The Central Bank of India is making its way on rates. But for how long ?

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Back in February, with India still refusing its inflation challenge, economists at Nomura Holdings Inc. summed up the choices before the monetary authority in three neat boxes. First, they said, there was a 15% chance that the central bank was right to ignore supply-side pressures. But their base case, which they assigned a 50% probability, was that the Reserve Bank of India was wrong and would have to pivot to contain price increases. They considered a third possibility to which they gave a fairly significant 35% chance: that the RBI, despite being wrong about inflation, would simply continue to tolerate it.

“This is a scenario of fiscal dominance, in which policy rates rise much less than expected in 2022, but macroeconomic risks – inflationary and external – could be much higher than our current benchmark,” the analysts wrote. by Nomura, Sonal Varma and Aurodeep Nandi. in a note dated February 25. “We see a potential stagflationary outcome in this scenario.”

Fiscal dominance occurs when government finances—for example, the cost at which it borrows—take priority and force the monetary authority’s hand over interest rates, undermining its inflation-fighting power. . This is not the case in India at the moment. In early May, as the fiction of temporary inflation became untenable, India’s central bank surprised the market with an unexpected 40 basis point hike in the benchmark interest rate. He followed on Wednesday by raising the policy rate another 50 basis points, although this time the tightening was widely expected. For now, it does not appear that the fiscal authority wants to dissuade the central bank from doing its job.

At 7.8%, the pace of annual price increases is at its highest level in eight years and continues to climb. In other words, India is only at the beginning of the fight against inflation, and the Ministry of Finance could still lose its temper if, in the process of controlling price pressures, the RBI is pushing bond yields too high, complicating the government’s plan to raise funds by selling a record 14.31 trillion rupees ($184 billion) of notes this year.

So far, Prime Minister Narendra Modi’s administration appears unshaken. If anything, New Delhi has announced a $26 billion package, which includes fuel tax cuts, to help the RBI contain inflation. This package is unlikely to replace other rate increases; it could even expand the public borrowing plan. Add to that Wednesday’s price hike of monsoon-sown crops – including rice – which the government will pay farmers to procure their crops for public distribution. It will also be necessary to find money for that.

RBI Governor Shaktikanta Das is to assure New Delhi that its borrowing program would be completed without pushing the 10-year yield much higher than the current level of around 7.5%, a three-year high. The question is, can Das really hold the line on long-term bond yields? And will the government change its reckless air if it can’t. Luckily for Das, so far there has been none of the bluster of 2015 when, according to a recent Al Jazeera expose by The Reporters’ Collective, the top finance ministry official called internally for an investigation into Governor Raghuram Rajan’s decision to maintain interest rates. high, by which it would have aided the “white man” – shorthand for investors in rich countries – at the expense of domestic investment and growth.

After Rajan’s decision in 2016 to return to the University of Chicago, friction spilled over to his successor. Governor Urjit Patel came under pressure on everything from interest rates – which were now decided by a monetary policy committee – to his handling of soaring corporate bad debts and, finally, whether the RBI had more capital than it needed. Patel’s deputy was mocked for warning the government of the consequences of raiding the RBI’s coffers. Following Patel’s abrupt resignation in December 2018, his job was handed to Das, a former Finance Ministry mandarin who carried out Modi’s draconian currency ban in late 2016. A new period of peaceful coexistence between tax authorities and currency began and accelerated during the pandemic when such cooperation became the norm globally.

But now the pandemic is over and new sources of friction are emerging. On rate hikes, the central bank and finance ministry may be singing the same hymn book, but the RBI capital issue is starting to simmer, thanks to the lowest dividend the ministry has received from the RBI for a decade: just under $4 billion, or a third of last year’s payout.

Crucially, even this reduced dividend was made possible by the central bank’s simultaneous sale of $97 billion of its foreign currency reserves in the spot market and purchase of $114 billion. Ignore purchases. Each dollar sold is valued at its historical weighted average acquisition cost. Since this figure is lower than the current exchange rate, selling dollars for around 78 rupees today means a profit, which is then shared with New Delhi. Without this “active conversion of revaluation gains into realized profits, the RBI would have required a net injection of capital from the government”, according to Observatory Group analyst Ananth Narayan.

A reduction in the balance sheet also helped limit the RBI’s capital requirements and prevented its dividend from falling to zero, Narayan said. This tussle – whether RBI gives money to the government or uses it to raise funds – could stay under control again if the central bank’s assets don’t swell this year either. This could well be the case since there are hardly any inflows of dollars in India at present, only outflows. Yet the economic capital of the RBI, which by Narayan’s calculation has already fallen below the 20.8% minimum in assets set by a 2019 committee, is a blind constraint. This would never have happened if the Ministry of Finance had not in the past coveted the capital of the RBI. Having to depend on politicians for money is not a good outcome for an institution that must project its autonomy to make its war against inflation credible.

India’s fragile public finances mean that the risk of fiscal dominance of monetary policy still lurks in the background. Right now, that’s not a big threat because inflation gives an unexpected boost to tax revenue. But as Nomura’s Nandi puts it, monetary tightening is “far from the finish line.” Just two months after taking office, Das slashed rates in a surprise stimulus ahead of Modi’s re-election in May 2019. That was then. Now that the cycle has turned, it will be interesting to see if the RBI chief can keep his political masters in good spirits. Or if his relationship with the government – like that of his two predecessors – will also begin to unravel.

More from this writer at Bloomberg Opinion:

• India’s sticky inflation savvy magic prices: Andy Mukherjee

• RBI must do more to regain credibility: Andy Mukherjee

• Inflation’s ‘fun’ period was far too short: Jared Dillian

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Andy Mukherjee is a Bloomberg Opinion columnist covering industrial companies and financial services in Asia. Previously, he worked for Reuters, the Straits Times and Bloomberg News.

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Shawanda H. Saldana