Exactly a year back, the central bank had initiated the process of closing out the exceptional monetary accommodation successfully created to defend the Indian economy from the worst rigours of the global economic crisis. Over the past 12 months, the Indian economy has responded handsomely and shown how strong were the foundations of the engines that drive investment, consumption and growth in this economy. The Reserve Bank of India (RBI), in its third quarter macroeconomic review, has characterized the strong impetus of growth coming from all directions within the economy.
It has noted that of the exceptionally strong growth recorded in the first half of 2010-11, a large component came from higher investment and, an even larger one, from private final consumption expenditure, while government consumption expenditure took a back seat. It touched upon strong growth in farm sector output and that in corporate sales. Clearly, there is no evidence of a paucity of demand growth. However, there is some evidence of the slack in capacity thinning out. The anecdotal evidence suggests that in some, if not many industries, capacity limits are close to being hit, as the deferment and delays on capital expansion that happened in the second half of 2008-09 and in the first three quarters of 2009-10—as a consequence of the global economic crisis—is now beginning to bite.
Poor economic conditions, combined with acute power shortages had resulted in closure of some castings and forging units in the crisis period, which is further compounding the problem today, especially in the engineering industry. The order book of equipment manufacturers is reportedly full, and there is a considerable waiting period for delivery. While conditions are conducive for a stepping up of industrial output, increases in capacity are likely to begin materializing in a significant manner only in the middle of 2011-12. Or so the anecdotal evidence would suggest.
In addition to the strong domestic economy, export conditions are also improving—especially over the past six months. Of our export sectors, the hardest hit during the crisis was the engineering industry, especially the auto components sector.
There has been a sharp rebound here, especially since September 2010. Other exporting sectors, including textiles and apparel, are also experiencing conditions favourable to growth. In part, this is due to surging domestic demand in China and, as a result, improved competitive conditions globally.
Any economy growing at close to 9% is bound to face inflationary pressures. Further, globally there has been a surge in prices—especially in commodities—even as the economic recovery in advanced western economies remains somewhat subdued. Then, again, the magnitude of accommodation—both fiscal and monetary—that the developed economies (and to an extent, developing ones also) have injected into the global economy is massive. That their lagged and unintended effects could be felt on prices is hardly unexpected.
Furthermore, currency markets are in a state of heightened flux, deriving from (a) the debt crisis of some euro zone members, (b) the general uncertainties on both sides of the Atlantic and (c) the perceived, if not stated, objective of driving down (with limited success) the external value of the dollar, relative to Asian currencies, especially the Chinese renminbi, and with much greater success (even if unintended) vis-à-vis the euro and yen. In this climate, commodities tend to acquire a monetary character—conditions that are adverse to monetary stability.
In this context, RBI has quite correctly taken the steps it has to tighten the monetary stance by another notch. It has signalled that it will make the necessary adjustments to ensure adequate liquidity for the credit demands of the economy.
In a situation where you need to protect the growth momentum while preserving price stability, raising the cost of capital is one available instrument for the monetary authority to push for greater efficiency in capital allocation.
Even as more supply comes in and also, perhaps, greater efficiency in diverse areas, as long as the Indian economy continues (hopefully) on a trajectory of 9% growth, it will have to do so in a domestic environment where monetary policy will always have to be on guard against inflation. While RBI has raised its expected inflation in March 2011 to 7%, this is not a target—just two months before the event. RBI sees that with appropriate fiscal consolidation (and other supportive policy measures) inflation would moderate through 2011-12.
Saumitra Chaudhury is member, Planning Commission.