The current economic scenario globally presents a difficult choice for central banks. The world?s super-economies seem to be in a slowdown, with the US economy possibly having tipped into recession already. However, globally, inflation has remained firm, defying economic logic. This makes policy formulation by central banks throughout the world challenging. It is no different for RBI.
The Indian economy has been facing slowing production trends. Consumption demand, especially of interest-sensitive consumer durables, has slowed significantly. Consumer durable goods production witnessed de-growth of 1% in April-February 2008, compared to a 9.7% growth in the same period last year. Even as consumer non-durables production held relatively strong, overall consumer goods production is lower in 11 months of 2007-08 compared to last year.
And demand is likely to weaken further. First, the lagged impact of monetary policy tightening will continue to bite. Along, with higher interest rates, the recent spike in inflation (that too in food items) is capable of reducing consumption expenditure allocated for non-essentials, which is largely discretionary. On the other hand, the booming stock market had led to a sharp increase in consumer perceptions of wealth. With the recent stock market dip, this feel-good factor is likely to be on the wane, thereby reducing consumer confidence and discretionary spending.
It is widely acknowledged that the Indian economy?s unprecedented boom has been a result of soaring domestic demand, even if the big contributing factor was investment demand rather than consumption demand. The current economic cycle, starting from around 2001-02, witnessed a sharp rise in investment demand, with India?s gross domestic investment as a percentage of GDP rising from 22% in FY02 to around 36% now. More importantly, even as there were signs of weakness in consumption demand on the back of tighter monetary policy, until recently investment demand had held strong. However, in January 2008, the capital goods sector clocked a disappointing 2.3% growth, the lowest in nearly six years. Growth in this sector did recover to around 10.1% the following month, but was still lower than the average growth of 17.5% in the first 11 months of 2007-08.
Investment demand, like consumption demand, is also likely to weaken further. Any direct impact of the global credit market crisis on Indian financial institutions is unlikely, as they have practically no exposure to US mortgage-backed securities and other problematic credit market instruments. However, the global credit market crunch and quantitative restrictions on ECBs raised in foreign currency have made it difficult for Indian companies and financial institutions to gain access to cheap overseas capital. Indian business houses will thus be forced to borrow at higher domestic interest rates, thus moderating investment demand.
The cost of financing is not the only factor. The level of private investment in the days ahead would also depend on corporate profits, expected to diminish as consumption demand slackens. Export demand is down, even as input costs of manufacturing rise?costs which cannot be easily passed on to end users. Sadly, apart from economic factors, the political outlook and general confidence levels are also restraining investment decisions.
Even as there are clear indications of weakening growth, it is not enough to be swinging RBI on to an easing cycle. On the contrary, there is now renewed talk of a re-emergence of a hardening cycle for interest rates, especially with headline WPI inflation jumping up to above 7% in a swift and unexpected manner. But most of this rise in domestic inflation is due to higher food and metal prices, both of which are on a firm uptrend in international markets. And even as a significant portion of domestic fuel prices remain administered, the inflationary expectations out of the firmness in global crude oil prices remain strong.
As a significant part of the strong inflationary pressures is due to supply side factors and also not purely caused by domestic factors, a tighter interest rate environment is unlikely to help much. The RBI has thus attempted to arrest the inflationary expectations by reducing rupee liquidity by hiking the CRR requirement of the banking sector by 50 basis points. In fact, RBI in its last monetary policy had indicated that liquidity management would emerge as the overriding priority for monetary management, and its recent action is in line with this. On the other hand, with growth already slowing, any signal from RBI pointing to a higher interest rate cycle could have a crippling effect on industrial production rather than helping in reducing inflationary pressures. ?
I think, after the 50 bps increase in the CRR, RBI should prefer a wait-and-watch approach. While maintaining an adequately hawkish stance on inflation on April 29, I think RBI will stop short of either increasing the repo rate or the reverse repo rate.
The author is chief economist, Kotak Mahindra Bank. These are his personal views
