Is it growth or CPI inflation? This or that?
To be fair to the RBI, the Philippines central bank, Bangko Sentral ng Pilipinas, is facing a similar quandary this year. Like the RBI, the BSP’s primary mandate is to maintain low and stable inflation within the 2-4% target range. Year to date, headline CPI inflation in the Philippines has averaged 4.5% y/y. Even though Q1 GDP contraction was worse than consensus expectation, the BSP maintained the policy rate. This rate hold was in line with market expectations given previous comments by BSP Governor on the appropriateness of policy setting and growth optimism. The messaging was consistent throughout.
The list of priorities is growing.
Since 2020, India has received massive foreign direct investment flows which boosted the capital account balance and strengthened the currency (please refer to my previous blog post on the relationship between capital account balance and currency). The RBI absorbed these capital inflows by building its FX reserves buffer and in the process controlled the Indian Rupee (INR)’s appreciation.
The RBI’s arguments were that currency appreciation hurts exports and lumpy capital inflows are vulnerable to reversal. It wanted to build a war chest of reserves to prevent currency weakness during periods of external risk-off. And again, to be fair to the RBI, it is haunted by the developments during the 2013 Taper Tantrum and 2018 Fed rate hike, when the INR sold off massively.
But there are flaws in the RBI’s logic and communication style. Currency weakness brings with it imported inflation, which an inflation targeting central bank is well aware of. Additionally, since 2019, Indian inflation has exceeded the RBI’s inflation targeting band.
Secondly, the RBI has not been clear about what magnitude of reserves are considered sufficient. India’s FX reserves have risen to a historical high of over USD 600 billion, the fifth largest globally. They are enough to cover anticipated capital outflows as well as almost 12 months of imports. Despite this robust cover, the RBI recently opined that reserves were insufficient in covering imports compared to Switzerland, Russia and China. Should the RBI be competing with other central banks or considering domestic needs? And like other good communicators, should it not clarify the parameters it is considering?
Finally, currency control appears to be an added priority on top of inflation targeting and growth support. This exacerbates the earlier point on the market’s confusion over RBI’s policy goals.
Will you be there when I need you the most?
The Covid-19 induced fiscal relief packages have weakened the Indian government’s fiscal profile. The government’s debt is estimated at 90% of GDP and it needs the RBI to control bond yields. The RBI stepped in nicely by buying government bonds in the secondary market and executing operation twist (buy long dated and sell short dated bonds to flatten the yield curve and ameliorate the government’s debt servicing needs).
For the most part, the RBI has been successful in suppressing yields. Moreover, its liquidity enhancing policies have massively cushioned the blow to the economy, particularly given the government's limited fiscal space. These have included credit lines and easier loan terms to consumers and SMEs, much needed financing to the struggling shadow banks and loan restructuring schemes to stressed segments.
What it has been less successful at is winning bond investors’ trust. At several points throughout 2020 and 2021, bond investors were unsure about whether the RBI will step in to keep yields low. Indian CPI inflation has been stubbornly high due to food prices and several rating agencies cut India’s sovereign rating and outlook. These factors necessitated higher bond yields and raised valid questions from bond investors.
The RBI has tended to step in when yields crossed a certain threshold, making its intervention reactive rather than proactive. Look at it this way, Mario Draghi’s comment “we will do whatever it takes to save the Euro”, singlehandedly calmed the market and prevented a sovereign debt crisis. This is the power of words and good communication personified.
The RBI has also been forced to cancel several bond auctions because the market was unwilling to accept low yields. The fundamentals were unsupportive and without the RBI’s explicit support, Indian bonds were not a comforting bet. Drawing parallels with other central banks, Bank Indonesia and BSP were more forthright in their government debt purchases. The BSP announced an arrangement with the Bureau of Treasury and secondary market purchase of government securities. The Indonesian government announced legal changes to allow primary market government debt purchase by BI and a burden sharing agreement as well. These were bold, unprecedented measures which were needed during unprecedented times. Although the market was concerned about institutional autonomy and exit strategy, it had the necessary information to forecast future policy actions. This was a major difference to the RBI.
All these arguments are not to belittle the quality of monetary policy in India or its makers. Rather, it is to point out the areas that still need improvement. Particularly since the adoption of inflation targeting, the investor community has been impressed with central banking in emerging Asia and the RBI is no exception. The RBI's efforts to clean up the non-performing debt in the banking system and its financial stability reports are well regarded and widely read by the investor community and policy analysts. Not to forget, the hugely important role that the RBI has played in steering the economy through this crisis.
It is precisely why the market has formed an expectation about the RBI’s monetary policy making. That it is good and well though out (most times). And when expectations are high, it doesn’t take much to lower them.
