Three bumps in the road ahead

There is now a palpable sense of relief as the monsoon rapidly advances across peninsular India. There is hope that a good monsoon, after two successive drought years, will ease rural distress, bring down food prices and boost demand for consumer goods.

Such optimism is understandable, but it is very likely that three key risks that India will have to face in the coming months will get far less attention than they deserve. These risks are definitely not of the scale that almost tipped the economy into a crisis three years ago. However, they cannot be ignored because they will present stiff challenges to Indian policymakers.

First, global oil prices have been inching up for quite some time now. They are currently near the highest level since the beginning of January. Minister of state for finance Jayant Sinha said last week that the government has no reason to worry—in terms of inflation or the budget arithmetic—even if global oil prices go up to $60 a barrel. That is a fair assessment, since a lot of shale oil will enter the market if prices rise above the $60 mark. But it is also important to remember that the Reserve Bank of India has built its inflation projections assuming oil at $40 a barrel. Rising oil prices will not be a costless affair.

The second emerging risk is on the price front. The Indian central bank has to bring headline inflation down to 5% by January 2017, while the latest inflation reading is 40 basis points above that. Then, it has to shift to its target of 4% by January 2018. Inflation expectations are still much higher than actual inflation. The road from here may not be easy.

It is widely believed that a good monsoon will help crack the persistent food inflation problem, but there is not enough empirical evidence to back this claim. The correlation between the monsoon and food prices is weak. So, the last stage in the fight against high inflation could be more tricky than most observers assume, especially since the RBI is now committed to an accommodative monetary policy that includes massive liquidity injection over the next few months as part of its new liquidity management framework. It is also useful to remember that meaningful disinflation ended more than a year ago. Inflation has been sticky since then.

The third challenge could be faced in the foreign exchange market. The Indian central bank had pulled in some $30 billion of dollar deposits in September 2013 as part of its defence of the rupee. To make it attractive for banks to get more dollars in, RBI picked up the costs of hedging these dollar liabilities in the swaps market. The $30 billion that came in nearly three years ago will have to be repaid in September, and policymakers are realistically assuming that at least $20 billion will leave the country. To minimize the impact on the exchange rate because of this sudden withdrawal of dollars from India, RBI has been assiduously preparing itself by buying forward dollars. But even the most careful preparation may not be able to completely control excess volatility in the foreign exchange market, especially if there is some global shock at the same time.

None of these risks will overwhelm the Indian economy. But they could be jolts to a system that is now in danger of slipping into a zone of complacency. There is no doubt that India is a beacon of stability in a volatile world, especially when one considers the emerging markets. That does not mean that all our economic problems have disappeared into thin air—or are about to be blown away by the monsoon winds.

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