Price of change

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: With the weekly inflation reading crossing 11% on Friday, RBI has hiked the policy rate another 50 bp, following a 25 bp hike two weeks ago. It appears that, after this aggressive move, only a limited additional tightening will be needed to stabilise the economy. This largely reflects the nature of the growth acceleration of the past few years.

As stressed by RBI, inflation does not just reflect higher global oil prices. The price of petroleum products increased by 25% in the year to June 2007, which, of course, reflected the recent increase in retail oil prices. And because the WPI is mainly composed of commodities or commodities intensive goods such as metal products, WPI-based inflation reflects mainly commodities price trends. However, since early April, the prices of manufactured goods such as machinery and machine tools or transport equipments have started to trend up. There is a risk that commodities driven price inflation could be spreading to other components of the price index as it is in a number of other Asian countries.

The acceleration in the price of manufactured goods suggests India could be experiencing resource pressures. Indian manufacturers, who by now have endured several years of rising cost of energy and raw materials, may have started to pass these on to their customers. This pricing power likely reflects the strength of domestic demand: FY08 growth was 9%, only slightly below the record high growth of 9.6% in FY07. And, of course, the weakening of the rupee since early April has raised the price of imports, which has given Indian manufacturers additional room to raise their prices.

So bringing down inflation may well require growth to slow to such an extent that manufacturers feel that their customers no longer have enough purchasing power to absorb price increases. Without slower growth on the other hand, there is a risk that inflation could continue to accelerate. India, like other countries that are net importers of commodities, is going through a terms of trade shock. Higher prices of energy and raw materials have reduced India’s income and domestic demand needs to adjust to this new reality.

How much of a growth slowdown would be required to bring down inflation? Over the past five FYs, growth has averaged 8.9% a year, against 5.4% in the five years to FY03. If this growth acceleration was entirely structural, there would not be much of a need for a slowdown as current growth would only be slightly above the economy’s potential. If, on the other hand, the growth acceleration was entirely cyclical i.e. reflected accommodative policy settings rather than a long term increase in the economy’s potential, then there would a need for a considerable slowdown.

In practice, the acceleration of growth is likely to be both cyclical and structural. The IMF estimates that long term growth rates in India range between 8 and 9% and that FY07 trend growth was in a 6.8 to 8.8% range, against actual growth of 9.6% (Wild or Tame? India’s potential growth, September 2007). That is rather good news as it suggests India will only need a limited period of growth below potential to alleviate resource pressures and tame inflation.

In addition to the RBI aggressive tightening, long term rates have increased sharply. For instance the yield on the benchmark 3 year government bond is now 9%, compared with 7.36% six months ago: long term rates have increased by more than the policy rate and the yield curve has steepened. This form of market induced tightening of monetary conditions will help bring down aggregate demand and inflation. Overall, it appears the RBI may not need more than another 25 bp hike to tame inflation, based on oil prices remaining at current levels and food prices coming down in the post monsoon harvest.

And rupee appreciation will help alleviate inflationary pressures. Recent data shows that India’s forex reserves have stopped increasing since end FY08. In fact, in the week to June 13, India lost $5 bn in external reserves. With more than $310 bn in external reserves, India’s external liquidity position is not in doubt. But the slowdown in forex reserve accumulation signals that India is attracting less capital than in the past and also that its current account deficit is widening: in CY07, the current account deficit was $11.8 bn, against $9.5 bn in CY06.Against this backdrop, the RBI’s aggressive move could help support capital inflows.

Of course, the alternative to policy tightening and growth falling below potential could be an acceleration of structural reforms to raise India’s long-term growth rate. There is much room to raise productivity growth for instance through reforms that would support the development of labour-intensive manufacturing. Similarly, actual liberalisation of the retail sector could see widespread productivity grains. And reform of the financial sector would raise investment efficiency. There is still a vast pool of untapped reform potential that India could tap to bring down inflation and raise long term growth.