RBI’s Studied Silence Over External Vulnerabilities

Critics are questioning the wisdom of the RBI after a 25 basis point reduction in benchmark interest rates fell short of capital market expectations

The Reserve Bank of India’s (RBI) 25 basis point reduction in benchmark interest rates fell short of capital market expectations. They were expecting a deeper cut but the Monetary Policy Committee (MPC) played safe, given uncertainty surrounding the future inflationary path. Critics are questioning the wisdom of the central bank and its MPC.

MPC members surely deserve to be cut some slack. But, in the general din over low food inflation, insufficient interest rate cuts and RBI’s unchanged neutral policy stance, the central bank’s policy statement omitted mention of a small crimp: a tsunami of portfolio flows, another possible source of inflationary pressures. The central bank’s studied silence about external vulnerabilities raises many questions.

This rush of foreign currency has forced RBI to take steps which have disappointed overseas debt markets and investors: for instance, rules have been tightened for issuing masala bonds through introduction of maturity floors and interest rate caps. This comes when masala bonds were gaining popularity with both issuers and investors. In another (though seemingly unrelated) circular, the RBI has sought to elongate the maturity profile of investments by foreign portfolio investors (FPI) in government bonds. Capital markets regulator, Securities and Exchange Board of India (Sebi), followed through with another circular, ordering a temporary stop to future masala bond issuances.

The RBI has probably sensed higher risk—in terms of both rates and exposures—in the opening of masala bond floodgates, especially after offshore arms of certain Indian companies raised foreign currency loans in overseas markets and then on-lent the proceeds to domestic entities as rupee bonds. This structure defeats the entire purpose of shielding Indian borrowers from exchange rate volatility since it provides original lenders with an indirect claim on domestic assets.

Sebi’s rationale is that FPI investments in corporate bonds have reached close to the limit of Rs244,323 crore. This ceiling includes all rupee-denominated bonds, offshore or on-shore. The regulator’s circular also states that masala bond investments can resume only after limit utilization falls below 92%.

RBI’s rear-guard action also probably stems from the combined effect of two other reports—its own report on India’s external debt and the annual External Sector Report from the International Monetary Fund (IMF). Both sound circumspect about India’s rising short-term foreign debt levels. The IMF reports states: “Given that portfolio debt flows have been volatile and the exchange rate has been sensitive to these flows and changes in global risk aversion, attracting more stable sources of financing is needed to reduce vulnerabilities… Further initiatives on creating a more conducive business environment, particularly the implementation of long-standing labour market and power sector reforms, are necessary to attract greater FDI flows.”

FPI investments in equity and debt markets saw combined net inflows of Rs171,581 crore till July end. This is six times more than the Rs27,055 crore invested by FPIs during the same period of 2016. This surge had rupee appreciating by almost 5.8% between 2 January and 31 July.

Such large inflows put RBI’s absorption skills to the test. First, it has to intervene in the foreign exchange market to absorb foreign currency inflows so that portfolio investments do not push up the rupee-dollar rate beyond its sustainable and economic value. The resultant overhang of rupee liquidity then requires a second defensive action: the RBI has to mop up liquidity through a variety of instruments. For example, in the 11 working days between 17 July and 29 July, RBI absorbed Rs405,228 crore. Sterilization has its costs, especially when central banks sell high-yield domestic instruments while buying relatively low-yielding foreign currency assets. There are also fiscal implications.

The central bank’s woes do not end here: it needs to calibrate another two-step dance. The RBI’s remonetization exercise is still far from complete but it is unable to accomplish that at full tilt, given the wash of domestic liquidity. At the same time, it has to ensure that there is enough liquidity to make up for lost productivity during demonetization. Both will require precision and fine-tuning. Plus, it needs to ensure there’s just enough liquidity to keep yields soft.

There’s another dilemma. The FPI investment limit in corporate bonds was fixed when the exchange rate was below Rs50 to a dollar and common sense dictates a re-calculation of the limit. But the central bank is not doing that just yet, given that its hands are full trying to staunch current inflows.

Times like these are ripe for conspiracy theories. There are misgivings that RBI’s efforts could be an indirect attempt to ensure borrowers do not export the domestic bank credit market to offshore centres. While bank credit growth remains anaemic, Bloomberg data shows Indian companies raised $8.9 billion through overseas bond sales till July, 63% higher than the previous year. It is believed many companies took advantage of tightening spreads and used foreign currency bond sales to refinance domestic bank exposures, thereby intensifying balance of payments risks.

The MPC statement omits mention of external sector developments. Hopefully, the RBI will separately provide a more comprehensive communication that details the risks and the mitigation measures.

The article originally appeared in Mint newspaper on August 9, 2017, and can also be read here

Heady Days For Finance

The Economic Times today carried an Op-ed piece written by me. Here it is.

Heady Days For Finance

Exciting proposals to overhaul the financial services sector are on the table — implement them

The financial services sector could be in for exciting times, if proposals now on the table are anything to go by. Many changes are being proposed and if these get implemented, the sector is in for massive churn. Spoiler alert: some legal hurdles could still play spoilsport.

First out of the gates is likely the issue of new bank licences. A range of new players is likely to get a shot at opening new banks. Banking is still considered a coveted business segment in India despite many risks and overwhelming regulation. This is because of two reasons. One, a growing economy will need credit to expand and build new infrastructure. In India only banks can offer savings bank deposits, which work out cheaper than other sources of finance. 

The real fun and games can be expected to kick off when the changes suggested by the Finance Sector Legislative Reforms Commission, a body set up by the finance ministry to look into the raft of laws and structures in financial services and suggest ways to recast them, are implemented. Going by the approach paper released by the commission recently, some of the changes have the potential to be a game-changer.

Under the proposed structure, the financial sector will have seven main pillars. Two proposals stand out. One is to convert the Reserve Bank of India into a pure-play monetary authority (with debt management of government bonds housed in a separate, independent office), one that will enforce consumer protection and micro-prudential laws in banking and payment systems. The second is to create a unified financial regulatory agency by collapsing different financial sector regulators into it: Sebi, Irda, PFRDA and the Forward Markets Commission.

The proposed structure is likely to create a completely new architecture for financial services regulation. The new design will be achieved primarily through re-visiting the sector’s existing legal framework, which is at odds with the changed financial landscape. As the approach paper mentions, the sector is governed by 60 Acts and multiple rules and regulations. According to the paper: “The superstructure of the financial sector governance regime has been modified in a piecemeal fashion from time to time, without substantial changes to the underlying foundations... The piecemeal amendments have generated unintended outcomes including regulatory gaps, overlaps, inconsistencies and regulatory arbitrage.” 

In all the changes being contemplated, there are two legislation-related challenges. 

• The commission is duty-bound to re-examine legislation governing central banking. The RBI Act was enacted in 1934 and is still a ‘temporary’ piece of legislation. But the real issue seems to be designing the right framework that enhances RBI’s independence as a monetary authority, insulated from the executive’s short-term outlook and pressures.

The commission does promise to “…draft a monetary policy law emphasising the issues of independence, enumerated objectives, enumerated powers, and accountability mechanisms.” The RBI Act has to be overhauled since it seems to have been designed to give control to the government, like the power to appoint the governor and his deputies, power to vary their tenure, power to issue directions (after ‘consultation’ with the governor), and so on. The challenge, of course, is marrying independence with accountability. The approach paper says that one of the strategies used globally is inflation targeting. However, RBI has rejected this time and again primarily because most of the factors influencing inflation in India are outside the central bank’s controls.

RBI’s website says: “The formulation, framework and institutional architecture of monetary policy in India have evolved around these objectives – maintaining price stability, ensuring adequate flow of credit to sustain the growth momentum, and securing financial stability.” Enumerating these can be tricky; as goalposts, they need to be moved around every time the landscape alters. 

• The commission has to remember that states also have varying degrees of interest in financial services. These could have a disruptive influence on the normal functioning of financial services. The Andhra government’s intervention in microfinance is a recent example.

The confusion arises because of the legal framework. The Constitution empowers states to legislate on moneylending and moneylenders. As a consequence, there are 22 Acts on money-lending enacted by different states (some states like Andhra and Orissa, have two Acts). However, provisions of these acts, which deal mainly with registering, licensing and regulating moneylenders, are mostly ignored, especially when the moneylenders are politically connected. The conflict heightens when the formal banking system encroaches. A technical working group was set up by RBI in 2006 to study the legislative framework for moneylenders. This group mentioned the need to modify existing legislation, but shied away from suggesting an overhaul of the framework. The commission now has the chance to do so, even if that requires Constitutional amendments. 

War Of The Lords

What an unholy row! The unseemly spectacle of India's two financial sector regulators locking horns in public, and sparring with flailing fists, can only spell disaster for the country’s financial sector and its "orderly" development.

These two regulators should also realize that, with this spat, they have played into the hands of the government. It is well known that North Block in New Delhi, which houses the Finance Ministry, is keen to play mid-wife to the birth of a new super-regulator for the financial sector.

Pranab-babu’s Budget speech in February had promised a new super-regulator for the financial sector but was conspicuously silent on the details. Since then speculation has mounted about this new creature and its genetic make-up. The latest spat between securities markets watchdog Sebi and the insurance regulator, Insurance Regulatory and Development Authority, has now fuelled rumours that the ministry might use this seemingly intractable row to insert itself and lay the foundations for a government controlled super-regulator. SEBI and IRDA will then have to report to this new organization.

It is strange that such a disagreement was not sorted out in the High Level Coordination Committee on Financial Markets, an informal body created to specifically sort out similar issues of turf between different regulators. In fact, the coordinated action by Reserve Bank of India and Sebi recently against Bank of Rajasthan proves that this apex level committee can stymie designs of those who want to profit from regulatory arbitrage. However, there could be one possible weakness: this organization lacks legislative teeth. Various committees have recommended that the HLCC should either be given legislative powers or a super-regulator be set up.

This has become necessary since institutional activities and products increasingly straddle multiple markets today. Also, as the recent crisis has shown, achieving overall financial stability – which means ensuring that risks in each and every part of the inter-connected financial system are within manageable limits – has now been accorded greater importance than ensuring the stability of the banking system alone. And, it is believed that a super-regulator with a 30,000-feet-helicopter-view alone can perform this job. But, the important question that arises is: is the government the right agency to undertake this responsibility? And, if all the regulators in the financial system are to report to this omniscient regulator, what are the consequences?

Conclusion: there should be a widespread debate before finalizing the DNA structure of the yet-to-be-born institution.