The storm clouds gathering on the horizon are undeniable. The question I am most frequently asked these days is this: Does the Indian economic situation today resemble the one in the middle of 2013?

It is a fair question, given the tremors being felt in other emerging markets such as Turkey and Argentina. However, there are some important differences. Inflation today is half of what it was five years ago. Fiscal deficits are relatively lower than they were then. The current account deficit as a proportion of gross domestic product (GDP) is also less scary. There are ample foreign exchange (forex) reserves that can be brought into play in case there is selling pressure on the rupee.

This is not the time for complacency. Almost all macro indicators have moved in the wrong direction over the past few months; they are flashing amber. Core inflation has gone up. So has the headline inflation number. The current account gap is widening. The rupee is slipping. Bond yields have increased once again. The Reserve Bank of India (RBI)—that was under immense pressure to slash interest rates as well as not accumulate foreign exchange reserves—deserves credit for its conservatism.

Indian policymakers are likely to have a tricky journey in the coming months. The first test will be when the monetary policy committee (MPC) meets in the first week of June. The difference in tone between the policy statement released in April and the MPC minutes released later confused the markets. The volatility in the bond markets led to a buyers’ strike. There is likely to be less ambiguity from the MPC this time around. Most economists in the financial markets are expecting a more hawkish policy statement. Some are betting on a rate hike.

The consensus view earlier this year was that RBI would hold rates steady for a long time. Many now believe that there are two rate hikes coming by December. The market overnight index swaps seem to be pricing cumulative rate hikes of 100 basis points over the next 12 months.

The RBI has a difficult balancing act ahead. It may need to ensure that the money market is not starved of liquidity even as it fights inflation with higher interest rates. Tight liquidity will push bond yields to levels that could further damage bank balance sheets, though critics have been arguing that a central bank with a formal inflation-targeting mandate should not be focused on financial stability issues.

The Indian central bank will have to provide sustainable liquidity, by growing its balance sheet to increase reserve money. How? The RBI is unlikely to have space to increase its forex reserves in the coming months. The most logical alternative to increase its central bank assets to back reserve money creation will be to buy government securities through open market operations (OMOs), a form of quantitative easing. The Indian central bank may need to do OMOs of around Rs1 trillion in this fiscal year if durable liquidity is to be created. There is a third option that was used in 2010—to desequester the securities issued under the market stabilization scheme after demonetisation. That would increase central bank assets through an increase in net RBI credit to government.

The other arithmetic that will matter in the months ahead will be on the external front. The sharp rise in global oil prices is widening the current account gap. India had a modest current account deficit of $15 billion in fiscal 2017. That could shoot up to above $50 billion in fiscal 2018—high, but not alarming. The current account deficit may be more than $75 billion this year in case oil prices stay at current levels. India will thus need $75 billion in capital flows from foreign direct investment as well as foreign portfolio investment to fund the gap, at a time when flows to emerging markets could be hit by higher US interest rates.

The supply of dollars will be squeezed as the US begins to reduce its monetary base as part of the exit from quantitative easing. That is well understood. The other potential cause for worry is that a lower US trade deficit—thanks to the Trump trade offensive against China—could reduce dollar supply to the rest of the world, as was pointed out way back in the 1950s by Robert Triffin. Are we then on the verge of facing a new version of the famous Triffin paradox?

India is likely to be affected by the rising heat in the emerging markets—but not totally consumed by the fire. India is no longer as risky as it was five years ago, but it still has a twin deficit problem. India, Indonesia and the Philippines have faced the most intense selling pressure in Asia, both in the foreign exchange and bond markets, because all three have both fiscal as well as current account gaps.

It is crucial that the Narendra Modi government does not let public finances go off track when inflation is rising while the currency is depreciating. The classic response to macroeconomic stress—especially when the output gap is closing—is prudence in both fiscal and monetary policy.

That is easier said than done as the next general election comes closer. The two key decisions on the fiscal front will be the policy of farm support prices and whether higher global oil prices should be completely passed down to the Indian consumer. They are the two clouds hovering over the fiscal outlook.

The macro calculation is thus as much political as it is financial.

Niranjan Rajadhyaksha is executive editor of Mint.

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