It has been a turbulent year for markets and the economy, but for the Reserve Bank of India (RBI), this is only the beginning of challenging times.
At the start of the year, the chief macro concern was the impact of the US downturn and global credit crunch on India’s growth. By mid-March, a second global shock hit the Indian economy — high commodity prices, especially oil.
Consequently, the overriding concern became inflation. Caught in the mindset of slowing growth, and viewing the commodity shock as temporary, RBI was too complacent on inflation. Since June, however, RBI has adopted a very hawkish stance, and Tuesday’s move was in that direction.
The higher than expected rate hike was warranted and appropriate to contain inflationary expectations and get ahead of the curve. Going forward, the danger is that the preoccupation with inflation may cause RBI to go overboard in containing demand. With clear signs that the economy is slowing, will RBI be behind the curve again. In other words, having engineered a slowdown, is RBI ready for it?
A slowdown in growth is imminent. Investment demand, which contributed nearly half of total GDP (gross domestic product) growth in FY08, will be significantly affected by higher interest rates.
The drying up of the primary equity market, the government’s crowding out of private sector credit and the demands from oil will worsen the financing constraints that companies trying to build capacity are facing.
We expect the impact to be felt primarily in FY10, and growth to slow even more than in FY09.
Going forward, concerns about growth should take precedence over inflation.
The impending slowdown in demand, prospects of a normal monsoon, a slowdown in the rate of change of commodity prices, well-anchored inflationary expectations, ongoing productivity change, and especially a high base, will help make inflation less of a concern in 2009.
Although headline inflation numbers may not come off meaningfully until well into 2009, RBI needs to read the tea leaves carefully and respond with alacrity if demand slows significantly. In particular, it needs to focus diligently on the health of the financial system, so that the latter is not adversely affected by the downturn.
As the credit cycle turns after four years of credit growing at nearly 30%, defaults and delinquencies will rise. As banks’ asset quality turns for the worse, all the central bank’s skills would be called to guard against any systemic implications of deterioration in bank balance sheets.
This would entail a heightened vigil to guard against dislocations in the availability of liquidity. A growth slowdown would require a toolkit slightly different from the instruments that RBI has been using lately. For the economy to achieve a soft landing, it is imperative that the central bank remains ahead of the curve on its concerns about growth.
Tushar Poddar is vice-president, Asia Economic Research, Goldman Sachs.