Food inflation is still close to 20%, and has been high for more than a year. Wholesale Price Index-based inflation is now near 10%, with substantial contribution from non-food items. Asset inflation is making stocks and real estate expensive. Globally, energy prices are rising. These indications alone should suffice to ordain what the Reserve Bank of India (RBI) should do. But there is more compelling evidence from the demand side. Industrial growth has been strong, and is broad-based across most categories. Non-oil imports have spurted. Even bank credit is growing, with the incremental credit-deposit ratio well in excess of 100%. There is thus a clear and unambiguous case for monetary tightening. Indeed it may be overdue.
Ajit Ranad, Chief economist, Aditya Birla Group
In October, the RBI governor said India needs to exit from its monetary stimulus stance well before advanced economies. If he was referring only to the US, the euro zone or Japan, we may still be ahead of them in terms of timing. But among other advanced economies, Australia and Singapore have already tightened, and China has introduced a slew of aggressive regulatory and prudential measures to cool asset and commodity inflation. Asia’s rapid growth in the first quarter of 2010 (China 12%, Singapore 13%, India expected 8.5%) will renew the debate on decoupling, which frankly is immaterial to RBI’s imminent monetary policy decisions. The recovery in the North Atlantic economies is still uncertain, with unemployment and housing still in the doldrums. As for the US, the fiscal woes of some of its states foretell a domestic Greece-like situation, which may need federal bailouts, despite the already high deficit. Hence, the chances of a double-dip North Atlantic recession cannot be ruled out, which means that RBI needs to have enough room to cut rates in the future. Its current stance doesn’t leave enough room for that eventuality. If, on the other hand, there is a faster recovery in the West, then too RBI needs to be ahead of the US Federal Reserve in monetary tightening.
The pressing need is clearly to raise policy rates and the cash reserve ratio (CRR) by at least 50 basis points. This will ensure that the monetary stance will be close to neutral, not hawkish. By using asymmetric hikes, RBI may consider widening the gap between repo and reverse repo rates. A hawkish repo will serve to curb inflationary expectations, which have already spilled into non-food sectors as well as the labour market. Of course, other factors are also responsible for wage inflation, but that does not absolve RBI from doing its bit. The fiscal forces are anyway all arrayed to undo monetary restraint; hence, the need for RBI resolve is more acute.
RBI faces three distinct but interrelated challenges. These relate to management of inflation, liquidity and the exchange rate. Inflation fighting requires raising the repo rate, since that will soon be the operative rate. Liquidity management requires raising the cash reserve ratio. Inbound capital flows will aggravate the problem of liquidity management, just as in early 2007. Hence, this cost must be shared with the Union treasury (using market stabilization bonds), with banks (using higher CRR), with exporters and their ilk (using some currency appreciation) and finally, with foreigners (by taxing inflows, as done already by Brazil). This last option was taboo until recently, but actions of Brazil, and a change of heart at the International Monetary Fund (IMF) make this acceptable now. Instead of a direct Tobin tax, RBI may consider applying unremunerated reserve requirements on capital inflows, for a period of, say, six months. This will help reduce volatility and also the probability of “sudden stops”, a form of disruptive outflows that can destabilize financial markets and the economy.
As for exchange rate management, it is important to reiterate that the currency affects not just exports but the entire trade sector. The scope for fighting inflation by making imports cheaper is very limited. Moreover, exports create jobs, imports don’t. An overvalued rupee, especially when compared with Asian peers, creates an unnecessary competitive disadvantage. The chances of yuan revaluation are slim since China now has a current account deficit, for the first time in six years. For a large country such as India, currency is as much a strategic instrument as merely a measure of competitiveness. Sharp and abrupt rupee appreciation can adversely affect small enterprises particularly, as was seen in 2007. Hence, RBI is well advised to restrain itself from using the exchange rate option in fighting inflation.
Clearly, inflation is top priority, and it calls for a maximal response, not minimal, not accommodative, and not tentative.
This is the last in a series of columns by four top economists on their expectations from the Reserve Bank of India’s annual monetary policy announcement scheduled for 20 April that comes against the backdrop of rising inflation and a resurgent economy.
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