The RBI, long being accused of falling behind the curve in fighting inflation, seems to have propelled itself nicely forward at its policy review. It not just increased the repo rate by 50 bps, but also took a remarkable forward-targeted preemptive measure of announcing a further 25 bps CRR increase effective end-August. The clear intention was to signal a zero tolerance for any liquidity build up in the system.
How much will any of this help to contain inflation, the prime target of this policy? Over the course of the year, high crude prices, both directly through the fuel group and indirectly through chemicals inputs, transport costs, energy prices have been a major contributor to WPI inflation. Industrial inputs, primarily iron ore, and high food prices, including edible oils, has added to the inflationary woes.
The common skein that runs through this list, unfortunately, is that India is essentially a price taker in most of these. When intolerably high prices leads to demand destruction in the US or China, there is a material impact on global prices of these commodities. In India, if demand for food, steel or diesel falls, we will probably merely be consuming less at the same higher prices.
Globally, food prices are rising, both on increased consumption and diversion of some acreage and output towards bio-fuels. Although the link between global and Indian food prices are more tenuous than for industrial inputs, there is no denying the increasing correlation between Indian and global food prices, despite the bans on trading in many agricultural commodities at Indian commodities exchanges and on physical exports. Note too, that a large part of the increasing demand for food in India is from the increasing purchasing power permeating through the country. None of these fundamental drivers is very susceptible to increasing interest rates.
The next presumed driver of inflation is money. Fiat (or reserve) money, M0, is growing at over 26% as of June. A large part of this is showing up as an increase in currency in circulation. This had increased by around Rs 35,000 crore in 2008-09 upto mid-July, compared to Rs 11,000 crore in the corresponding period the previous year. The proximate cause of this increase was a drawdown in the Centre?s deposits with the RBI of around Rs 58,000 crore during the aforesaid period, compared with a drawdown of Rs 10,000 crore in 2007-08. This essentially means a much higher government expenditure in 2008-09, which has inter alia resulted in the increased currency. With certain ifs and buts, then, fiscal and monetary policy seem to be working at cross purposes.
Note the incidence of the monetary policy, with the banking sector being the origin of the transmission channel. Bank credit growth continues at over 26%, and the latest numbers on bank credit to different sectors provides clues to the underlying drivers. Apart from infrastructure, the major increases in bank lending have been to the petroleum and chemical products segments, which seems to validate our understanding that a large part of the increase in bank credit was being driven by short-term working capital loans to oil marketing and fertiliser companies, to provide them cash flows to tide over their under-recoveries. Increases in the cost of funds will not moderate this demand much.
One thing the increasingly tight monetary policy is certain to do is to worsen the fiscal situation. The lower rates of sales and profitability growth is bound to worsen revenue collections through corporate and sales taxes, and given the more firm expenditure commitments of the government, the pressure on the fiscal deficit is likely to worsen. In any case, the cost of the government?s market borrowing programme will have gone up.
Where will all this leave the rupee? Lower corporate growth will certainly make portfolio investors more wary of returns from India. Indian corporates, on the other hand, will probably look for debt capital from global capital pools, and the RBI?s willingness to use global capital inflows to move the rupee up will increasingly divert demand from Indian markets. Which way the sum of the two will lead the rupee is anybody?s guess, but the implication of rising external indebtedness in the context of the twin deficits, fiscal and current account, will inevitably lead to a worsening of India?s sovereign external ratings. Be that as it may, and to the extent that an appreciating rupee plays a role, however small, in moderating inflation, this is to be welcomed.
Pulling it all together, the inevitable slowdown of economic activity will help to moderate demand and thereby inflation; global policy measures currently underway will buttress this. But global uncertainties still remain high, limiting the extent of these interventions. India remains much too exposed to global volatilities in commodities prices. Distortions in domestic price structures prevent the optimally desired responses to price increases, and the measures of the RBI provide, unfortunately, only blunted signals for behaviour modification.
The author is vice-president, business & economic research, Axis Bank. These are his personal views