The backdrop of the monetary policy due on April 29 is a marked deterioration in the domestic macro environment as compared to what it was a few months ago. Given the rise in commodity prices across all classes, as seen in most economies worldwide, inflation in India is rising while growth is cooling off. The slowdown in growth which was earlier visible on the consumption side of the economy has now spread to the investment side as well. On the external front, the slowdown in the global economy, coupled with the continued uptrend in oil prices, will result in a widening of the current account deficit, while capital flows are likely to be lower due to the rise in risk aversion and implementation of tighter norms for external commercial borrowings (ECBs).
However, headline inflation is well above RBI?s comfort zone of 5%, and assuming prices are not rolled back, inflation is likely to remain in the 6-8% range in the coming months. Thus, in addition to the recent CRR hike, with 2008 being a pre-election year and the obvious need to dampen inflationary expectations, one can expect additional measures both on the monetary and fiscal fronts.
The key question is: what?s next? On the fiscal front, besides the continuation of duty cuts/export bans, possible measures include price controls on manufactured products as well as bans on trading in sensitive agricultural commodities. On the monetary front, although the timing is tricky, further CRR hikes to drain out excess liquidity are likely. On policy rates, while we maintain our view that monetary tightening will not bring down current levels of inflation?in fact, it will only widen interest rate differentials and slow down growth further?given the need to dampen inflationary expectations, one could see a reluctant 25 basis points hike in policy rates.
The biggest challenge for RBI would be to maintain the balance between growth and inflation. A tight domestic financing environment, coupled with restrictive overseas borrowing norms, has taken its toll on growth. While the downturn seen on the consumption side since early last year may get arrested on account of the fiscal stimulus?specifically the budgetary proposals and the Sixth Pay Commission recommendations, what is worrying is that the deceleration in growth has spread to the investment side as well. The reason being that in the recent past, the India story has been largely investment-led (investments have risen 15% on a y-o-y basis, with the investment-to-GDP ratio increasing to 36% from 25% in FY03). Although the investment story is supported by low net gearing levels, availability of surplus funds in the banking sector, and an uptrend of savings, the increase in risk aversion, low appetite for public offerings and high domestic interest rates could dampen/delay investment demand. As a result, headline GDP growth, which has averaged 8.7% for five consecutive years, is likely to come in lower at 7.7% in FY09.
While this still makes India among the world?s fastest growing economies after China, things do not look as good if one takes into account per capita income levels. On this front, India?s per-capita income ranks it below all Asian economies except Pakistan and Bangladesh. Thus, to raise the standard of living and alleviate poverty, besides addressing the population issue, the Indian economy would need to grow at a faster pace. To this end, a significantly tighter policy would not only slow but also derail the growth momentum.
While, ideally, one would have liked to see measures to stem the deceleration in growth, what makes this difficult is the recent rise in inflation. Till early March, on the back of a favourable base effect, fiscal measures and the impact of higher interest rates, inflation as measured by the WPI remained well within RBI?s target range of 5%. While there were latent inflationary pressures, admittedly, the rise in inflation by over 200 basis points in less than a month has caught most observers by surprise.
Going forward, assuming prices are not rolled back, coupled with global food/fuel issues, inflation will likely remain in the 6-8% range, higher than the sub-5% level expected earlier. Adding to the problem is a relatively loose fiscal policy. The government has targeted a fiscal deficit of Rs 1,333 billion, or 2.5% of GDP, but this is understated as it does not include the Pay Commission payout, farm debt waiver and the likely issuance of oil bonds. Including the above, India?s fiscal deficit would be closer to 4.6% of GDP. In addition, money supply growth at 21% is way above RBI?s target of 17-17.5%. All these factors, coupled with a need to dampen inflationary expectations, could result in further monetary action by RBI in the coming months.
The author is India economist, Citigroup Global Markets. These are her personal views
