The Reserve Bank of India (RBI) has acted along expected lines in its attempt to restrain inflationary concerns and sustain gross domestic product (GDP) growth rate by not dampening investment demand. I doubt if anyone will argue against RBI moving to a tighter monetary policy stance in the given circumstances. The issue is whether it has underestimated the inflationary risks and not acted strongly enough in a situation wherein it will face substantially greater pressure on liquidity management and where global commodity prices could be rather volatile with an upward bias.
RBI projects GDP growth rate for 2010-11 at 8% with an upside bias. This could well be too much of a good thing. In the event, RBI may have overlooked some major downside risks to GDP growth. The first of these, which it acknowledges, is the worrying developments in the external sector. The year 2009-10 is estimated to have ended with an exceptionally large current account deficit of 4.1% of GDP, compared with 2.4% in 2008-09 and 3% in 1990-91, the latter being the year of the twin crises. This should normally result in a depreciation of the exchange rate, to achieve a better external balance. However, the rupee appreciated by 15% in 2009-10 (till February) against a depreciation of 10.4% in the previous year. This will put a strong constraint on the economy benefiting from higher external demand.
Moreover, with the persistence of an accommodative monetary policy in the Organisation for Economic Co-operation and Development economies, more foreign capital flows will be attracted to the country, pushing up the exchange rate further. This could be handled if RBI had the space to sterilize the larger inflows. But, sadly, it does not because the government’s borrowing programme has to be financed by issuance of fresh securities, which will be 36% higher. The government borrowing to be financed by RBI through securities is estimated to be 4.91% of GDP in 2010-11 compared with 4.07% in 2009-10. The RBI governor’s statement pithily states the central bank’s dilemma when it says: “While monetary policy considerations demand that surplus liquidity be absorbed, debt management considerations warrant supportive liquidity conditions.” Higher bond yields will dampen investment sentiments.
The second risk is in the extreme dependence on investment demand for sustaining growth. Winding down of public expenditure to achieve the stipulated reduction in fiscal deficit by 1.2% of GDP in 2010-11 will reduce the contribution of government demand to GDP growth to less than 14%, which it was in 2009-10. Private consumption accounted for 36% and net exports contributed a whopping 20%. This is completely in contrast with the trend of negative 8% contribution of net exports to GDP growth during 2001-08 and was achieved only because imports slumped much more than exports. With imports rising at 66% in February, it is clear that net external demand will become negative again in 2010-11. Private consumption demand will be on a slower track due to wearing off of the one-time effects of the Sixth Pay Commission awards and the farm debt waiver. It will also weaken in response to rising prices of manufactured goods.
This leaves only investment demand, which contributed a measly 26% to GDP growth in 2009-10, but is admittedly on the rise, with non-food credit offtake coming up to 16.9% by March 2010 compared with 17.3% in 2008-09 and 22% in 2007-08. But it is still weak. The steady increase in the growth rate of capital goods imports since September also points in the same direction. But the business expectation index has begun to moderate. The hike in banks’ lending rates, already announced, and which are likely in the wake of this round of monetary tightening and the government borrowing requirement, could further weaken investment intentions. The appreciating rupee will also dampen capacity expansion and employment generation in the export-oriented sector.
Overall it may have been more realistic for RBI to keep its sights at a lower GDP growth of 6.5-7%. A lower growth target, still stellar compared with an expected global growth rate of 3.6% in 2010-11, would have allowed RBI to take a more robust approach to tackling inflationary expectations. This would also have sent the necessary signal to the government to pursue the programme of second-generation structural reforms more vigorously. That alone would have raised the growth rate of potential output.
RBI’s estimate of Wholesale Price Index inflation of 5.5% in March 2011 is perhaps too low. From our estimates, inflation is set to rise in the coming months and will remain in double digits until around October, and then decline to 7-8% by March 2011 if there is no further stress on food supplies or a rise in global oil and commodity prices. So RBI could have acted more decisively to try and get ahead of the curve on controlling inflation and put the onus more clearly on implementing a programme of structural reforms and keeping government borrowings on a very tight leash.
Rajiv Kumar is director and chief executive of the Indian Council for Research on International Economic Relations. These are his personal views. Comment at firstname.lastname@example.org