The November inflation data has quashed the faint hope of a reversal in RBI?s monetary policy stance in its forthcoming mid-quarter policy review. Two of the biggest concerns (growth and the rupee) need to be addressed very quickly, while the third (inflation) is becoming increasingly intertwined with the former.
Although the case for the economic situation warranting an easing of monetary policy stance still remains strong, it is easy to empathise with RBI?s caution in doing so.
India?s growth is now precarious, with the growth-inflation balance now firmly tilted towards a slowdown, fortunately with a commensurate drop in inflation. Even the recorded growths of 7.7% and 6.9% for Q1 and Q2 are partially illusory, created by a downward revision in the GDP in the two corresponding quarters of FY11, so that the growth rates got bumped up; without this crutch, actual growths would have been 7.2% and 6.4%, respectively, with H1 growth of 6.8%.
Assuming optimistically H2 FY12 growth of 7%, we have a 6.9% growth in FY12. FY13 growth is likely to be lower, with a loss of momentum due to the weakening overhang of projects that are being implemented.
This renews questions about the output gap, potential output and the neutral (policy) rate. Although the ?real interest rate?, i.e. policy rate minus inflation, remains negative, this is probably going to change with the December inflation data, and remain positive until at least the end of 2012, serving as a pre-emptive deterrent to excessive investments. And a disincentive for capex is probably the last thing we want.
The second concern is the very rapid slide in the rupee, which, over a year?s horizon, has been the worst performing currency (down 17%) but one, next only to the Turkish lira. In the past month, it has tied with the Brazilian real (down 3.5%). This drop is creating its own set of problems, and is closely tied with the growth outlook. First, corporate earnings are taking a big hit, which is likely to aggravate the growth slowdown. The rise in costs of bulk imports, crude, fertilisers, etc, will increase the subsidy burden, putting further stress on the fisc. Most worrying, it may undo some of the gains that falling commodity prices have given to inflation.
Another indication of a deterioration in India?s external accounts is that system liquidity has also tightened, probably aided by net foreign outflows, aggravated by RBI intervention in the forex markets, selling dollars (its own data shows that it sold close to $1.8bn in September and October, thereby extracting R9,000 crore liquidity). RBI?s system liquidity band at plus/minus 1% of banks? funds has been breached in the past month or so. The situation is likely to worsen over this week, even if transiently, with advance tax payments by corporates, before they flow back into the system through expenditures. How best to mitigate this, though, is another story.
The one bright side in this environment are signs of moderating inflation, but even this needs to be treated with some caution. November?s WPI inflation came in at 9.1%, somewhat higher than Street expectations. Given trends in global prices for metals and other commodities, the source of surprise (basic metals, chemicals, non-metallic products, gold, etc) is likely that the weakening rupee has offset the drop in global prices. Despite this, we are probably on track for inflation falling significantly below RBI?s projection of 7% by end-March 2012, particularly if the rupee does not fall much further.
Despite the arguments above, an explicit easing and policy reversal is unlikely on Friday. Why might RBI exercise caution in reversing its rate stance? Concern, obviously, is that inflationary pressures remain merely dormant and surge again, as soon as some indicators of global growth begin to tick up, with global commodities increasing sharply. The US economy is already showing signs of a stronger-than-expected recovery and China might actually arrest its slowdown. In particular, how might the dollar move? Normally, with increasing prospects for global recovery, especially in the US, the dollar might be expected to appreciate. But global currency dynamics have changed. A perception of global recovery will reduce risk aversion, leading to a move to emerging market assets, actually weakening the dollar, and increasing dollar-denominated commodity prices. The blessing here would be that the rupee might strengthen, offsetting higher commodity prices. RBI will probably wait for the full array of surveys and data for its third-quarter review in January, rather than the mid-quarter review on Friday.
Even with these concerns and ambiguities, we think that is a case for an immediate policy reversal. To the extent that the weakening rupee is aggravating inflation, even in the face of sharply slowing growth, this has to be the target of policy. The best antidote to the falling rupee is boosting growth, and thereby investor confidence. If there remains a fundamental weakness in growth dynamics, particularly if so perceived by investors, central bank interventions will be transient and palliative at best. This is now evident across the world, where central banks have initiated and accelerated reversals in monetary policy tightening?China, Australia, European
Central Bank, among others?acknowledging that economic conditions deemed plausible even six months ago are now unlikely.
The author is senior vice-president, Business & Economic Research, Axis Bank. These are his personal views