One of the objectives of making monetary policy announcements more frequent was, as the Reserve Bank of India’s December 2010 Financial Stability Report puts it, “to help manage expectations and reduce uncertainties”. That doesn’t seem to have helped on both counts.
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Inflationary expectations among households have kept on rising and, as for reducing uncertainties, the central bank added to it when it surprised the market by raising the policy rate by 50 basis points during its last monetary policy meeting. This time too, most economists expect a 25 basis points hike in the policy rate, because wholesale price inflation stubbornly refuses to come down, in spite of the helpful impact of a high base.
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But what is RBI’s thinking about the macroeconomy at present? Several clues are available in its latest, or June 2011 edition, of its Financial Stability Report. It’s pretty blunt and concise about its view. Here’s what it says : “On the domestic front, growth is likely to moderate while inflation is likely to remain firm because of rising commodity prices. This is expected to have an adverse impact on the fiscal consolidation process. The current account deficit is likely to remain elevated because of rise in imports resulting from higher oil and commodity prices, along with challenges of financing, as global conditions increase volatility in capital flows. High input prices and interest costs may result in downward pressure on margins of corporates. The aggregate impact of moderately paced global recovery, domestic growth moderation, upside risks to inflation and higher interest rates on the financial sector is likely to remain somewhat adverse during the year.”
In a few simple words, the optimistic view in a section of the market that the second half of the year is likely to be better than the first has been effectively scotched. Growth is going to slow, while inflation is going to remain high. It won’t be stagflation because growth is still going to be pretty high, but we could call it “stagflation with Indian characteristics” or, perhaps more appropriately, moderate-growth-flation. The report says that inflation will face upward pressure from “fuller pass-through of oil and coal prices, higher subsidy expenditure of the government and rise in wages and raw material prices.” Add to that, the stickiness in food prices as a result of the masses, for the first time, being able to afford some decent food, thanks to the social security measures announced by the government.
To be sure, RBI had said that inflation would remain high in the first half of the year and the 9% print in May would not surprise it. We could even argue, it’ll be pleased that growth is finally slowing, which is what it wanted. But what it wouldn’t be pleased about is the rise in inflation in non-food manufactured products, its proxy for core inflation. That suggests pricing power among firms is strong and so is demand. And it’s interesting that non-food manufacturing inflation is up at a time when commodity prices had fallen.
The financial stability report contains what the central bank calls a “macroeconomic risk map” with six points. These risks are global, capital flows, inflation, fiscal, corporate and household. The difference between the June report and the December 2010 one is that while global risks have declined, inflation risks have increased. The rest of the factors have seen no change.
But then, the June report also says that the fiscal deficit for the current year is likely to be much higher than projected this year, because of higher oil and fertilizer prices and consequently higher subsidies, a belief it shares with most of us, except the finance minister. That means higher borrowing by the government and, combined with RBI’s monetary tightening and the already high credit-deposit ratio with banks, it will result in even higher interest rates.
What’s more, the financial stability report also mentions a few risks to the corporate sector, which has been borrowing cheaply abroad, without much thought about hedging its exposure. Companies had also raised money through foreign currency convertible bonds (FCCBs) during the boom years and it’s now time for payback, since many of their share prices are well below the conversion price. Says the report, “More than a few firms potentially face severe funding problems in the next two years which may not remain confined to their industries.” The accompanying chart shows the amount of FCCBs coming up for redemption in the next few years.
So there we have it—slowing growth, high inflation, a squeeze in margins, high interest rates and risks from foreign borrowing—and there’s little reason to be optimistic about corporate earnings or about equities. As if that was not quite enough, the RBI also sees the risk of a further slowing of capital inflows. The report says, “Financing of CAD (current account deficit) is going to be a challenge as advanced countries begin exiting from their accommodative monetary policy stance. This could slow down capital inflows to EMEs (emerging market economies), including India, as investors rebalance their portfolios.”
The only positive is that most of these fears have already been baked into equity prices.
Graphic by Paras Jain/Mint
Manas Chakravarty looks at trends and issues in the financial markets. Comment at firstname.lastname@example.org