Handling the doller deluge

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 Handling the doller deluge

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• Expanding RBI balance sheet: From the 22% of GDP level in Feb 2020, the RBI's balance sheet had grown to 27% of GDP by July (last seen in 2006-08). This is happening out of compulsion, due to the "impossible trinity". 
• What is that: India's BoP surplus has expanded, forcing RBI to buy dollars to stop the rupee appreciating. This problem will continue. Meanwhile, the advanced countries' central banks have grown but due to funding the govt. borrowings.
• BoP surplus: India's 2019-20 BoP surplus was $59 billion (2% GDP). Trade deficit shrank to $159 b due to lower imports (weakness in economy and low oil prices), and capital inflows kept coming heavily. FY21 trade deficit may be no more than $80 billion. A rare moment of joy, as current account surplus happens! (IT exports robust, though remittances falling)
• Two ways to see BoP surge: It can grow due to huge capital inflows, or it can grow due to drop in trade deficit. Today, drop in gold imports and low oil is driving it. Add to that weak demand for non-oil/gold goods.
• Worldwide phenomenon: Wherever in the world the pandemic is surging and govt. is not giving demand stimulus, the trade deficit has dropped or surplus has risen. Why? Exports do better as China has recovered (so demand) or is rebounding (US, UK) due to fiscal stimulus. 
• Why is India worried: A BoP surplus would be a great thing, but its size is problematic now. Why? Normally, the RBI pushes money into the system very slowly, but this surplus is forcing it to push it much faster. In past few years, money supply growth lagged the nominal GDP growth, and actually contributed to the slowdown (prior to COVID). Today, "excess money supply growth" is very high (difference between growth in money supply and nominal GDP growth).
• Impact: As demand is weak, inflation may not rise, but financial assets may become costlier. That may be helpful in reducing cost of funds but only if companies issue shares and raise funds. Only a few financial firms are doing so today. In bonds, higher prices would mean lower interest rates for borrowers, but that's not so for most firms. Gap between bond yields and RBI's repo rate is very high, as is the case with average bank lending rate.
• How to adjust this huge surplus BoP: The govt. should issue a new stimulus, so demand will grow, so imports will rise, and BoP will reduce. Otherwise, excess capital will keep inflating asset prices and one day burst.
• Dangerous times: Two things are happening in parallel - imports substitution is gaining pace, so imports won't rise. And FDI inflows will be steady, and even capital a/c is being opened up and ECBs rising. A whole new thinking is needed.

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