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A research report from the State Bank of India’s Economic Research Department says that at least 59% of the increase in inflation is because of geo-political conflict, and it is futile to blame central banks. 

The report has been authored by Dr. Soumya Kanti Ghosh, group chief economic adviser, State Bank of India.

Here are the key highlights from the report.

Inflation continues to be a bugbear and it looks unlikely that it will correct anytime soon. The latest inflation numbers however reveal that while in the rural areas, the impact has been disproportionately higher for food prices, in urban areas it is disproportionately higher as far as fuel price impact and pass through is concerned since the war began, as per the report.

We did a dipstick study to understand the exclusive impact of war on inflation trajectory in both the rural and urban areas. Using February as the base case (the beginning of the Ukraine and Russia conflict), our study reveals that because of war alone, Food and Beverages (assuming that vegetable price increase was mostly because of seasonal factors, that are largely domestic) and Fuel and Light & Transport contributed 52% of the increase in overall inflation since February. If we also add the impact of input costs particularly on the FMCG sector, thus adding the contribution of personal care and effects, the total impact at all India level comes to 59%, purely because of war.

Against the continued increase in inflation, it is now almost certain that RBI will raise rates in forthcoming June and August policy and will take it to pre-pandemic level of 5.15% by August. However, the important challenge facing the central bank remains whether inflation will tread down meaningfully because of such rate hikes if war related disruptions do not subside quickly.

In particular, as retail loans are benchmarked to an external rate (mostly to RBI’s repo rate) with quarterly reset clause, so the interest rate on loans benchmarked to repo rate will increase directly with the increase in repo rate. As of Dec’2021, around 39.2% of the loans are benchmarked to external benchmarks, so the increase in repo rate will eventually increase interest cost. In a situation of incipient demand recovery post Covid, the question will be whether growth could be a large casualty in case of large and persistent rate increases, even as inflation prints will continue to be of serious concern.

As per the report, it is noteworthy that transmission to lending rates since October 2019 reveals that even as repo rate was cut by 140 basis points, the weighted average lending rate (WALR) on fresh rupee loans declined by more than 186 basis points. This was one of the primary reasons for significant jump in credit impulses during pandemic, apart from financial stability concerns being addressed eloquently by RBI through using yield curve as a public good. The current turbulence in a way mirrors such conundrum the RBI faced while navigating through the pandemic as larger rate hikes to quell inflation might have an impact on nascent growth impulses. Also, the RBI may have to use a shorter window to address inflationary concerns given the realpolitik challenges in the not so distant horizon.

We thus must support RBI in its endeavour to quell inflation through hikes in interest rates. A higher interest rate will be also positive for the financial system as risks will get repriced. The situation is different than during the global financial crisis wherein the lending started increasing aggressively from March 2009 onwards much before the rate hike cycle began (Mar’2010 till March’2012). Currently, the rate hike cycle has begun and now the bank lending will increase according to the adequate risk pricing and demand. Interestingly, retail personal loans have grown at a scorching pace of 23.1% in FY22 with an interest rate that is much higher than home loan rates which are EBLR linked rates. Additionally, Household Leverage as a % of GDP has now declined to 31.8% of GDP in March 2022 from a high of 37.2% in March 2021, said the report.

There is one point of caution though. Indian inflation internals are much different than those of advanced economies such as the US. Building wage pressures mirrored in the multi-decadal high annual wage growth are fueling broad-based price pressures across all advanced economies. In contrast, in India nominal rural wages for both agricultural and non-agricultural labourers picked up during H2 FY22, with easing of restrictions/lockdowns imposed by states and restoration in economic activity. However, the wage growth has remained soft. The weighted contribution of wage growth in CPI build-up remains modest. Thus, even after rate hikes, inflation will take time to moderate in India.

We also strongly recommend that the RBI may intervene in the NDF market instead of the onshore market through Banks during Indian time zone as this has the benefit of not impacting rupee liquidity. This will also save the foreign exchange reserves, with only settlement of differential amount with counterparties on maturity dates, said the report.

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