The ECB (European Central Bank) is widely expected to announce bond purchases of Italy and Spain (two and three year maturity bonds) in its policy meeting scheduled for the 6th of September 2012. The ECB president Mario Draghi had indicated in August 2012 that the central bank would do all it can to keep the Euro stable amidst threats of collapse. Markets are positioning for an ECB bond purchase announcement with two year bond yields of Spain and Italy rallying by 280bps and 180bps respectively from highs seen in July 2012. The Euro has rallied by 4% against the US Dollar (USD) while global crude oil prices have gone up by 16% since July 2012 on the back of ECB bond purchase expectations.
The ECB in purchasing bonds of indebted Euro nations of Italy and Spain to stabilize financial markets is doing so with great reluctance. The mandate of the ECB is to maintain an inflation target and its bond purchases are seen as financing the deficits of spendthrift nations. ECB had bought bonds of deeply indebted countries of Greece, Ireland and Portugal over the last two years to stabilize bond yields of these countries but the bond purchases have not gone down well with some ECB members. The ECB’s chief economist Juergen Stark resigned on principal against bond purchase while Germany is opposed to bond purchases as it feels it will encourage nations to maintain high fiscal deficits.
ECB is torn between the markets threatening to destabilize the Euro and its own mandate to maintain an inflation target. In a sense the ECB bond buying decision should be independent of any fiscal issue that a country faces as the ECB decision is independent of European governments. However, the fact that the ECB is restricting itself to bonds of indebted European nations suggest that the central bank is buying bonds to keep borrowing costs for the indebted countries down. The act of buying bonds of debt ridden European nations has taken away the independence of the ECB.
RBI is in a similar dilemma faced by the ECB. The government of India is showing no signs of fiscal consolidation with the fiscal deficit set to surpass budgeted target of 5.1% of GDP for 2012-13. The fiscal deficit is expected to go higher on two counts, one is the slowdown in India’s GDP growth expectations from 7.6% to 6.7% (government revision) and two is the rising oil subsidy bill that is showing no signs of being tackled. India’s first quarter 2012-13 GDP growth came in at 5.5% and for India to meet growth forecast of 6.7%, the country’s economy has to grow by close to 7% for the next three quarters, which at this point of time looks impossible given weak monsoons and global growth slowdown.
Diesel prices have been left untouched for more than a year and the government fuel subsidy bill is expected to surpass the budgeted amount of around Rs 43,000 crores by a wide margin. The first quarter 2012-13 has seen the subsidy bill touch Rs 32,000 crores, which is close to 75% of total budgeted amount. Oil marketing companies are bleeding due to non payment of subsidies and the big three oil marketing companies IOC, HPCL and BPCL have declared losses for the first quarter of 2012-13 with IOC declaring the largest ever loss of around Rs 20,000 crores by an Indian company.
RBI is fighting three main issues at present a) inflation that is running at close to 7% levels against the central bank’s desired rate of around 5% and below b) GDP growth for 2012-13 threatening to fall well below RBI’s revised estimates of 6.5% growth and c) liquidity conditions that have been in deficit of well above RBI’s desired level of 1% of NDTL (Net demand and Time Liabilities).
RBI is addressing the inflation issue by refraining for lowering the policy rate, the repo rate from 8% levels despite the expected fall in GDP growth. RBI by holding on to interest rates is not helping the cause for economic growth, which in turn is placing pressure on the government’s fiscal deficit. On the liquidity front the RBI is adding primary liquidity into the system by buying government bonds (it has bought over Rs 80,000 crores of bonds in fiscal 2012-13 to date). RBI is defending the government bond purchases as a liquidity measure and not a backdoor deficit financing measure but there are lingering doubts on the beneficiaries of the government bond purchases by the RBI.
RBI is citing the government’s inability to control the fiscal deficit as a reason for its own reluctance to focus on growth. However linking fiscal deficit to monetary policy actions is a clear indication that the RBI is tying the government with itself and it’s independence comes under scrutiny.
ECB and RBI will do what must be done but the fact is that both the central banks have to deal with fiscal pressures using monetary tools and that by itself reduces their independence by a wide margin.