BackPositive real rates, rupee and reserves adequacy
Inflation expectations saw a sharp decline only when the Reserve Bank of India (RBI) managed to turn real rates positive in India
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After the Reserve Bank of India (RBI) adopted an inflation-targeting framework, real rates have turned positive in India, thanks to the central bank’s cautious monetary policy stance and single-minded focus on bringing headline consumer price index (CPI) inflation below 5%. Between FY15 and FY17, CPI inflation has averaged 5.1%, with the momentum continuing to ease over the course of the last three years. In FY17, CPI inflation averaged 4.5%, which was the lowest outturn in a decade. Real interest rates in terms of CPI were 2% on an average in the last three years, which helped to bring inflation expectations down to 9.6% in FY17 (fiscal average), from 13-15% levels in the pre-inflation-targeting period.
Real rates do influence inflation expectations and the evidence is clear in India’s context. It is not coincidental that India’s inflation expectations were uncomfortably high when real rates were also persistently negative. Inflation expectations saw a sharp decline only when the RBI managed to turn real rates positive in India. This implies that in order to lower inflation expectations further, the RBI would need to keep real rates positive in the range of 1.5-2.0%, as it has done in the last few years.
The latest round ( March 2017) of the RBI’s inflation expectations survey shows that households expect inflation to rise to 8.8% one year from now, but the important point to note is that these expectations are still below double-digit levels compared to the pre-inflation-targeting period when inflation expectations were firmly entrenched in the 13-15% range. While the RBI has been able to push inflation expectations lower by 5-6 percentage points, the central bank will likely not remain satisfied with this achievement. In line with its medium-term target of achieving 4% CPI inflation on a durable basis, the central bank will in our view also try to drive inflation expectations sustainably lower by another 4-5 percentage points. This will be relatively difficult to achieve and therefore may require a more conservative stance from the RBI in the period ahead, especially given that global disinflation is behind us.
The policy path that India and the RBI have chosen is to focus more on strengthening financial stability, while continuing with various structural reforms, which is likely to yield dividends in the medium term. Supporting growth remains an important objective for the RBI, but it is not the most important priority for the central bank, in our view. We think the RBI believes that the policies geared towards strengthening the pillars of macro/financial stability (maintaining positive real interest rates, fiscal consolidation, reducing inflation expectations) will help generate better-quality, sustainable growth in the medium term and therefore sees little inconsistency in its policy stance with regard to growth. Indeed, the central bank’s somewhat conservative stance and the government’s resolve to continue with fiscal consolidation are currently paying off—with India continuing to attract large amount of foreign investment inflows.
The improvement in India’s external sector outlook has also been quite impressive. Currently, India has sufficient foreign exchange reserves to cover 11 months of imports, which makes the economy resilient to potential external shocks. But if the 11 months of import cover needs to be maintained, then the central bank will have to continue buying foreign exchange (at least $15-20 billion per year), assuming imports will increase from FY18 onwards on account of higher global oil prices and an incremental recovery in growth.
Given the excess amount of liquidity in the money market, the RBI has shown greater comfort with rupee strength in the current phase, compared to past periods. There is probably another reason why the RBI has tolerated more rupee strength in the current period. Our understanding is that the RBI is comfortable with the current bout of rupee appreciation, because it helps reduce pressure on imported inflation, which is a key source of inflation risk for the Indian economy, as per the central bank’s view.
Apart from the foreign exchange pass-through risks to inflation, there are various other risks (a bad monsoon, pay commission allowance related inflation risk, goods and services tax, etc.) which the RBI does not have control over, and hence the central bank is probably happy with the recent bout of currency appreciation as it helps reduce at least one source of inflation risk (as per the RBI’s estimate, a 5% appreciation of the rupee against the US dollar could soften inflation by 10-15 basis points in FY18).
Going forward, the central bank, in our view, will have to balance its priorities of achieving an ambitious inflation target (4% CPI inflation on a durable basis) while ensuring that reserves adequacy strength remains intact or improves further through steady accumulation of foreign exchange and prudent demand management strategies. We think the RBI will continue with a balanced approach of foreign exchange intervention, which further strengthens the reserve adequacy position, but opportunistically also allow the rupee to appreciate a bit more at times (like in the current episode) to help contain imported inflation risks.
Finally, a word of caution for Indian corporate entities. India’s short-term external debt on a residual maturity basis (up to 1 year) was $189 billion at the end of December 2016. While non-resident Indian deposits ($75 billion), which are sticky in nature, account for the bulk of this short-term external debt, the external commercial borrowings of corporate entities, at $25 billion, are also not trivial. Many Indian companies continue to carry unhedged foreign exchange exposure, which is a risky strategy. While the RBI will continue to manage volatility in the foreign exchange market, this should not be taken for granted, and in our view it would be prudent for companies to continue hedging in a disciplined manner to avoid disappointment in the future.
Kaushik Das is the India chief economist for Deutsche Bank AG.
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