How long can the RBI Governor Dr. Raghuram Rajan maintain an anti inflationary monetary policy? The condition of the Government of India and the Banking Sector warrants an economy that has to grow else the condition can only get worse. RBI would have to step in to bail out the government and the banking system before it goes into a downward spiral.
RBI formally adopted an inflation target in its monetary policy review in January 2014. The central bank raised the repo rate by 25bps to 8% given the target for CPI (Consumer Price Inflation) inflation was set at 8% for fiscal 2014-15 and 6% for fiscal 2015-16. CPI inflation was at 9.87% in December 2013 before it fell to 8.79% in January 2014.
The Indian economy is expected to grow at 4.9% in fiscal 2013-14 against a growth rate of 4.5% seen in fiscal 2012-13. Outlook for growth for fiscal 2015-16 is not robust given the government is struggling to service its borrowings and the banking sector is feeling the weight of bad loans.
The government spends 80% of its borrowing on interest payments on its outstanding debt and every year it has to borrow to repay bond holders. Government bonds worth Rs 1567 billion (Rs 1,56,700 crores) is coming up for redemption in fiscal 2014-15. In the fiscal years 2015-16, 2016-17, 2017-18 and 2018-19, government bonds worth Rs 1146 billion, Rs 2312 billion, Rs 2567 billion and Rs 2424 billion are coming up for redemption respectively.
The government will struggle to service its debt if its revenues do not rise, deposits in the banking system does not grow as banks are the largest buyer of government bonds (banks hold 54% of total outstanding government bonds) and capital markets are lacklustre. Primary Dealers underwriting bond issues will have a problem in finding buyers for government bonds if the government is not able to refinance its borrowings.
Higher yields on government bonds will take up borrowing costs for the government leading to more borrowings to service debt. A self fulfilling cycle of rising yields, more borrowings and rising yields.
Banks balance sheets are coming under stress, as loans are turning sour in the face of sluggish economic growth. United Bank of India, a Government owned bank, showed bad loans tripling in the third quarter of 2013-14, leading to gross NPA ratio more than doubling to over 10%.
Analysts estimates of bad loans in the banking system range from Rs 7000 billion to Rs 10,000 billion or around 12% to 18% of total outstanding credit. Banks will be constrained to lend given the stress in asset quality and will also be constrained to grow its balance sheet given weakness in the economy and tight monetary policy environment. Banks lack of lending power would lead to further economic weakness while banks lack of growth in the balance sheet would lead to low off take of government bonds.
It is a Catch-22 situation for the RBI. It cannot afford to let its guard drop against inflation but at the same time if the economy falters it will have a huge problem in managing government borrowing and managing the banking sector NPAs. The RBI would be forced to give thrust to growth to prevent a systemic economic collapse. Hopefully given weak demand in the economy, inflation may not rear its head up thus helping the RBI.