In the run-up to Diwali, lets be grateful for small mercies. Back in August, the Indian economy was caught in a vicious spiral of macroeconomic instability. The rupee was falling like a stone. Short-term interest rates had been hiked 300 bps to defend against the currency. This, in conjunction with the rupee at 68, meant that corporate balance sheets were bleeding, runaway fiscal slippage looked the norm, and the quantum of pass-through from the FX deprecation to tradables inflation looked truly frightening. Lets be grateful that some calm has returned after the stormboth on account of policy actions at home and unexpected but favourable (from the standpoint of emerging markets at least) events globally.
The clearest manifestation of this is the mean reversion and relative stability of the rupee. Its too early to claim victory until public sector oil demand (estimated to be $5-6 billion a month!) is not introduced back into the spot market. Lets hope this tapering of oil demand is not as tricky as what the Feds going through in its own version of the taper. All that said, theres clearly good news on the external front. Even including oil demand, the current account deficit in the July-September quarter is expected to collapse to less than $5 billionfrom more than $22 billion the quarter before. In fact, September likely witnessed a current account surplus! The quibble, if any, is that some of the structural underpinnings of the current account deficitcoal and scrap metal imports, the lack of iron-ore exportsstill remain. So, this is a cyclical narrowing not a structural one. Yet lets be grateful for small mercies this Diwali. One step at a time.
The relative stability of the rupee has meant that the Reserve Bank of India (RBI) has been able to systematically unwind the emergency tightening measures from July. In all the angst about policy rates going up (more of that below), whats gotten missed is that the interbank call rate has fallen by 150 bps over the last two months. And short-term market rates are down almost 300 bps from their August highs.
So, with the FX stabilising and the liquidity measures being unwound, we are back to where we were pre-May 22 (the fateful day on which Ben Bernanke hinted at tapering and all hell broke loose in Mumbai, Sao Paulo, Jakarta and Johannesburg). So, what now are the key challenges facing Indian policymakers Jump-starting growth, of course. But, I would submit, doing so without exacerbating already-elevated inflationary pressures.
Here are some of the common arguments against RBIs rate hikes over the last two months. With growth so much below potential, shouldnt RBI be cutting rates to support growth Or the common refrain on inflation, Its all food inflation outside RBIs purview, so why hike rates.
It is undoubtedly true that India is currently running a negative output gap (economist jargon for growth being below potential). But if there is so much slack why is that not translating into lower core inflation. Why is core CPI been stubbornly at the 7-8% level Why is the momentum of core WPI inflation (three-month on three-month annualised) back up above 5%
To my mind, it is a combination of a few reasons. Either the output gap is not as large as we think, in which case it is not clear that CPI core inflation will come down without any policy action.
Or, more worryingly, despite the existence of significant slack there is not commensurate downward pressure on prices because inflation expectations are so entrenched. Its worth noting that household inflation expectationsin RBIs latest surveyhave seen a sharp move up in the July-September quarter.
This is the unpleasant corollary of the situation that advanced economies faced over the last two years. The quantum of the negative output gap in those economies should have suggested deflationary pressures. But because inflationary expectations were well anchored at the 2-3% mark, deflation did not result.
India faces the opposite problem. Because expectations are so entrenched among wage and price setters, the slack is not translating into commensurate reduction in inflation. In economist jargon, the Phillips curve is moving up and getting flatter.
Whats more, firms margins have taken a beating over the last two years. With the 12% rupee depreciation since May pushing up input costs, some firms have little choice but to raise output prices. And with external demand picking up and rural demand expected to do so, it appears increasingly probable that firms will use this opportunity to normalise their margins. Good for corporate profitability. But not so good for core inflation.
It is for all of these reasons that the central bank needs to remain vigilant. We know just how damaging entrenched expectations can be. Remember the rupee in July and August It took a fire-fightand lots of external good fortuneto win that battle. The last thing we need is for inflation expectations to get more deeply entrenched. Because the disinflationary costs will be disproportionately higher. Of course, jump-starting growth is important. But no country in the world has seen high and sustainable growth with retail inflation in double digits.
Indias growth concerns are real. Yes, growth will likely get a boost from exports and a record harvest. But this is likely to be a two-quarter story. Ultimately, any sustainable growth pick-up will need to be based on a pick-up of Indias corporate investment cycle. The government deserves credit for finally clearing a slew of projects (if only this was done a year ago!) but translation from clearances to activity may well have to wait until the resolution of political uncertainty.
Its easy to get depressed in the current economic environment. But, this Diwali, lets count our blessings. The rupee is not at 70. The government seems committed to keeping to its fiscal deficit levels. There is no loose talk of a ratings downgrade. Market rates are 300 bps lower than their August levels. And the current account deficit will print closer to $50 billion than $90 billion. The growth and inflation challenges are real. But at least theres a sense of macroeconomic stability returning on other fronts. For that, lets be grateful this Diwali. But, not for a moment, should that gratitude turn into complacency.
The author is senior South Asia economist at JP Morgan