Is there a bank-sovereign feedback loop in India?

Between early October 2016 (shortly before demonetization) and today, the Reserve Bank of India (RBI) has cut its policy rate twice (October 4, 2016 and August 2, 2017) to bring the repo rate down by 50 basis points from 6.5% to 6.0%. But the ten year Government of India bond yield is roughly 100 basis points higher than it was in early October 2016. Apparent monetary easing has been accompanied by a substantial tightening of financial conditions. This looks like a reverse of Greenspan’s Conundrum of 2005 in which the concern was that 150 basis points of rise in the US policy rate was accompanied by a falling trend in the long term yield.

Is it possible that the Indian situation could be a mild form of the bank-sovereign feedback loop?

1. A deterioration of the health of the public sector banks (non performing assets) causes fiscal stress because the sovereign has to recapitalize the banks.

2. The enhanced borrowing requirement of government causes a rise in government bond yields.

3. Rising bond yields cause more stress in the public sector banks because they hold a large amount of long term government bonds (unlike the private and foreign banks who tend to hold shorter term bonds). Rising bond yields may also act as a drag on the economy and worsen the non performing assets of the banks. In either case, the deterioration of the health of the public sector banks takes us back to Step 1 and the cycle can begin all over again.

If this analysis is correct, what can be done to break the bank-sovereign feedback loop? Several possibilities come to mind:

• The government could take duration risk out of the banks with a giant interest rate swap that immunizes the banking system from rising government bond yields. This turns a significant fraction of government debt into floating rate debt.

• The RBI could take a leaf out of the Yield Curve Control policy of the Bank of Japan, and set monetary policy to prevent a rise in Indian government bond yields. In essence, the policy rate would no longer be the repo rate but the 10 year government bond yield.

• The government could accomplish a massive pre-emptive recapitalization of the banking system that breaks the loop decisively.

• The government could turn many of the public sector banks into narrow banks (or even shut them down) to eliminate the feedback loop.

The bank-sovereign feedback loop should not be a big problem for a currency issuing sovereign. This does not require any appeal to MMT, but is simply a reflection of the fact that banking sector liabilities are all nominal liabilities, and a currency issuing sovereign should not have any problem in backstopping these liabilities. If we still see evidence of such a loop, it should reflect some degree of mismatch between monetary policy, fiscal policy, and the bank recapitalization framework. And it should not be hard to fix the problem.

Posted at 4:54 pm IST on Mon, 26 Feb 2018         permanent link

Categories: banks, bond markets, sovereign risk

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