RBI’s Never-Ending Dilemma

Context: Recent attempts by the Reserve Bank of India (RBI) to control interest rates on Government Securities (G-secs) by adopting an aggressive Open Market Operation (OMO) plan may aggravate the existing problems like inflation. 

Recent actions by RBI: When market participants pressed for higher rates, it repeatedly stepped into the bond markets, purchasing several trillion rupees of G- secs

• Most recently, on April 7, it went one step further, announcing a plan to buy Rs 1 trillion worth of government securities in the first quarter of 2021-22.

Risks due to aggressive OMO commitments:

• It  may fail to keep a lid on G-sec rates: Reasons-
  • OMO does not address the reasons for which bond investors are demanding higher interest rates- which includes a large fiscal deficit leading to massive borrowing by the government in the bond market and high and rising inflation.
  • The reluctance of market participants to purchase bonds at current interest rates. 
• Possibilities of collateral damage:
  • In the short run, it could adversely affect interest rates for the private sector; if banks fail to make adequate returns on G-secs due to OMO plans, they will try to compensate it by charging more on credit to the private sector.
  • In the long run, OMO plans may nullify the key benefit of the bond market (i.e.  Imposing fiscal discipline on governments by forcing them to pay higher interest rates when government borrowing increases) and thus may result in large fiscal deficits.
• It may jeopardize the achievement of the inflation target: There will be a dilemma for RBI to choose between OMO and inflation targeting if the inflation remains high; both marred with challenges
  • If it fails to fulfil its commitment and prematurely ends the liquidity injection, it could lose the confidence of the bond market for a long period of time.
  • Lowering the interest rates may lead to a depreciation of the rupee, which may further add fuel to inflation by raising the import bill.
  • If the RBI is too slow to tighten policy and rein in the liquidity it has created, the country could end up facing the kind of inflation crisis that was witnessed in the post-2008 period.