A continuing paradox in Indian policy-making circles appears to be that some of those who are most bullish on economic growth are also the ones who are either unwilling to accept the emerging threat of demand-driven inflationary pressures, or are irresponsibly playing down that threat. This is despite the widespread acknowledgement that the impact on inflation of the emerging demand-driven pressures could be exacerbated by higher international commodity prices, and India's infamous supply constraints and bottlenecks.
In most countries, both governments and central banks want low inflation, but each approaches that objective differently. Central banks should move well ahead of inflation becoming a problem, while governments typically wake up when inflation becomes a problem. But by the time inflation becomes a problem, it is already too late - and that is when governments look for a magic wand to quickly fix the inflation problem and central banks often become the scapegoat.
An important risk to the evolving economic upturn is that the absence of effective near-term monetary action by the Reserve Bank of India increases the probability of a heavy-handed response later. That, in turn, could have an unnecessarily bigger adverse effect on growth than would be the case with stepped-up adjustment now.
What does effective action mean? After all, hasn't RBI increased the cash reserve ratio and policy rates? Indeed, it has. But have they meaningfully impacted the overnight rate? Not really. The CRR hike of 75 basis points shrank the excess liquidity, and the 25bps increase in the repo and reverse repo rates only increased the floor rate by 25bps (the reverse repo is the relevant rate as there is excess liquidity in the money market). Liquidity conditions are still easy despite the anticipated loan growth and government borrowing.
However, the absence of a meaningful impact so far of RBI's actions is understandable as the two moves were more normalisation rather than tightening. But the emerging economic conditions hint that RBI should move again - preferably in its scheduled meeting on April 20 this time - in its normalisation towards a neutral monetary setting.
Most likely, RBI will forecast GDP growth of 8.0-8.5 per cent for 2010-11, end-FY11 wholesale price index -based inflation at around 6 per cent, and loan growth of 18-20 per cent. It will issue a hawkish statement and sound concerned over rising non-food inflation and the combination of strengthening aggregate demand and higher international commodity prices.
The critical issue for April 20 (hopefully not sooner!) is the choice of instrument: will it be policy rates, or CRR, or both? The evolving growth-inflation dynamics and the urgent need to have a more effective transmission of monetary policy moves warrants that RBI increase the policy rates and CRR by 25 bps each. Note that RBI has no qualms about inter-meeting moves, it is possible that it presses one button on April 20 and the other button a month or so later.
Excess money market liquidity will have recovered by the time of the next policy after the recent seasonal hit from the advance tax outflow. RBI has so far not been intervening in the foreign exchange market, although that might have to gradually change, and it might prefer CRR to market stabilisation securities to neutralise its intervention in currency market. The sizeable government borrowing means that RBI is unlikely to push the liquidity setting into a deficit immediately. However, there is still scope for further drainage of excess liquidity, especially as it rebounds later this month.
Loan growth should pick up as the year progresses. It is worth noting that loan growth has so far been a poor indicator of the strength of the economic upturn. Further, several non-bank sources of finances have been more appealing than bank credit. Perhaps banks need to be more competitive in their interest rates to make them more appealing to customers. Recall that banks had not echoed the aggressiveness of the slashing of policy rates by RBI.
The optically eye-popping year-on-year growth in industrial production will lose some of its recent vigour and also become more broadly based, with intermediate goods and capital goods becoming more important drivers of headline industrial recovery. Indeed, the vehicle sales segment is already showing this.
It should be appreciated that the current monetary cycle is significantly different from the last rate up-cycle that began in late 2004. Firstly, the growth upturn carries better visibility this time, whereas policymakers and the private sector (including analysts) were surprised by the strength and length of the upturn, partly owing to global demand and liquidity cycles.
Secondly, RBI was then battling unprecedented capital inflows but the pressure from government borrowing on monetary dynamics was less of an issue. However, this time, government borrowing is the big issue while the magnitude of capital inflows has so far not been a major worry.
Non-food inflation will come more into focus as higher international commodity prices and strong domestic demand come together. But RBI's fixation on WPI inflation tends to overstate inflationary pressures compared to other central banks that focus on consumer price index inflation. This is because input prices tend to move more and are more volatile than consumer prices.
However, two domestic uncertainties will persist for some time. One, what is the June-September monsoon season going to be like? A normal/good monsoon might actually prompt RBI to step up its tightening even if it is positive for inflation as economic growth will get an additional tailwind. Conversely, a poor monsoon will likely push food inflation but may not prompt RBI to become more aggressive in its tightening owing to the monsoon's impact on growth, and the inability of monetary policy to fix short-term food supply shock.
Two, it is unclear whether the government will finally have the courage to undertake meaningful reform of subsidies. Moves, if any, will surely have a one-off effect on inflation. But it would be counter-productive for RBI to get overly aggressive in its tightening and cripple growth in dealing with the impact on inflation of these long-overdue moves on subsidy reform.
The author is head of India and Asean economics at Macquarie Capital Securities, Singapore. Views expressed are personal.
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