Deepak Mohanty: Unconventional monetary policy and the Indian
economy
Paper presented by Mr Deepak Mohanty, Executive Director of the Reserve Bank of India, in
the SAARCFINANCE Governors' Symposium, Colombo, 24 July 2014.
* * *
The assistance provided by Rajeev Jain in preparation of this paper is acknowledged. The views expressed in this
paper are personal and not necessarily that of the Reserve Bank of India.
I thank Governor Cabraal for this opportunity to share with you our experience in handling
the spillover from unconventional monetary policy being followed by many advanced
economies. Conventionally, central banks operate monetary policy with an interest rate
instrument. For example, they raise the policy interest rate to signal a tighter monetary policy
and vice versa. However, this procedure has limits. In abnormal times, if central banks were
to sharply loosen their monetary policy, they cannot go beyond a point as the nominal policy
interest rate cannot be lowered below zero. We saw this phenomenon play out in full force
following the global financial crisis in 2008. As the zero lower bound began to constrain
conventional monetary policy of major central banks, they had to deploy unconventional
monetary policy measures to provide further monetary accommodation. Unconventional
monetary policy essentially relates to the balance sheet policy of central banks. However,
entry and exit from such policies have strong externalities and spillovers as we have been
experiencing for some time now.
Against this backdrop, I will begin by discussing the broad contours of unconventional
monetary policy and possible channels of cross-border spillovers. I will then focus on India's
experience after the first announcement on early quantitative easing (QE) tapering in May
2013 and our response. I will end by drawing a few broad conclusions.
Unconventional monetary policy
The limitation of transmission of conventional monetary policy through interest rate led major
central banks to undertake measures which were monetary in nature but unconventional in
their instruments and operational targets. For example, a crisis may impair the normal
functioning of financial markets. In such a situation, central banks can resort to direct
financial asset purchases and/or loosen collateral standards to expand their balance sheets.
In the recent global financial crisis most advanced country central banks resorted to
unconventional monetary policy. Although the design of unconventional monetary policy
measures varied across central banks, they included lending to financial institutions, targeted
liquidity provisions for credit markets, outright purchases of public and private assets,
purchase of government bonds and forward guidance (Annex 1). These measures were
aimed at lowering longer-term bond rates and ease monetary conditions, and were intended
to signal a policy shift towards maintaining interest rates at lower levels for a longer period.
Spillovers to EMEs
It is widely perceived that in absence of unconventional monetary policy measures, financial
sector meltdown and recession, particularly in advanced economies, would have been more
severe, which in turn could have significantly impacted the global economy.1 However,
opinion remains divided on the efficacy of prolonged recourse to unconventional monetary
policy. It is argued that greater risk taking behaviour as an outcome of unconventional
measures could undermine financial stability. Furthermore, there is the risk of postponement
of necessary fiscal reforms that were otherwise required. More importantly, there are
concerns of cross-border spillovers in terms of capital flows, exchange rates and other asset
prices, particularly in emerging market economies (EMEs). This was fully in evidence as the
Fed communicated its intention of undertaking tapering earlier than anticipated which
increased financial vulnerabilities across EMEs, though subsequent communication
somewhat eased the pressure. These policy developments, however, have significantly
altered the external financial environment in many EMEs, including India.
Even before the tapering talk, the impact of policy changes in systemically important
advanced economies on the rest of the world through various channels was in evidence.
Unconventional monetary policy measures not only supported domestic economies, but also
boosted a broad range of asset prices globally, especially equity and bond markets in
EMEs. In fact, recent literature suggests that besides domestic pull factors in EMEs, push
factors - monetary policy in advanced economies and global risk appetite - were important
determinants of capital flows to EMEs.2
While the presence of cross-border spillovers from policy changes/announcements in
advanced economies is well recorded in the literature, the more recent debate has been on
the degree and kind of spillovers across EMEs and how these could be minimised. Governor
Rajan argued that capital flows pushed into EMEs due to ultra-accommodative monetary
policy in source countries tend to increase local leverage not only through cross-border
banking flows but also through appreciating domestic currencies and escalation in asset
prices. The exit from a prolonged use of unconventional monetary policy also poses the
risk of asset prices overshooting on the downside which can cause significant collateral
damage.3
According to the IMF, EMEs received much larger net private financial flows of about
US$ 3.0 trillion in the form of direct and portfolio investment during 2009-13 as compared
with US$ 1.8 trillion during 2004-08.4 With indications of likely normalisation of monetary
policy in the US, concerns regarding potential outflows were expected. As long-term US
interest rates rose immediately after the tapering announcement, risk aversion among foreign
investors for EME markets escalated. Capital flight from the bond segment of financial
markets weakened currencies in EMEs, which in turn triggered equity sell-offs. This suggests
that despite the fact that equity and debt are two different classes driven largely by growth
premium and yield differentials, both were affected by shifts in broad sentiment towards
EMEs (Chart 1).
The multilateral institutions, such as the International Monetary Fund (IMF) and the Bank for
International Settlements (BIS), have done significant research on the issue of spillover. Most
studies found that EMEs with better domestic fundamentals and deeper financial markets
were relatively more resilient to adverse shocks from US Fed tapering.5 There was also a
view that foreign investors did not differentiate EMEs based on macro fundamentals. Rather
the EMEs with larger and deeper markets were under more pressure.6 On balance, it would
seem that most EME currencies depreciated and countries with weaker fundamentals were
affected more (Chart 2).
Keeping in view the complex interaction of global spillovers and domestic vulnerabilities,
EMEs deployed a variety of policy measures. These policy responses were in the form of
monetary, capital flow measures and other structural policy actions. For example, while
Indonesia and Turkey made greater use of their forex reserves to curb downward pressures
in their currencies, others like South Africa used exchange rate as the main shock absorber.
Many EMEs had to raise policy rates to curb capital reversals and contain downward
pressure on exchange rates (e.g., Turkey, Brazil, South Africa and India). Subsequently,
greater clarity on tapering from the Fed coupled with domestic policy action helped EMEs
gradually stabilise their markets. Since January 2014, market conditions in EMEs have
improved and most of the EME currencies have appreciated albeit with some exceptions.
This may suggest that since the actual tapering phase, pull factors were more dominant as
evident from increasing investors' discrimination across countries (Chart 3).
Impact on India
Let me briefly give you a background of our domestic macroeconomic conditions before
discussing the impact of the recent tapering announcement. Until the emergence of the
global crisis in 2008, India had witnessed a phase of high growth along with low and stable
inflation. Growth was largely supported by domestic demand emanating from growing
domestic investment financed mostly by domestic savings and sustained consumption
demand. Better macroeconomic performance was also attributed to sequential financial
sector reforms, move towards a rule-based fiscal policy and forward-looking monetary
policy.7
During the initial phase of the crisis, Indian financial markets remained relatively insulated
from global developments due to negligible exposure to illiquid securitised assets. The
impact on broader financial markets, however, was severe after the collapse of Lehman
Brothers in September 2008. Consequently, India could not remain unscathed for long and
was eventually impacted significantly through all the channels - financial, real and more
importantly, the confidence channel.
Taking cognizance of deteriorating economic and financial conditions, the Reserve Bank, like
most other central banks, took a number of conventional and unconventional policy
measures to contain the adverse spillover of global developments. These included
augmenting domestic and foreign exchange liquidity and a sharp reduction in the policy rate.
The Government also supported the economy by fiscal stimulus packages, reversing the
earlier efforts at fiscal consolidation.
Supported by substantial monetary and fiscal stimulus, the domestic economy recovered
quickly. In the process though, inflation also picked up, partly aggravated by spurt in global
commodity prices, particularly oil (Table 1). Consequently, the Reserve Bank shifted policy
focus to exit from accommodative monetary policy in a calibrated manner. Fiscal policy was
also tightened. At the same time the economy was confronted with a number of supply
constraints. In this process growth slowed, inflation still remained at levels not conducive to
sustained high growth and current account deficit expanded which made the Indian rupee
more vulnerable to external shocks.
In the financial year 2012-13, growth had slowed to its lowest level since 2003-04 at 4.5 per
cent, current account deficit (CAD) had expanded to its highest level at 4.7 per cent of GDP,
gross fiscal deficit of the central government was 4.9 per cent of GDP and consumer price
inflation remained in double digits. Hence, macroeconomic conditions were weak. Into the
financial year 2013-14, volatility in the financial markets returned following the
announcement in May 2013 of the Fed's intention of likely tapering of QE. The impact of
announcement of tapering was evident in the form of tightening of liquidity and higher
volatility in all market segments along with sharp decline in stock prices. Portfolio capital
inflows which were buoyant till the third week of May 2013 began retreating as US yield rates
hardened and yield spread narrowed significantly (Chart 4).
At the time when the tapering was announced, domestic concerns pertaining to high CAD,
low growth, high fiscal deficit, high inflation and policy uncertainty were already major
concerns for foreign investors. This apparently amplified the impact of tapering
announcement on foreign flows to India which in turn caused downward pressure on the
Indian rupee. The rupee which was hovering around Rs.55 per US dollar in March 2013
depreciated by about 20 per cent and touched a low of ' 68.4 per US dollar as on August 28,
2013. However, with proactive measures by the Government and the Reserve Bank, the
rupee recovered significantly by November 2013 and turned less volatile (Chart 5). Let me
now turn to the specifics of our policy response.
Policy response during taper talk phase
Taking into account the spillovers of global developments on Indian markets, the Reserve
Bank the Government announced various policy measures since June 2013. The policies
can be broadly categorized into: (i) currency intervention, (ii) monetary policy, (iii) trade policy
and (iv) capital flow management measures. A chronology of policy measures is given in
Annex II.
Currency intervention and monetary policy
In order to stabilize the domestic currency market, the Reserve Bank intervened in the forex
market by selling dollars during June to September 2013 (Chart 6).
As the downward pressure on rupee continued despite the initial rounds of intervention in
forex market, monetary tightening measures were undertaken to stem speculation by making
it expensive to build up long positions in dollars. Accordingly, the upper bound of the policy
rate corridor (i.e., MSF rate) was raised by 200 basis points and the quantity of central bank
liquidity available through the RBI's overnight liquidity adjustment facility (LAF) window was
restrained. In addition, the level of daily average maintenance of required cash reserve ratio
(CRR) was raised. These had the desired effect of tightening the monetary conditions and
raising the effective policy rate sharply to the MSF rate (Chart 7).
In order to signal the transitory nature of these measures and avoid hardening of interest
rates at the longer end, a form of operation twist was tried by conducting outright OMO
purchase of government securities alongside sale of short-term government cash
management bills. This inverted the yield curve, though accompanied by some increase in
long-term rates.
Simultaneously, steps were taken to augment foreign exchange reserves. In this regard,
banks were incentivized to mobilize fresh non-resident foreign currency [FCNR(B)] deposits
and swap those directly with the Reserve Bank. The overseas borrowing limit of banks was
also increased from 50 to 100 per cent of their unimpaired Tier I capital with the option of
swap with the Reserve Bank. Under this scheme, the banks mobilized US$ 34.3 billion and
swapped with the Reserve Bank. This helped in bolstering foreign exchange reserves
despite some outflow on account of directly meeting the foreign exchange requirement of oil
imports.
Trade policy
The single largest component of imports is oil which accounts for nearly one-third of total
imports. The Reserve Bank opened a forex swap window to meet the entire daily dollar
requirements of three public sector oil marketing companies (IOC, HPCL and BPCL). Under
the swap facility, the Reserve Bank undertook to sell/buy USD-INR forex swaps for fixed
tenor with the oil marketing companies.
Recognising that high gold imports were a key source of stress in India's external sector,
customs duty on gold imports was raised and importers were required to set aside at least
20 per cent of their gold import for exports. These measures helped in moderating gold
imports from 1,014 tonnes in 2012-13 to 666 tonnes in 2013-14. As international gold prices
also moderated significantly, the decline in imports from US $ 54 billion in 2012-13 to
US$ 29 billion in 2013-14 was substantial which helped to bring down CAD within a
sustainable range.
Capital flow management
The limit on foreign investment in government dated securities was enhanced to
US$ 30 billion. Public sector financial institutions were allowed to raise quasi-sovereign
bonds to finance long term infrastructure requirements. PSU oil companies were allowed to
raise additional funds through ECBs and trade finance.
FDI norms were modified for a number of sectors. For instance, FDI limit was raised from
74 per cent to 100 per cent in telecom sector and asset reconstruction companies. The
extant FDI limits in sectors such as petroleum and natural gas, courier services, commodity
exchanges, infrastructure companies in the securities market and power exchanges were
placed under automatic route.
Besides these, the Reserve Bank restricted banks to trade only on behalf of their clients in
currency futures/options markets, tightened of exposure norms, and raised margins on
currency derivatives to check speculative activities; reduced the limit for overseas direct
investment (ODI) under automatic route; and lowered the limit on remittances by resident
individuals under the Liberalised Remittance Scheme (LRS).
Unwinding of temporary measures
As portfolio capital outflows waned and the balance of payments (BoP) situation improved
significantly, stability returned to the foreign exchange market in the second half of 2013-14.
This prompted the Reserve Bank to withdraw many exceptional measures. Swap scheme for
fresh FCNR(B) deposits and overseas borrowings of banks were closed, the forex swap
facility for public sector oil companies was phased out, the interest rate ceiling on foreign
currency deposits were reverted to its earlier level, and the limit for overseas direct
investment under automatic route was restored.
Monetary policy was also normalised by restoring the policy interest rate corridor to its
original position and the repo rate to its signalling role of policy. Though the policy repo rate
was increased by 25 basis points each in September 2013, October 2013 and January 2014,
this was more on considerations of growth and inflation outlook.
Actual tapering
When the Fed started actual tapering in January 2014 by gradually reducing its volume of
asset purchases,8 the impact on most EMEs, including India, was relatively muted. There
could be two broad explanations. First, after the initial shock global financial markets may
have better internalised taper and inferred that despite QE withdrawal monetary conditions
still remain and are likely to remain accommodative in the advanced countries. This is
reflected in easing of US bond yields since the actual tapering in January 2014 (Chart 8).
Further, the European Central Bank's indication to keep interest rate lower to spur economic
activity has also added to market comfort. Consequently, the downtrend in yield rates in US
bond market have led investors again to embrace EME equity and bond markets in search of
higher yields.
Second, various policy measures helped improve domestic fundamentals. For instance, with
sharp reduction in CAD, external financing requirement has reduced, resulting in accretion to
foreign exchange reserves thus improving various external sector vulnerability indicators
(Table 2). The Reserve Bank's commitment to a monetary framework focused on inflation
coupled with adoption of consumer price inflation as the nominal anchor and the
Government's commitment to fiscal consolidation may also have helped in mitigating
macroeconomic concerns of foreign investors. Further, with a stable central government in
place, political risk has also abated. Nevertheless, headwinds to growth from domestic
constraints continue to pose downside risks, and vulnerabilities in India's external sector,
though mitigated, have not totally disappeared.
Conclusion
Let me conclude. First, the stance of monetary policy in advanced economies has spillover
effects on EMEs. This is now increasingly recognised in academic literature and
acknowledged by international institutions such as the IMF and BIS. One of the key channels
of transmission of vulnerability seems to be through accentuation of cyclicality in global
capital flows. In an upswing while there is an upward pressure on asset prices and exchange
rate, in a downswing the downward pressure on exchange rate could be quite severe. This is
not to deny that relatively open capital accounts have their benefits but one has to be
cognisant of risks which could arise essentially from exogenous events.
Second, while spillover is unavoidable, domestic fundamentals are important to cushion its
adverse impact, particularly for countries with greater external financing requirement as
reflected in their current account deficits. It will, therefore, be desirable to contain the CAD
around its sustainable level. For example, our average CAD of around 4.5 per cent of GDP
during the two year period 2011-13 was far in excess of our estimated sustainable level of
around 2.5 per cent of GDP. Hence, we were more vulnerable to external shocks. Since
then, our CAD has improved to 1.7 per cent of GDP in 2013-14 imparting greater resilience
to our external sector.
Third, in the event of sudden capital outflow as happened towards end-May 2013, domestic
foreign exchange reserves become the first line of defence to contain volatility without
resisting depreciation pressure. It is therefore important to have adequate reserves. It is,
however, difficult to say how much of reserves is adequate. For example, India's foreign
exchange reserves stood at US$ 292 billion in mid-May 2013, even that level was perhaps
considered inadequate by international investors and markets.
Fourth, capital outflows in a way reflect an imbalance in terms of surge in demand for foreign
currency vis-à-vis domestic currency. Hence, the price of domestic currency needs to go up
to provide some defence against capital outflows, though it may have adverse impact on
growth. Accordingly, monetary tightening becomes a standard response.
Fifth, in the event of a shock, external stability takes precedence over domestic objectives. In
such situations, there is no single instrument to address the challenge. Drawing from the
recent Indian experience, I could say that there is a need to use multiple instruments
including drawdown of foreign exchange reserves, monetary tightening, augmentation of
reserves and administrative measures to dampen speculative outflows and encourage
inflows to stabilise market conditions. At the end it is difficult to say what worked and what
did not work and how best to sequence these policies; but surely once the pressure abates it
is important to reverse extraordinary measures to reinforce market confidence.
Thank you.
Annex I:
Unconventional monetary policy during the crisis
Liquidity Provision
Forward
Central Bank
Guidance
Instruments Collaterals Counterparties
ECB Long-term govt. Bonds Banks Yes, Qualitative
Refinancing "open-ended"
Operations guidance
(LTROs)
Securities Markets Sovereign paper Counterparties
Programme eligible for
Outright Monetary Marketable debt Eurosystem
Transactions instruments monetary policy
(OMTs) operations
Bank of England Asset Purchase Long term govt. Non-banks, with Yes Explicit
Program (AAP) bonds and private banks as guidance linked to
assets intermediaries unemployment
and inflation
Funding for ABS, MBS, Banks and
threshold
Lending Scheme covered bonds, Building societies
(FLS) and sovereign and
central bank debt
Bank of Japan Comprehensive Japanese govt. Banks and Yes,
monetary easing bonds (JGBs), financial "Openended" guidance
programmes corporate bonds, institutions (FIs) linked to
CPs, exchange qualitative and
traded funds quantitative
(ETFs), Japanese easing
real estate
investment trusts
(J-REITS)
Quantitative and JGBs of longer Banks/FIs
Qualitative maturity, ETFs,
Monetary Easing J-REITS
(QQME)
US Fed Term Auction ABS, MBS, All depository Yes Move from
Facility (TAF) treasuries, agency institutions "open-ended" to
bonds "time-contingent"
to "state-
Large Scale Asset Treasuries, Including
contingent"
Purchase (LSAP) agency bonds, Nonbanks
threshold based
MBS
guidance
Operation Twist longer term
treasuries
Source: 1. IMF (2013), "Unconventional monetary policies - recent experience and prospects", April 18. 2. Bank
of England (2013), "Monetary policy trade-offs and forward guidance", August.
Annex II:
A chronology of major policy measures during
June to September 2013
June 5: Customs duty on gold imports was raised to 8 per cent from 6 per cent.
June 12: Limit on foreign investment in government dated securities raised by US$ 5 billion to
US$ 30 billion.
July 8: Banks were prohibited from proprietary trading in the currency futures / exchange traded
currency options markets. [Proprietary trading in ETCD market was allowed within banks' net open
position limit and any limit imposed by the exchanges on June 20, 2014.]
July 15: Upper bound of the policy rate corridor (i.e., MSF rate) raised by 200 basis points. Quantity
of central bank liquidity available through the LAF window restricted to 1.0 per cent of net demand
time liabilities (NDTL) of banks. [The interest rate corridor was realigned to normal policy operations
by end-October 2013.]
July 22: Gold importers were required to make available 20 per cent of their gold imports for
exports.
July 23: Liquidity adjustment facility (LAF) by way of repos at each individual bank level was
restricted to 0.5 per cent of its own NDTL. Maintenance of daily cash reserve ratio (CRR) balance
raised to 99 per cent of the requirement from 70 per cent earlier.
[Daily CRR requirement was reduced to 95 per cent w.e.f September 21, 2013.]
August 13: Customs duty on gold imports was further raised to 10 per cent.
August 14: Limit on overseas direct investment under (ODI) through automatic route reduced from
400 per cent to 100 per cent. Limit on remittances by resident individuals under the Liberalised
Remittance Scheme (LRS) reduced from US$200,000 to US$75,000 per financial year. [Limit under
LRS scheme was enhanced to US$ 125,000 without end use restrictions except for prohibited
transactions in June 2014 and ODI limit was restored to 400 per cent in July 2014.]
August 22: FDI limits/routes were relaxed for select sectors.
August 28: Forex swap window with the Reserve Bank to meet the entire daily dollar requirements
of three public sector oil marketing companies. [Since December 2013, oil companies have sourced
their entire dollar demand from market.]
September 4: ECB norms were liberalised making it available for general corporate purposes.
September 6: Banks were offered a window to swap their fresh FCNR (B) dollar funds with the
Reserve Bank. The overseas borrowing limit for banks was also raised from 50 to 100 per cent of
unimpaired Tier I capital with option to swap with RBI. These schemes mobilised US $34.3 billion.
[Swap schemes were closed by end-November 2013.]