Ill-effects of neglecting macroeconomics (The Hindu)

Mains Paper 3: Economy
Prelims level : Corporate bond market
Mains level : Developing Corporate bond market and its effect

Context

• The most general definition of macroeconomics is of spillovers between sectors and markets and from the system as a whole to its parts.
• A medical specialist focusses on a part of the human body and often does not understand that if a medicine given to heal a part hurts the health of the whole, it can harm the part she wants to cure as well.
• A sector specialist tends to neglect general equilibrium interactions.

Inflation targeting and markets

• Inflation targeting was among the hundred small steps recommended for India in a report on financial sector reforms.
• Low inflation and fiscal consolidation were seen as prerequisites for the development of corporate bond markets.
• The corporate bond market fell to new lows. Leveraged corporates are not in a position to raise money in a high real interest rate regime.
• They did not want to invest as demand was low.

Can the corporate bond market develop if corporates are in trouble?

• As an aggressively independent inflation targeting RBI bought too few government securities (G-Secs) in open market operations (OMOs), durable liquidity shrank and spreads rose. Credit creation in the economy as a whole slowed.
• The development of financial markets suffered.
• Inflation targeting did help to reduce inflation, but through falling inflation expectations and commodity prices.
• The rise in real interest rates only reduced aggregate demand and growth.

Lender of last resort

• An RBI liquidity window for NBFCs, when viewed from the narrow lens of a financial sector specialist, implies exposing the RBI to unknown credit risk and creating moral hazard by rescuing people who have borrowed short and lent long and encouraging such inappropriate arbitrage in future.
• But this neglects the necessity of a lender of last resort function whenever there are spillovers and systemic risk.
• In times of fear, institutions without access to such a lender hoard liquidity because they expect other participants to behave irrationally and not lend although fundamentals maybe strong. X factors in Y’s irrationality.
• There is an externality — a slowdown is triggered. Borrowers are not able to repay and the quality of assets deteriorates further.
• A liquidity window removes the fear of not being able to repay if there is a demand.
• Lending rises, asset quality improves and the RBI is not stuck with large low-quality assets as the liquidity window is not actually used.
• The lending can be costly, based on excess good quality rated collateral.
• NBFCs without good assets would not be able to access it and so would continue to exit or merge. There would be no moral hazard.

Sovereign dollar borrowing

• The suggestion on sovereign dollar borrowing made in the Budget shows a similar lack of appreciation of systemic interlinkages.
• Raghuram Rajan wrote that borrowing $10 billion abroad will not reduce pressure in the G-Secs market because the RBI would reduce its holdings of G-Secs to sterilise reserve accumulation from the $10 billion dollar inflow. As a past central banker he knows,
• Because this is exactly what happened in 2017-18 due to raising caps on foreign inflows into G-Secs.
• In October 2015 bi-annual increases in limits were announced to reach up to 5 per cent of government bonds by March 2108.
• This cap was fully utilised at $19 billion by then. This was more than required to finance the current account deficit (CAD) so did not reduce the cost of government borrowing since the RBI decreased its holdings of Indian G-Secs and bought US treasuries at zero interest from the excess inflows it accumulated as reserves.
• Despite the additional source of demand for them, the interest rate on domestic G-Secs shot up to 8 per cent almost 2 per cent above the Repo rate.
• Since the domestic G-Secs market is large even a low cap on foreign G-Secs holdings as a percentage of the domestic debt market (currently 6 per cent) can lead to excess inflows.

Way forward

• If their share becomes too large in India’s total foreign liabilities that can affect the domestic interest rate cycle. Currently, this share is 11.36 per cent and with additional $10 billion government borrowing it will become 12.17 per cent. It should be kept below 10 per cent.
• Capital flow management should adjust so that inflows are not in excess of the CAD and the share of G-Secs in the RBI balance sheet does not fall below 40 per cent. In 2018 it fell to 20 per cent.
• Deepening and diversifying financial markets is a valid objective but the government would be better off finding ways to revive domestic demand to trigger a virtuous investment cycle than relying on fickle external suitors.
• Public spending must be preponed and implemented vigorously even as the cost of borrowing comes down.

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  General Studies Pre. Cum Mains Study Materials

Prelims Questions:

Q.1) Pro-Active Governance and Timely Implementation (PRAGATI) is set up under the:
A. DoPT
B. PMO
C. Cabinet Secretariat
D. Niti Aayog

Answer: B
Mains Questions:
Q.1) The fall in aggregate demand and the NBFC liquidity squeeze are due to policymakers’ failure to appreciate systemic inter-linkages. Comment.