There are several aspects of the Infrastructure Leasing & Financial Services Ltd (IL&FS) story, which has been in the news for a while now. One of these is the role of short-term funding, which has not received much attention.
Why do borrowers such as IL&FS rely so much on short-term funding even though their investments are primarily long term?
The usual answer is that the short-term interest rate is less than the long-term interest rate, and so it is profitable to borrow as much on a short-term basis as possible.
There is merit in this answer except that it takes for granted the fact that there is usually not much of a roll-over risk. But we need to look at this more closely.
Now it turns out that the Reserve Bank of India (RBI) uses short-term interest rate as its key policy tool. This means that the RBI typically sets the short-term interest rate for two months. It may change the interest rate, if required, at its next bi-monthly meeting but until then, it is almost certainly fixed. Even if the interest rate does get changed in the subsequent meeting, there is not much of a surprise – at least not a big surprise. This is because the RBI provides forward guidance on possible changes in the short-term interest rate in the near future.
This has an interesting implication.
For short-term borrowers, there is little risk in so far as the interest cost in the roll-over of funding is concerned. This encourages them to borrow short-term at low interest rate rather than borrow long-term at a high interest rate; the proportion of funds borrowed short-term then gets higher than what it would have been otherwise.
What is the way out?
A part of the new research by this author on the wider issue of macro-financial stability provides a new answer. The RBI can use base money instead of the short-term interest rate as a key policy tool in conducting its monetary policy.
It is true that there is no close connect between base money and inflation (or other macroeconomic targets). However, this is also true of the short-term interest rate as a key policy tool. So, base money does not fare any worse than the short-term interest rate as a policy tool in this regard. On the other hand, there is the benefit of using base money as a key policy tool. If the RBI uses base money as a policy tool, it need not fix the short-term interest rate. Indeed, this can be determined by market forces.
It is true that such a market-determined price is very likely to fluctuate – possibly considerably (more so because the price is determined in a wholesale market wherein fluctuations in price are the rule, rather than the exception). But that is indeed the whole idea. If the short-term interest rate fluctuates, this increases the risk in roll-over of short-term funding.
This discourages borrowers like the non-bank financial companies (NBFCs) in general and firms like IL&FS in particular to avoid excessive short-term funding.
The operational part of the suggested policy can be as follows. The monetary policy committee (MPC) of the RBI can take a decision on changes in base money rather than on possible changes in short-term interest rates.
If inflation is more than the target inflation, the MPC can reduce the growth rate of base money. Conversely, if inflation is low, the MPC can somewhat raise the rate of growth of base money. As we know, the RBI has adopted flexible inflation targeting. This means that the RBI may, as far as possible, take care of objectives other than inflation. Accordingly, if there is a slowdown in the real economy, then it may raise the rate of growth of base money. And if there is a boom, it may somewhat decrease the rate of growth of base money.
What is important for the real sector of an economy is the stability of funding rather than the stability of short-term interest rates.
It is, as research by Gary B. Gorton and Andrew Metrick (and others) has shown, the instability of such short-term funding that aggravated the global financial crisis in 2007; it was not the behaviour of short-term interest rates that were at the centre-stage then.
There is a lesson from that experience, which is that the policymakers need to let the short-term interest be determined by the market so that excessive short-term funding is avoided.
Consider an analogy. In the past, many countries used to operate with fixed exchange rates and that was considered a good idea but the actual experience was very different. Fixed exchange rate had, as Maurice Obstfeld (then at the University of California, Berkeley) and Kenneth Rogoff (then at Princeton University) argued, turned out to be a mirage.
Indeed, an important reason behind the East Asian Financial Crisis in 1997-98 was that the countries involved had fixed exchange rates. Subsequently, they shifted to flexible exchange rates.
Yes, these exchange rates fluctuate but that is a small price to pay for avoiding a possibly huge financial crisis. We have a similar story with regard to short-term interest rates. It is better to let these fluctuate according to market conditions; such fluctuations can reduce excessive short-term funding, which can be a source of instability for the real sector (projects may get delayed, if not abandoned altogether).
The acclaimed author, Nassim Nicholas Taleb, in his well-known book Anti-fragile, has argued forcefully that some fluctuations, here and there, now and then, can, in fact, contribute to making the whole system anti-fragile. Letting the short-term interest rates fluctuate can be useful in this context.
Note that large fluctuations in the short-term interest rate need not imply any significant volatility in long-term interest rates. The reason is simple. The latter is linked to not only the prevailing short-term interest rate but also the expected future short-term interest rates. While the actual short-term interest rates can indeed fluctuate, there is hardly any reason for expectations of future short-term interest rates to become volatile; this is particularly true if the RBI is committed to providing a stable framework for monetary policy now and in the future.
If base money is so much better than the short-term interest rate as a key policy tool, then why are central banks (including the RBI) not using this? Bennett T. McCallum made an interesting statement in the Handbook of Macroeconomics (volume 1, p. 1514). It is worth quoting him:
“One hypothesis is that interest rate instruments and interest rate smoothing are practised because financial communities dislike interest rate variability and many central banks cater to the wishes of the financial institutions with which they have to work in the course of their central-banking duties.”
The above statement was made even when the issue of short-term funding for shadow banks in India (or the US) was not in the picture.
With the experience of the global financial crisis in 2007 and the relatively small example of unstable funding for NBFCs (like the IL&FS) in India, the case against the central bank’s use of short-term interest rate as a key policy tool has become even stronger.
Gurbachan Singh is Visiting Faculty, Indian Statistical Institute (Delhi Centre) and Ashoka University.