Euro crisis may soften rupee, increase inflation

A weaker euro could result in a lower value for the Indian currency.

Consequently, inflation, which is expected to come off to 7.5% for December, and drift lower towards the 7% mark by March 2012, mainly on the back of a high base effect and a moderation in food prices, may remain at slightly higher levels than anticipated. Even without that though, the Reserve Bank of India (RBI) is unlikely to be convinced that inflation risks are low enough for it to be able to act in terms of trimming policy rates when it meets on January 24 to review monetary policy. For one, the rise in prices of non-food manufactured products, was nudging 8% for November.

Moreover, key drivers of inflation including higher incomes, wages, the minimum support prices for agricultural products, the weaker rupee and the deteriorating fiscal situation remain;the chances of a further depreciation in the currency in the wake of prolonged financial crisis in the euro zone, can only make the central bank more cautious about loosening monetary policy.

Headline inflation has stayed above 9%for 22 months now with the central bank asserting in mid-December that both inflation and inflation expectations remained above its comfort levels. The RBI did, however, expect inflationary pressures might ease in the coming months despite high crude oil prices and the depreciation of the rupee.

“While headline inflation could still moderate to 7% by end-March 2012, thanks to continuing sharp disinflation in food prices, it is not yet clear whether inflation will remain anchored below 7% through the course of 2012,” economists at Deutsche Bank wrote in a report last week.

They added that while their base case scenario factored in an average inflation of around 6.5% for FY12-13, any supply shock, such as a poor monsoon in 2012, could pose 150-200 basis points of upside risk to inflation. “We expect the RBI to be cautious before declaring victory over inflation,” they concluded.

While the bond markets have been hoping for additional liquidity through a cut in the Cash Reserve Ratio (CRR), that’s unlikely to be forthcoming.

The central bank may prefer to dole out liquidity to those banks that want it, through bond buybacks, rather than dishing it out to the system as a whole. Moreover, those banks that are in dire need of cash do have the option of borrowing through the Liquidity adjustment Facility or the Marginal Standing Facility.

Indeed, economists point out that a cut in the CRR at this stage might be read by the markets as a sign that inflation had been tamed, something that the RBI would be wary off.

Also, loan growth has moderated to sub 16% levels whereas deposits have been growing at a fairly brisk pace. While the central bank ahs expressed concern about slowing growth, it has been equally concerned about the worsening state of the government’s finances.