Rigidly high inflation is not the only blot on India’s macroeconomic landscape at this point. At least two other specks – fiscal and current account deficits – need watching. The picture could get blurred anytime as drying capital inflows and a depreciating currency feed through into the troika.
As bad luck would have it, foreign capital is rapidly fleeing to safer pastures just when a stronger currency could help. The RBI flagged the rupee’s fall as it combated inflation in its policy review last Friday. Two days before, it intervened to arrest its steep slide - 5% over its August average – as the currency pierced the Rs 48 per dollar price. The rupee is tightly correlated to the stock market. The Sensex, in turn, is largely driven by foreign investment flows. A cool $1.8 billion exited India’s markets in August due to escalating risk aversion of global investors, nervous about Europe’s sovereign debt crisis.
That is no good for inflation. Depreciation especially hurts oil companies and other commodities even as it benefits exporters. But with external demand slowing across advanced, and even Asian, countries, it is oil and commodity imports that matter far more at the moment. Rupee depreciation prompted policy makers to raise petrol prices last week as a worsening balance sheet loomed ahead due to rising subsidies and lower revenues as growth slows.
At times like these, India’s current account deficit - at 2.8% of GDP in March 2011 on an annual basis - and its vulnerability to shocks on the capital account contrast unfavorably with other Asian economies that appear far more virtuous with their current account surpluses and lower inflation rates; their currencies fall much less too, as the last fortnight saw.
Unfortunately, it looks as though policy makers may have to put up with a weak currency for a while. In a worsening global situation, efforts to boost capital inflows through other routes – raising the overall cap on external commercial borrowings to $30 bn – are unlikely to bear much fruit. Despite the large interest differentials between foreign-domestic interest rates, European lenders are freezing up loans.
The future may not be so bleak, however. Net capital flows have been positive in September, although meager at half a billion dollars. The economy is slowing in response to monetary tightening; demand pressures upon future price increases are thus likely to ease. If global financial and economic conditions continue to deteriorate, lower commodity prices will feed back into lower inflation at home. And the spot that’s hardest to clean – the fiscal deficit – looks to be getting scrubbed a bit. Recent reports say that policy makers’ heads are bent seriously to utilize savings (Rs 200-250 bn), cut some of the Rs 1680 bn planned spending on big schemes and rollover a part of the burden to the next financial year as oil firms’ dues touch Rs 1200 bn.
They should keep at it, for the fiscal flexibility that existed in 2008 no longer exists.
Renu Kohli is a macroeconomist and a former staff member of the International Monetary Fund and the Reserve Bank of India.