Photo: Pradeep Gaur/Mint
Photo: Pradeep Gaur/Mint

Monetary policy challenges persist in good times and bad

GDP data indicates a recovery is under way, but the numbers on corporate profitability, export performance and industrial output are less rosy

The Indian economy is now considered the world’s fastest-growing major economy. Inflation has dropped from double-digit peaks a few years ago to levels within the central bank’s target this year. The current account deficit has fallen to below 2% of gross domestic product (GDP) from more than twice that level three years ago. Foreign exchange reserves are back at high levels. This year’s budget reiterated the government’s commitment to fiscal consolidation.

This is the context in which India’s central bank will soon announce its monetary policy decision. Arguably, it is more favourable than in 2013, when India’s inflation hovered around double digits, the current account deficit had doubled as a percentage of GDP over the previous two years, while the real GDP growth rate had decelerated rapidly and balance of payments volatility was weakening the reserves position.

Yet, almost three years since India was buffeted by the so-called taper tantrum, the challenges of calibrating monetary policy to support growth without triggering inflation have not diminished. GDP data indicates a recovery is under way, but the numbers on corporate profitability, export performance and industrial output are less rosy. Bank balance sheets are still under duress. It is unclear how civil servant pay hikes will affect fiscal and inflation metrics this year. The benefits of lower oil prices on the current account deficit are somewhat offset by a more subdued outlook for remittances from migrants in oil-exporting regions. And the external financial environment remains volatile.

All central banks have to navigate the trade-off between domestic growth and inflation in an uncertain global environment this year. But India’s central bank has an additional challenge, because the extent to which this year’s monsoon will support or damage growth and inflation will remain a mystery until mid-year.

The potential risk of drought recurs annually, and constrains monetary policymaking in India, more so than in other economies of similar size and diversity. In general, weak growth is associated with a lower inflation outlook, allowing for monetary policy stimulus without consequent inflationary pressures. But a poor monsoon in India simultaneously weakens growth and spurs food inflation, complicating the central bank’s determination of growth/inflation trade-offs.

Monetary policy loosening to revive weak growth would exacerbate inflationary pressures. But tightening policy to dampen inflation could intensify the growth slowdown. Especially at this juncture, when the economic recovery is still fragile, India’s vulnerability to drought heightens monetary policy challenges.

Why is India more vulnerable to patterns of rainfall than its peers? There are several reasons. First, India’s weak rural infrastructure exacerbates the impact of volatile rainfall on agricultural output. Second, the relatively high share of agriculture in employment amplifies the impact of lower output on rural incomes, and hence GDP growth. Third, inefficient food distribution heightens the inflationary impact of lower agricultural output on the cost of food. Moreover, given low average income levels, a large portion of Indian household spending goes towards food, so total consumption suffers when food inflation eats into rural and urban household purchasing power. And finally, the impact of food inflation on the government’s food subsidy bill raises fiscal risks.

Notwithstanding the vulnerability to the monsoon described above, Indian inflation did decline over the past year, despite a somewhat suboptimal monsoon. Lower oil prices helped, as did the implementation of an inflation-targeting framework. However, in coming years, India’s demographics will steadily increase food demand, so unless supply is strengthened, food inflation will remain a constraint on the economy.

For the next few days, the key question about monetary policy will simply be whether or not the Reserve Bank of India changes policy rates. But for the longer term, the key issue is whether India’s food supply and distribution can be strengthened and made resilient to fluctuations in rainfall such that the uncertainty around the monsoon ceases to be a monetary policy constraint. Of course, such a strengthening of the agricultural sector would have numerous other economic benefits as well.

Atsi Sheth is Associate MD (Sovereign Risk Group), Moody’s Investors Service.