New Delhi: The Reserve Bank of India (RBI) will need to raise its policy rate significantly to bring down inflationary expectations and move towards adopting inflation-targeting as its primary objective, with retail inflation providing the principal nominal anchor for monetary policy, the International Monetary Fund (IMF) said on Thursday. In its annual Article 4 consultation report prepared after discussions with Indian government officials, the IMF said at the current juncture, with food inflation remaining persistently high for five years, monetary policy needs to be tightened to control generalized inflation.

“Given elevated and persistent inflation, the analysis suggests that the RBI may need to raise rates decisively to tackle inflation durably. As inflation is mostly backward looking, monetary policy has to maintain a tight stance for a prolonged period of time," it said.

The report, finalized a day before the RBI’s policy rate hike on 28 January, suggests that the repo rate would need to rise significantly over the next six months to lower inflationary expectations, tackle inflation inertia, and sustainably lower consumer price index (CPI) inflation to around 7% by end-2015.

RBI governor Raghuram Rajan surprised markets and analysts on 28 January by hiking the repo rate at which RBI lends overnight funds to commercial banks to 8%. “To further enhance the effectiveness of monetary policy, the RBI should clearly communicate how it intends to meet its stated inflation objectives and, as part of that process, should publish rolling one-year-ahead projections of both the CPI and WPI (wholesale price index)," the IMF added. “In addition, should high inflation expectations persist and inflation remain sticky, a more front-loaded path of interest rate increases may be needed." However, the IMF noted that during its interaction with the RBI, the central bank held that, given the risks of derailing the ongoing economic recovery and uncertainties surrounding monetary transmission, a gradualist approach was needed to disinflate the economy over an extended period.

“They were less persuaded of the need for a further, significant increase in policy rates to lower inflation and inflationary expectations. Instead, they believed it would be prudent to give some time for the effects of the recent interest rate increases to feed through before revising the policy stance," it added.

The finance ministry, anxious to revive growth, has been critical of the report of an RBI committee headed by deputy governor Urjit Patel that said inflation targeting should be made the main objective of the central bank and called for CPI, rather than WPI, to be made the anchor of monetary policy. Finance minister P. Chidambaram in his interim budget speech on 17 February said that RBI must strike a balance between price stability and growth while formulating monetary policy. “In a developing economy, we must accept that when our aim is high growth there will be a moderate level of inflation," he had said.

The Patel committee set a 4% target for CPI by 2016, within a plus or minus 2% band. For now, RBI should try and bring down inflation from the current level of 8.8% to 8% over a period not exceeding 12 months, and to 6% over a period not exceeding the next 24 months, it said.

The IMF expects CPI to decline from 8.8% in January to around 6.5% in 2018-19.

The IMF said while the RBI should see through the impact of transitory shocks, the current evolution of food prices, rising at a rapid pace for several years, is not a transitory phenomenon and reflects both consumption demand and supply constraints. “In addition, empirically, food price shocks propagate strongly and rapidly into non-food, non-fuel (core) prices," it added.

The Fund said India’s growth slowdown is unusual among emerging markets, both in its severity and the fact it has coincided with rising inflation. “Global factors have certainly hurt exports and weighed on investment. However, staff analysis indicates that about two-thirds of the slowdown can be explained by domestic factors, including supply bottlenecks, delayed project approval and implementation, and heightened policy uncertainty," it said.

The Central Statistics Office (CSO) has projected that India’s economy will grow at 4.9% in the fiscal year ending 31 March against 4.5% a year earlier. Initially a problem of stalled infrastructure and corporate investment, the economic slowdown has become generalized across sectors. The IMF expects economic growth at 4.6% in the fiscal ending 31 March and 5.4% in 2014-15. Given the upcoming general elections expected in April-May, the IMF said it does not expect any further policy changes, but “slightly stronger global growth, improving export competitiveness, a favourable monsoon, and a confidence boost from recent policy actions should deliver a modest growth rebound in the near term."

India’s trend growth is currently estimated at around 5.5% but is expected to rise to its medium-term growth potential of around 6.75% under current policies as unblocked investments are implemented and global growth picks up. The IMF said that since 2007, the risk profile of India’s non-financial corporate sector has significantly increased. Stress tests of corporate balance sheets conducted by the Fund based on four macroeconomic shocks—to domestic and foreign interest rates, the exchange rate, and to profits—show the sector has the highest vulnerabilities to individual shocks since 2002–2003.

The percentage of debt owed by loss-making firms has reached 17.3%. Indian companies whose total debt exceeds five times equity make up more than 18% of the borrowing by Indian corporates. These four indicators of corporate health were at their best in FY 2005/06.

“If a subdued economic outlook and global liquidity tightening combine going forward over a protracted period, further significant deterioration in corporate financial health, and subsequently higher restructured advances and NPAs, can be expected," it added. The IMF said the vulnerability is further aggravated by concentration risk: banking sector loans to India’s ten largest conglomerates account for almost 100% of banks’ net worth.

Biswajit Dhar, director general of the Research and Information System for Developing Countries said since seven members are common to the negotiations of TPP and RCEP, some of the negotiation elements of TPP may sneak into RCEP negotiations through backdoor. “TPP is being touted as the gold standard of trade agreements. Since US does not have the Congressional mandate to negotiate any such trade deal, it will be basically US standards which will be imposed on other negotiating partners. At the RCEP, India should make it clear that it will not accept any pre-determined template and negotiations should be carried out in a democratic way based on aspirations of individual countries," he added.

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