While recent measures to address exchange rate volatility have provided a temporary breather, it is important that structural reforms are pushed through to support growth revival and reduce CAD, the central bank said in its macroeconomic and monetary developments report, suggesting recent liquidity tightening measures may not be quickly reversed.
In fact, the RBI warned that external risks could build up from a number of possible developments.
The RBI warned that external risks could build up from a number of possible developments, most notably a possible shift of dollar flows from emerging market economies to advanced economies in the wake of withdrawal of quantitative easing measures by the US Federal Reserve.
Domestic factors such as slowing growth and a consequent widening of the fiscal deficit, high consumer price inflation leading to weaker savings growth and rising political uncertainties as part of the electoral cycle, are among the other factors that could amplify macro financial risks, according to the RBI.
The rupee had weakened to an all-time low of 61.21 against the US dollar in response to the threat of dollar outflows due to QE withdrawal. Since then, the RBI's liquidity tightening measures have marginally stabilised the currency, which closed at 59.42/$ on Monday.
The RBI also highlighted that financing the CAD may prove challenging in 2013-14 as the US Fed gets ready for QE withdrawal.
The central bank expects CAD to stay above its stated sustainable level of 2.5% of GDP for 2013-14. The RBI said that given the expected volatility in capital flows in the wake of the withdrawal of QE, sustained reforms to attract non-debt flows would be critical.
The country's CAD was a record 4.8% of GDP for 2012-13, which moderated to 3.6% of GDP for the March quarter. Professional forecasters surveyed by the RBI expect the CAD for 2013-14 to moderate to 4.4% of GDP for the full year of 2013-14.
While the central bank noted that its recent measures to stem the rupee's volatility has been positive for the currency, the current weak macroeconomic situation along with external pressures warrants a cautious monetary policy stance, it said.
The RBI adds that for its strategy to succeed in stemming the rupee depreciation, the government will have to do its bit.
The strategy will succeed only if reinforced by structural reforms to reduce the CAD and step up savings and investments, said the central bank.
The RBI noted that macroeconomic conditions have weakened significantly during April-June and said that speedy implementation of structural reforms by the government are critical to boost confidence of both domestic and foreign investors.
The government has fast-tracked opening up of foreign direct investment (FDI) in key sectors and giving clearances to various stalled infrastructure projects. Finance minister P Chidambaram, at an event on Monday, said that the government is considering all possible measures to attract dollars into the country.
Further in its report, the RBI upped the ante on consumer price inflation and linked the CPI pressures to possible risk to the currency. The RBI said the persistent near-double digit CPI inflation has kept the inflation differential with trading partners high, thereby making the rupee vulnerable to external pressures.
India's current macroeconomic deterioration, to a large extent, reflects the three years of high inflation, which is well above the threshold at which it turns detrimental to growth, the central bank said adding that a sustainable recovery requires control over consumer price inflation.
On growth, the central bank said recovery could be slow in 2013-14 and noted that most external agencies such as the World Bank and the International Monetary Fund have already lowered their 2013-14 growth forecasts for India.
The central bank's survey of forecasters too showed that GDP growth is now expected to be 5.7% instead of 6% expected two months back.
The RBI has recognised exchange rate volatility as a key danger to both growth and inflation dynamics. It has recalibrated its monetary policy in the wake of currency fluctuations, says the central bank's report.