RBI continued its pause on policy tightening, as expected, its discomfort with the extent of current liquidity tightness overriding its concern with the emerging risks to prices and inflation. However, containing inflation and anchoring inflationary expectations remain its objective primus inter pares, and liquidity management only intends to calibrate overnight policy rates consistent with this objective. Recent developments in global commodity prices, particularly crude, provide ample justification for RBI?s concern, having introduced additional uncertainties in RBI?s monetary policy decision process.
One of these uncertainties arises from India?s current account deficit. Some analysts have made dire prognostications of India?s current account deficit widening to 4% of GDP, a decided danger threshold. While we do not think this likely in FY11, a worsening deficit, driven by costlier commodities, is likely to have both direct and circuitous effects: directly feeding imported inflation via a depreciating currency and indirectly via the larger consequences of a widening current account gap.
Crude, in particular, has again become a big worry. In previous weeks, following reports of slightly better than expected global economic data, crude prices climbed rapidly to almost $90 a barrel. True, it is unlikely that doomsday is nigh. Global inventories remain high, and demand from the developed markets is still too anaemic to pose a major threat. Most analysts are predicting that crude prices will remain below $100/barrel in 2011. But there are enough indications that we should be starting to prepare for sufficiently adverse consequences, even if they are nowhere close to the situation of 2007 and 2008. Global economic conditions are indeed beginning to look better, other than Eurozone debt concerns.
Just two years after hitting record highs of $147 a barrel, global oil demand seems to have recovered to pre-recession peaks, notes a new report by global oil and metals consultancy Wood Mackenzie (WM). WM projects that world oil demand in 2010 (at an average 86.7 million barrels a day (mbd)) will exceed the previous record high in 2007 by 100,000 bd and is likely to rise further to 88.1 mbd in 2011. The surge has (and will) come from Asia, which accounts for 85% of the recovery in 2010. Oil demand in Q3 of 2010 will exceed the 88 mbd of Q4 2007. WM predicts that global demand is likely to be 2% higher than the peak pre-recession 2007 demand in 2011 and 4% higher in 2012. In addition, if the US dollar starts weakening, as is now being expected after a semblance of stability in Europe and the continuing QE2 in the US, this will probably give a further boost to dollar denominated commodities, particularly crude.
The implications for India?s current account deficit (CAD) are evident and as follows. Over 90% of India?s petroleum products consumption and exports is met through imports. Petroleum imports account for roughly a third of total imports by value. Diesel accounts for over 40% of total petroleum products consumption and this share has increased steadily from about 34% in FY04. Assuming that demand remains strong, the oil import bill is likely to increase significantly in FY11 and thereafter. Over April-October 2010, India imported $57 bn of petroleum products, a 25% jump over the same 7 months of 2009. India?s crude basket prices averaged $79.4/bbl during April-December in FY11, a 17% rise over same period average last year. The point is that consumption of petroleum products has increased significantly and expectations are that this increase will continue.
What does this portend for monetary policy? Unless capital inflows overwhelm the current account deficit, the rupee is likely to remain under pressure, although some of this will probably be moderated by a weakening dollar. A weakening rupee will increase imported inflationary pressures, potentially setting in motion a worsening cycle, with inflation differentials further weakening the rupee, further complicating RBI?s monetary policy decision variables. Normally, a widening current deficit should set in motion currency changes as equilibrating signals, making imports costlier and therefore less attractive, but capital inflows have the effect of disrupting these signals by keeping the rupee stronger than warranted. Although large capital flows are, in fact, likely, a large measure of uncertainty enters the picture.
The potential liquidity implications are much better defined. A large current account deficit is perceived to increase the absorptive capacity of capital inflows, but the nature of capital that is flowing in should give pause. In FY11, over April to October, India got about $15 bn of direct investments (FDI), compared to $20 bn over the corresponding 7 months of FY10. Net of reinvested earnings, these figures are about $13 bn and $19 bn. The bulk of equity inflows have been portfolio capital, about $51 bn compared to $18 bn in the first seven months of FY10. If the current account begins to worsen further from our current projections of approximately 3.0% of GDP, investor risk perceptions will adjust non-linearly, increasing after a certain threshold, leading to a flight of capital, mostly portfolio, all of which will worsen the rupee further and drain domestic liquidity. Liquidity management, therefore, becomes an even bigger decision input into monetary policy.
A corollary of the arguments above relates to petroleum products pricing. Compressing demand for petroleum products, particularly diesel, is critical to sustain stable growth, and this entails increasing prices of diesel and other petroleum products. A fuel price increase will automatically result in a demand compression, achieving a key monetary policy objective. The immediate increase in inflation is probably a short-term trade-off that we should accept for longer-term price stability.
?The author is senior vice-president, business and economic research, Axis Bank. These are his personal views