The Covid-19 pandemic, labelled a black swan event by many, has challenged central banks across emerging economies like never before. They face the policy trilemma of monetary independence, exchange rate stability, and financial openness.

But for the Reserve Bank of India (RBI), there’s one more factor to be taken care of: financial stability. This means that India’s central bank is dealing with a ‘quadrilemma’. State Bank of India’s (SBI) group chief economic adviser Soumya Kanti Ghosh believes that after the 2018 IL&FS crisis, financial stability has taken centre stage.

In a recent economic report, Ghosh says that an unintended consequence of financial integration is the growing exposure of developing countries to financial market turbulences associated with sudden stop of capital.

India witnessed this during the taper tantrum in 2013, when the U.S. Federal Reserve was reported to be stopping its quantitative easing (QE) programme which started in the aftermath of the global financial crisis. While the NBFC crisis—propelled by the IL&FS fiasco triggered turbulence in 2018—this year’s disruption is thanks to the Covid-19 pandemic.

While gloom prevails across global economies, Ghosh, in his report, highlights that the recent policy statements of the RBI have repeatedly emphasised the importance of financial stability in monetary policymaking.

Pursuing financial openness while maintaining financial stability of emerging markets typically leads to a jump in reserves, he says. “India’s international reserves/GDP ratio has thus increased substantially in the current fiscal year from 17.7% of GDP to at least 19.6% on an FY20 base,” Ghosh writes. In absolute terms, the jump is a whopping $63.8 billion.

While estimating the extent of the policy trilemma, using economic modelling, Ghosh underlines that monetary independence was at a significantly low level in Q4 of FY20 (it was at an all-time low since 1997), implying significant loss of monetary autonomy when India went into a strict lockdown mode. But it significantly improved in Q1 of FY21 with exchange rate stability returning to the markets.

The SBI report points out that the historical trend suggests that any extended loss in monetary autonomy is correlated with inflation volatility in India: CPI inflation ranged between 3.0% and 7.6% during FY20. “However, what is striking in the current pandemic is that the RBI stands out by achieving comparable levels of exchange rate stability amidst growing financial openness while increasing its monetary independence and even financial stability, reminiscent of Asian economies,” Ghosh notes.

Ghosh goes on to add that the RBI has been relatively successful in ensuring financial stability returning to the market since May. This indicates the policy quadrilemma is working well in the Indian context with the RBI building up reserves through direct purchase and swap transactions.

Historically, in FY08, when India’s foreign exchange reserves jumped by $110 billion, the rupee had appreciated nearly 10%, but in FY09, when foreign exchange reserves declined by $58 billion, the rupee had depreciated by around 27%.

The increasing exchange rate stability, with the RBI intervening significantly in foreign exchange markets to build up dollar reserves, is fuelling apprehension that appreciation in the exchange rate could hurt India’s exports. But Ghosh has contradicting views as his research finds clear evidence that the RBI tends to prevent more strongly an exchange rate appreciation than an exchange rate depreciation.

Ghosh also adds that inflation is unlikely to be a huge concern given that people are preferring to hold cash, with uncertainty over the pandemic looming large. “Hence the current RBI policy of liquidity overhang is working well.”

In order to keep bond yields in check, Ghosh is of the view that the RBI may need to further resort to unconventional policies as it has been successfully doing. An avalanche of state development loans (SDLs) is going to hit the market in Q4 of FY21, as state governments have completed less than 30% of overall borrowing till date.

“One option of managing yields in a non-disruptive manner by the RBI is to take the demand of SDL borrowings out of the market,” Ghosh says. As an analogy, he says that the RBI had instituted a separate window for oil marketing companies (OMCs) to borrow dollars during the global financial crisis and later. “In a similar vein, the RBI can think of investing in SDLs without the same hitting the market.”

Ghosh is of the view that through this mechanism, the RBI may cajole certain market players to buy securities at a specific rate in bidding that could be then subsequently bought by the RBI. “This will fulfil the desired objective of the RBI avoiding devolvement at auctions and nullifying market expectations of a higher yield with supply of papers far outstripping demand.”

Finally, Ghosh says that ideally, the market could be looking at an interest rate range of 5.90%-6.20% for 10-year government securities (G-secs), that will curtail interest payment outflows for the government on huge borrowings, and also keep banks’ mark-to-market and benchmark lending rates in check.

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