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