Price of change

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: 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.