In the run-up to Tuesday’s credit policy statement by the Reserve Bank, India has been experiencing higher than acceptable inflation, a growing merchandise trade deficit, still-high rates of domestic credit growth and, most recently, rapid rupee appreciation driven mainly by strong capital account inflows from volatile and sometimes debt-creating inflows. In short, all the classic signs of an overheating economy are increasingly present.
In our view, such trends are neither transitory nor are they merely coincidental or independent of each other. Rather, they are the effect of a structural shortfall in the demand absorption capability of India’s productive base. As such, the Reserve Bank’s credit policy announcement clearly indicates a heightened level of ongoing concern over its ability to restrain aggregate domestic demand before it further strains the supply-side capabilities of the Indian economy.
In the absence of more far-reaching structural reforms to boost supply-side capabilities, Indian fiscal policymakers have no option but to rely on either—i) Expenditure-switching measures, or ii) Expenditure reductions to quell the build-up of macroeconomic imbalances and inflationary pressures. The former—expenditure switching—involves the management of relative prices (including the rupee exchange rate) to ensure that foreign demand for India’s output outstrips domestic demand and thereby assuage the growth of the external deficits. The latter would have to rely on a range of monetary, liquidity, as well as fiscal measures to restrain the level of domestic activity and demand in order to ensure price stability.
However, in India’s case lately, the expenditure-switching option has been virtually neutralized by strong capital account inflows that far exceed its current account deficit and have put substantial upward pressure on the rupee, and also resulted in considerable accumulation of foreign exchange reserves. Such strong capital account inflows are partly debt-creating in nature (commercial borrowings and non-resident Indian deposits) or could be quite volatile (inflows from speculative foreign institutional investors, or yield-seeking portfolio investors). Taken together, the magnitude and quality of capital inflows has not only blunted a policy tool of macroeconomic adjustment, but is also leading to a loss of external competitiveness and an incipient upturn in foreign exchange mismatches on the balance sheets of Indian private-sector borrowers at the peak of a domestic credit cycle.
As a result, the burden of re-establishing macroeconomic stability is increasingly being borne squarely by “expenditure reduction” measures, mostly by monetary authorities. Fiscal measures such as price and export controls on wheat and cement have also played a part in restraining wholesale prices a bit. But, in our view, in the absence of more fundamental fiscal reform, such fiscally-instituted controls merely address currently visible symptoms, rather than future causes, of supply shortages and price pressures.
As a result, it comes as no surprise then that RBI’s announcement on Tuesday has stressed structural mechanisms—such as tighter caps on external commercial borrowing and lower interest rates on NRI deposits, to foster a more competitive exchange rate to ameliorate the growing external imbalance. Although key lending rates as well as the cash reserve requirement were left unchanged, the central bank left no one in doubt of its continuing hawkishness.
In Moody’s view, the pursuit of macroeconomic stability by India’s monetary authorities is going through a critical phase, and is important not only from a business, policy, and political perspective; but also for ensuring a stable trajectory of the sovereign’s local currency rating. In this regard, RBI’s tightening of monetary policy and capital account restrictions is appropriate even if it comes at the short-term cost of balancing economic growth versus scarce economic capacity. In the meantime, Moody’s would anticipate a firmer supply-side policy response that will ensure stronger medium-term growth accompanied by lesser (if any) overheating to achieve this result.
With Aninda Mitra, vice- president and senior analyst, Moody’s Investors Service.
Kristin Lindow is vice- president and senior credit officer, Moody’s Investors Service.