The article highlights the measures taken by the RBI in the recent MPC meeting to assure the buyers of the Government bonds and ensuring the policy rate transmission.

Dealing with the rate transmission issue and why it matters

• The gap between the repo rate and the average lending rate of banks is at a record high.
• So, the RBI and the MPC focused on improving rate transmission.
• This gap can be broken up into two parts:
• The first is the gap between the RBI-set repo rate and the rate at which the government of India borrows (the GSec yield).
• It is also called the “term premium” can be influenced by the RBI’s actions.
• The second is the gap between the GSec yield and the rate at which individuals or private firms borrow.
• This gap reflects risk aversion in the financial system and a lack of capacity.
• The RBI has avoided directly influencing the term premium, perhaps to maintain its credibility and independence, staying clear of accusations that it is financing the government’s fiscal deficit.
• However, unless the rate at which the government borrows comes down borrowing costs for the whole economy will stay elevated.

Challenge of Balance-of-Payment surplus (i.e. excess dollars)

• Over the past few months, the country’s foreign currency reserves have been growing at an unprecedented rapid pace.
• This means that India is getting far more dollars than it needs. Three factors are responsible for this.
• 1) Some short-term factors responsible are weak imports and a faster normalisation of exports.
• 2) There have also been structural shifts in India’s economic policy which point to a persistent BoP surplus.
• In addition to low energy prices, policies supporting Atmanirbhar Bharat mean lower imports and the push towards making India a participant in global value chains mean higher exports.
• 3) At the same time, India’s capital account is being opened up: The special-category government of India bonds, for example.

Why BoP surplus is opportunity

• When the excess dollar inflows turn into a deluge, as they have over the past six months, the supply of rupees in the domestic economy also becomes excessive.
• If the RBI can direct this surplus into government bonds, it can maintain its independence and credibility, and at the same time achieve its target of rate transmission.

Measures by the RBI to assure the bond market

• The buyers of government bonds need to feel reassured of not getting hurt by the volatility in bond prices.
• When bond prices rise, the yields fall, and vice versa.
• Banks parking trillions of rupees with the RBI at 3.35 per cent overnight would earn nearly 6 per cent if they bought government bonds.
• That they did not was because they were afraid of the bond prices falling, which would offset the gains from higher rates.
• The increase in the Hold-To-Maturity limits by the RBI  by one year to March 2022, has assured the banks that they need not fear booking interim losses if bond prices are volatile.
• The announcement that the RBI would purchase state and central government bonds on the market (even if in small sizes) would provide further comfort.
• The change in assessment of inflation should help buyers of government bonds take the risk.
• Banks or other bond investors that refrained from purchasing government bonds because they felt the RBI would increase interest rates at some point to comply with its legal mandate, would be reassured by this clear communication.
• The targeted refinancing operations (TLTRO) should help bring down borrowing rates in the targeted industries.

Conclusion

Economic challenges may persist for the foreseeable future. The economic scars of the last six months are likely to take time to heal. The RBI and the MPC, which have been proactive, creative and accommodative so far, may have to stay so for a while longer.

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