In line with consensus expectation, the Reserve Bank of India (RBI) hiked both the repo and reverse repo rates by 25 basis points (bps) each. In doing so, following the pause in December, RBI flagged off renewed inflation concerns that had looked like subsiding for a brief while last year. Indeed, RBI is not concerned only about inflation but about a host of macroeconomic risks to the India story. These include the high current account deficit (CAD), its financing and the fiscal situation. It is this concern over how these risks could affect both the real and financial sectors that has likely persuaded RBI not to opt for a 50 bps hike.
Of the risks mentioned, the stress laid on CAD feels like fighting last year’s battle. To be sure, CAD averaged around 3.5% of GDP for the four quarters ending Q2FY11, but it may have peaked at 4.1% of GDP in Q2. Going by the declining trend in monthly goods trade deficit since September—it averaged $7.1 billion in Q3 compared with $11.7 billion in Q2—I expect FY11 CAD at 3.1% of GDP. Looking ahead, I expect the CAD/GDP ratio to flatten out in FY12. Although CAD/GDP of around 3% still poses risk as long as it is coupled with large government deficits, the risk has receded compared with H1FY11.
The other two risks mentioned by RBI are, however, clear and present. And, as the central bank has elaborated in the policy statement, government policy has a central role in addressing these risks. On inflation, government policy has consisted of augmenting rural incomes and demand while not investing in improving productivity and output of agri-commodities, leading to persistent demand-supply imbalances. The government needs to adopt a medium-term strategy to augment agri-output through direct investment or, more likely, by reducing controls over the sector and encouraging greater private sector participation.
On the fiscal deficit, the government needs to unveil a credible strategy for medium-term consolidation focusing on both increasing the tax/GDP ratio and on compressing expenditure growth. A hike in excise duty and expanding the service tax net would help, even if it has some inflationary impact in the short run.
On the expenditure side, a two-year moratorium on launching new social sector schemes would be a good start. While this may be far fetched, absent some significant and credible effort at fiscal consolidation in the forthcoming Budget, RBI’s fears on macro-risks may come to pass.
The central bank may have no choice but to keep hiking policy rates given the inflation outlook. I see Wholesale Price Index (WPI) inflation averaging 7.5% in FY12 and remaining above 7% till November. Therefore, I expect another 75 bps of hikes in liquidity adjustment facility (LAF) rates in the rest of 2011, with a high likelihood that the next hike is effected in March. Tight liquidity conditions are also likely to persist well into FY12, even with some improvement in the balance of payments, ensuring that the monetary transmission process will remain strong.
A. Prasanna is senior vice-president, ICICI Securities Primary Dealership Ltd.