Mumbai: Rising inflation; slowing economic growth, which is reflected in sluggish credit growth; and a local currency that has been artificially kept weak against the dollar through sustained intervention. These are some of the concerns before the Reserve Bank of India, or RBI, when it presents the annual monetary policy on Tuesday.
Inflation: bigger worry than deceleration
Wholesale price-based inflation was around 3.11% in October. Six months down the line, it rose to a three-year high of 7.41% in March, against RBI’s projection of 5%. For the week ended 12 April, the inflation rate was 7.33%, mainly on account of high prices of oil and food items and a few essential commodities such as iron and steel. The sharp spike in oil prices, which recently breached a record $117 a barrel, has made India’s imports costlier. India imports about 70% of its oil needs and the commodity alone accounts for about 35% of the imports.
According to finance minister P. Chidambaram, the government is more concerned about inflation rather than growth. RBI governor Y.V. Reddy, too, has termed inflation “unjustifiably high”.
The government has taken several fiscal measures in the last one month to rein in the high level of inflation. For instance, it has scrapped import taxes on edible oils and pulses and banned the export of commodities such as rice and cement. An import tax reduction brings down the price of the product. RBI, on its part, has raised banks’ cash reserve ratio (CRR), or the amount of cash that commercial banks are required to keep with the central bank, by 50 basis points to tighten liquidity and dampen demand for credit. One basis point is one-hundredth of a percentage point.
“Inflation rate touching 7.41% is clearly unacceptable both from political and economic angles and, hence, controlling inflationary expectations has taken centre stage. The dilemma is that even as inflation is headed higher, growth is slowing and appears to dip further in the days to come,” says Indranil Pan, chief economist of Kotak Mahindra Bank Ltd.
According to him, any signal from RBI pointing to a higher interest rate cycle could have a crippling effect on industrial production.
Economic slowdown: difficult choice
India’s gross domestic product (GDP) in the past four years has been growing on an average by 8.8%. But, the growth story may not continue for long with taletell signs of a slowdown evident all around. The International Monetary Fund has forecast India’s GDP growth at 7.9% in the current fiscal. Chidambaram has also toned down his bullishness on growth and indicated that he would choose to contain inflation at the cost of growth.
“Though the measures to contain inflation may result in some moderation in economic growth, it is the endeavour of the government to sustain the current momentum of high growth with price stability,” Chidambaram said in a written reply to a question in Parliament on Friday.
According to Shuchita Mehta, senior economist, Standard Chartered Bank, policymaking is a big challenge for RBI. “We have already seen weak industrial growth numbers and the credit growth has also begun to decelerate. The inflation is on the rise. Against this backdrop of a decelerating growth and a rising inflation, the central bank would perhaps find it difficult to move in either direction. We believe that RBI would want to hold rates steady.” Mehta says.
Subir Gokarn, chief economist Asia Pacific for Standard and Poor’s, says RBI has to choose between growth and inflation. “It’s a trade-off between the two and RBI has to clearly identify its objective. It has to see what would be the relative impact of the instruments it employs in regard to each of these two issues,” Gokarn adds.
“From a purely technical perspective, RBI should choose a target on which its instruments are going to be the most effective. If interest rate move is going to be more effective and have a greater impact on growth than on inflation, it probably makes sense to look at the growth objective rather than inflation objective,” he adds.
Rupee vs dollar: the intervention continues
The rupee has all along been an important contributing factor in the making of the monetary policy. After rising 12.5% against the dollar in calendar year 2007, the local currency depreciated 1.75% against the greenback between January and April. RBI has been buying dollars from the market to prevent runaway appreciation of the rupee and this has an impact on money supply, as for every dollar RBI buys an equivalent amount of rupee flows into the system.
Gokarn says the rupee-dollar exchange rate is certainly not going to be a significant issue in the decision-making process at this point of time and that the focus of the policy will be on containing inflation. “The primary concern would be whether inflation is enough of a threat from the monetary viewpoint to warrant a response,” he says.
Following RBI’s aggressive dollar-buying from the market, India’s foreign exchange reserves rose by close to $110 billion in the past year to $313.5 billion.
Chasing high returns from the Indian equity market, foreign institutional investors (FIIs) bought stocks worth $17.3 billion last year, net of selling. However, this year, FIIs have net sold stocks worth $2.8 billion (the difference in value between the stocks they have sold and those they have bought).
“Although capital flows in 2008 began on a weak note, very recent numbers indicate that there is again a pickup in flow and it poses a challenge for RBI. If the flows make way into equity markets and in other asset classes, that will again spur inflation. In that case, RBI may have to temper the impact of rising rupee and intervene in the foreign exchange market,” says Mehta of Standard Chartered Bank.
Foreign exchange dealers say that in the backdrop of persistent weakness of the dollar against major global currencies, rupee can strengthen if RBI stops intervening in the market.
“In our view, deteriorating current account dynamics, muted portfolio inflows and presence of the RBI’s bid will lead to further rupee weakness; we forecast a rise to 41 by end-June,” says a recent JPMorgan Chase Bank report.
Slowdown in credit growth: cause of concern
After growing at close to 30% in the past three years, banks’ loan growth dropped to a four-year low in 2007-08. Bank credit for fiscal 2008 grew at 21.6% to Rs4.17 trillion, sharply lower than the 27.6% growth in 2007 and also below the central bank’s projection of 25% credit growth during the year.
Fearing asset bubbles, RBI insisted on higher provisioning as well as additional capital requirements for retail and consumer loans, mortgages and loans to real estate developers to make the cost of loans more expensive. The central bank has also been continuously raising banks’ CRR to stamp out excess liquidity from the financial system.
“RBI has met its objective in containing credit growth,” said Abheek Barua, chief economist of HDFC Bank Ltd.
According to him, the fact that bank credit is growing at barely 22% is indeed a cause of concern. There has been substantial cooling off in areas where RBI had feared overheating such as the mortgage market and retail loans. In fact, the decline in growth rate is largely driven by a slowdown in retail credit, Barua says.
According to bankers, the credit growth rate will slow further after the recent hike in CRR, and if the central bank goes for a hike in interest rates, that will deal a serious blow to loan growth.