After nine long months and much heartburn, the Reserve Bank of India (RBI) delivered what the markets had been clamouring for by cutting its policy rate by 25 basis points, or a quarter of a percentage point. But with inter-bank liquidity remaining tight—and likely to tighten further as the time for tax payments nears—and deposit growth slowing, banks were unlikely to follow suit by lowering lending rates. To aid the transmission of the lower policy rate to borrowers in the form of reduced loan rates, RBI also cut the cash reserve requirement, or the portion of deposits that banks need to keep with the central bank, by 25 basis points.
Was the monetary easing justified? Recent growth-inflation dynamics had clearly opened space for some modest easing. Inflation has slowed over the last three months and is likely to continue slowing until March-April. This time it is not just because of some statistical base effects. After two years of demand slowdown, excess capacity has begun to surface in several sectors of the economy, limiting the pricing power of producers.
Part of the reason why inflation has remained stubbornly high, despite growth slowing from 9% to below 5% (likely to have in the December quarter), is that capacity addition has also declined. Economists call the addition to productive capacity potential growth. In the case of India, potential growth has progressively fallen since mid-2008 from around 8.5% to around 6-6.5% currently as corporate investment has languished. With actual growth finally falling below this potential, a negative output gap—the difference between potential/capacity GDP and actual GDP—has finally opened up. Despite the widely believed Indian exceptionalism (poor agricultural supply chain and the vicious nexus between rising food inflation, higher farm labour wages via indexed wages under the government’s rural job guarantee programme leading to higher minimum support prices), the size and direction of the output gap has largely driven inflation. And so with the output gap turning negative, inflation has begun to subside and will continue to do so till this gap is reversed. Most high-frequency indicators suggest that the economy bottomed last quarter and that a modest recovery aided by a recovering global economy is under way. Corporate investment still hasn’t shown any signs of life so far. But one expects that with the government returning to reforms and fiscal consolidation, companies will begin investing soon. All this is good news, but there are significant lags before today’s investment turns into tomorrow’s capacity.
So a recovery in 2013, even if it is backed by a turnaround in investment, will turn the output gap positive and with that the pressure on inflation will be back. We think that will happen by the second half of 2013. And so RBI is rightly cautious that inflation will remain range-bound and that the space for aggressive rate cuts is limited.
But there is just one small problem. It is called the current account deficit. The September quarter deficit of 5.4% of GDP stunned the market and that’s not the worst of it. Chances are that the December quarter current account deficit can easily top 6.5% of GDP. This hasn’t really hit the markets or grabbed the attention of analysts, but it will on 31 March when the data is released. And if this coincides with even modest global financial weakness, the impact on the rupee can be significant.
RBI underscored this concern both in its macroeconomic review and policy statement. With such a large external vulnerability weighing on the economy, making it cheaper for exporters, importers, and companies with foreign exchange obligations to short the currency isn’t what any central bank would prescribe, regardless of the growth-inflation dynamics. But RBI chose to do so. And in doing so it added to the very risks that it exhorted us to guard against.
Jahangir Aziz, senior Asia economist, JP Morgan Chase