RBI likely to stay behind curve3 min read . Updated: 14 Apr 2010, 09:50 PM IST
RBI likely to stay behind curve
My main concern relates to where India lies in the economic cycle. While it is tempting to believe that the country is at the early stages of recovery with plenty of spare capacity to grow into, I suspect that it is much further advanced in the cycle than that.
According to a quarterly survey conducted by the National Council of Applied Economic Research, for example, more than 97% of companies suggested they were operating “at or above an optimal level of capacity utilization" in January. This is within a whisker of the previous cyclical high reached in early 2007. With this in mind, it is perhaps not surprising that import growth has climbed sharply in recent months, leading to a sizeable deterioration in the trade position.
Meanwhile, survey evidence also points to a growing number of firms experiencing skilled labour shortages. The series is well above its long-term average and might explain why attrition rates and wage growth appear to be moving higher. A January survey by the consultancy firm Hewitt Associates Llc showed that Indian companies were planning to pay wage rises averaging more than 10% in 2010—roughly 4 percentage points higher than in the same survey for 2009.
In a sense, India is a victim of its own success. Having survived the global credit crunch well, it hasn’t taken much of a bounceback in the economy to see capacity constraints re-emerge, particularly in the industrial sector. This puts India in a rather different position from the more trade-dependent economies of the region which felt the full force of the “great recession" in the US and Europe.
It is certainly true to say that Indian companies are reacting to the high utilization rates by boosting their capital expenditure and indeed fixed investment is set to grow by around 16% in 2010-11 (helping drive a strong pick-up in bank credit growth which could touch 30% later this year). The trouble is it will inevitably take time for the extra capacity to come on stream and in the interim the extra capex will use up scarce resources.
Overall, it seems likely that underlying inflationary pressures in India are building and will continue to do so as demand expands strongly. Export demand will benefit further from Asia’s strong, domestic-led recovery, while Indian private consumption and investment will continue to enjoy the benefits of an accommodative fiscal and monetary stance. I also expect to see a strong bounceback in agricultural output following the drought.
One of the difficulties for the policymakers is that India lacks a decent measure of underlying inflation or wage growth on which to base and judge the effectiveness of its decisions. Wholesale and consumer price inflation are at best poor indicators of domestically driven price pressures and at worst downright misleading. They tell us more about international commodity price moves and/or food supply developments than they do about the balance of demand and supply. As such one is left to rely heavily on survey based data of the sort mentioned earlier which are now flashing amber or red.
The case for action is strengthened by the fact that interest rates are at very low levels as RBI slashed rates at the end of 2008 and early 2009 in a successful attempt to head off a severe downturn. Both the repo and reverse repo rates are roughly 2 percentage points below their long-term average. If we take account of inflation, then real rates are significantly negative—highly inappropriate for an economy enjoying a vigorous recovery.
While in my view the case for a rapid “normalization" of interest rates is strong, I suspect the rate rises will prove slow to come through. After all, the central bank and government will continue to worry about a double-dip recession in the US and Europe and might be reassured somewhat by a drop in “measured" inflation rates later this year (reflecting lower commodity price rises).
All in all, I am looking for a total of 200 basis points of repo and reverse repo rate hikes, although I doubt the monetary tightening will be completed before mid-2011.
This is the first of a series of columns by four top economists on their expectations from the Reserve Bank of India’s annual monetary policy announcement scheduled for 20 April that comes against the backdrop of rising inflation and a resurgent economy. Respond to this column at email@example.com