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More tightening seen from RBI despite mounting global woes

More tightening seen from RBI despite mounting global woes
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First Published: Wed, Aug 10 2011. 06 33 PM IST
Updated: Wed, Aug 10 2011. 06 33 PM IST
Mumbai: The Reserve Bank of India (RBI) is expected to continue tightening policy in coming months until inflation peaks, despite increasing uncertainty over a global economic slowdown and an extended period of easy policy in the developed world.
Further tightening in Asia’s third-largest economy would contrast sharply with the approach of central banks in China and other parts of the world, which are increasingly expected to put plans for more rate rises on ice until the global outlook improves.
Heavy selling in financial markets in recent sessions, Europe’s festering debt crisis and the US Federal Reserve’s pledge on Tuesday to keep rates near zero for at least two more years have only reinforced that cautious view.
The RBI next meets to review policy on 16 September. It has already raised rates 11 times since March 2010 as it struggles to rein in stubbornly high inflation, with the last hike being a shock 50 basis points (bps) last month.
Some players have begun to price in a pause in rate hikes, as seen by a retreat in bond yields and fall in the short-end rate swaps. But inflationary pressures in India show few signs of abating even as global commodity prices have recoiled from recent highs.
Here are some questions and answers on the likely scenarios for the economy and the course of action the central bank may take:
Will RBI’s focus shift from inflation to growth?
Unlikely. The RBI can’t take its eyes off inflation despite renewed concerns about the health of the global economy.
Nearly all headline inflation estimates for India expect it to remain above 9% until October, with the peak likely in September. Even then, price pressures are expected to remain strong for some time, moderating only slowly over the following months.
The wholesale price index (WPI), India’s main inflation gauge, rose an annual 9.44% in June, well above the RBI’s upwardly revised forecast of 7% for end-March and its “comfort” range of 4-4.5%.
Global commodity prices, which have a large impact on the country’s headline WPI, may remain uncomfortably elevated despite retreating globally in recent weeks.
Commodity prices so far are behaving differently from their post-Lehman extended slide and are showing signs of a rebound. Even if that does not last, they are bound to remain highly volatile.
India’s food price index rose 8.04% in the year to 23 July while the fuel price index surged 12.12%, data showed last week. The primary articles index was up 10.99% compared with an annual rise of 10.49% a week earlier.
Factory and service sector PMI reports last week also showed input costs continued to rise sharply in July, and those increases will inevitably bleed into the broader economy, adding to the argument for further policy tightening.
While debt problems in the US and Europe and market turmoil have revived fears of another global crisis, some analysts noted the situation was far different than the dark days after Lehman Brothers’ collapsed in late 2008. For one, inflation had already peaked and was steadily easing at that point, giving central banks more room to act to help stimulate their economies.
If global growth does slows further, it may help in cooling commodity prices to a more tolerable level. But much of India’s problems stem back to supply-side pressures such as inadequate infrastructure to get products to market, sluggish investment and political paralysis on tackling unpopular but much needed reforms.
How will the US ratings downgrade impact India?
Not much.
If S&P’s credit downgrade of the United States on Friday erodes business and consumer confidence further and leads to higher borrowing costs, the US economy could remain sluggish for much longer than earlier anticipated. But unless the US economy tips back into recession, the impact on India is not expected to be that significant.
Unlike many of its export-reliant Asian neighbours, the drivers of India’s growth are largely domestic. The RBI has said it won’t be too worried about growth unless it consistently falls below 8%. The economy expanded by 7.8% in the Jan-March quarter from a year earlier, less than expected.
Growth will likely slow, but analysts do not expect a sharp correction. A top government panel now expects the economy to clock growth of 8.2% in the current fiscal year, while the RBI is still holding on to its baseline 8% projection.
Will the RBI take pre-emptive steps to help money markets?
No. The call rate, which has been an indicator for money market volatility, has closely hugged the central bank’s main lending rate which stands at 8%. Stock markets have been volatile, but there has been no margin call issues.
The RBI has a daily liquidity injection window as well as a newly instituted emergency borrowing facility. Money market participants will be expected to take recourse to that if needed.
The central bank will keep a close eye on the call rate, any stock market margin calls as well as mutual fund redemption pressures for signs of stress.
Will the RBI intervene in forex market?
Unlikely. The RBI has largely stayed away from the forex market in the last few years, allowing the rupee more flexibility in line with the globalization of the economy.
The RBI will intervene only if there is extreme disruptiveness in the market. Nothing in the rupee’s movements following the US downgrade suggest any need for that.
Is there any chance of RBI diversifying its asset base?
India’s central bank is comfortably placed with over $300 billion in foreign exchange with a large holding of in US Treasuries.
Liquidity will be the key issue when a country thinks to shift its asset base to other currencies like euro or assets like gold. Risk management will be the key imperative when taking any decision. US Treasuries, inspite of the recent downgrade, will remain the key liquid asset for the foreseeable future.
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First Published: Wed, Aug 10 2011. 06 33 PM IST
More Topics: RBI | Monetary Policy | Economy | Rupee | Dollar |