The Reserve Bank of India (RBI) in its first quarter review of the monetary policy decided to keep the policy rates unchanged. While the policy decision was on expected lines, the central bank has cut its growth forecast for the current financial year to 5.5% from 5.7%. It also dubbed the external sector as the biggest source of risk to macroeconomic outlook and refrained from laying out any timeline for rolling back the measures it took in order to curb volatility in the currency market in July, which effectively reversed the stance of the monetary policy.
The policy statement by RBI clearly suggest that there is more pain in store for the Indian economy. Despite a lower base, the growth is not going to be significantly better than the last year. The only saving grace for the economy at this stage seems to be good monsoon and agricultural growth. The manufacturing growth has collapsed and there is virtually no sign of any revival in the sector. And with tightening of credit conditions to defend the currency, scope of any revival has only diminished.
Further, the external situation has become extremely vulnerable which will have an impact on economic growth and macroeconomic stability. Remember, the adjustment in the global financial system which led to the outflow of foreign capital from the Indian market, resulting in a sharp fall in rupee, was in anticipation of a possible roll-back of asset purchase by the US Federal Reserve. We do not know for sure if that adjustment is over. There is a fair chance that when the Federal Reserve actually begins to cut its asset purchase, there would be a similar reaction—maybe at a larger scale—making the management of the external account and currency extremely difficult for the central bank. Therefore, it is highly unlikely that measures taken by the central bank to curb liquidity will be rolled back anytime in the near future. Put differently, corporate and households should not expect interest rate cuts in the foreseeable future.
To be fair, there is very little that the central bank can do at this stage. Cutting rates to support growth could affect expectations in the currency market, though there is no guarantee that just tightening of conditions in the money market will protect rupee for a very long. But keeping interest rates at higher levels to protect currency will further damage the corporate balance sheet and affect growth prospects. Clearly, RBI is caught between a rock and a hard place. The rupee once again breached the 60 mark against the dollar and fell 1.76% on the day of the policy announcement.
However, this situation could have been avoided. Apart from shifting goal posts for the monetary policy from anchoring inflationary expectation to supporting growth to protecting currency, RBI also allowed a huge build-up of the short-term foreign debt in the country. The total foreign debt has risen from the level of $306 billion at the end of March 2011 to the level of $390 billion at end of March 2013. The composition of short-term debt during the same period has also gone up from 42% of the reserves to 59%. Complicating matters further, the reserves as proportion of debt has fallen from 99.7% to 74.9% during the same period. Evidently, servicing external debt in the near term will be a big challenge for the economy. It will only intensify the impact of a sudden stop or reversal.
Interestingly, all this while, RBI maintained that it does not need to interfere on the external account, but the moment currency came under pressure and vulnerabilities on the external account started getting exposed, currency became the guiding factor in shaping the monetary policy. If the build-up in external debt was not allowed at this scale, the currency would have adjusted to the macroeconomic weakness more gradually. It would have certainly put more pressure on the government to act in time and address the structural weakness in the economy. However, what happened instead was that the capital account was liberally used to hide the structural weakness and falling competitiveness in the economy. As a consequence, we have now reached a situation where it is probably too late in the day to restore confidence and make corrections in the internal dynamics of the economy without going through the pain of slower economic growth—which could have been avoided—while the external account now purely depends on statements and action by the Federal Reserve. This is certainly not the place that India deserved.
The Indian economy has reached a stage where no macroeconomic indicator is in favour. It has large fiscal and current account deficits, a falling currency, slow growth and high inflation. To make matters worse, there is no visibility as to how we will get out of this situation. The present situation and future possibilities indicate a tough ride for the Indian economy ahead.