The Fed stumbled where RBI steadied the ship
4 min read . Updated: 21 Jul 2022, 09:56 AM IST
PremiumOur central bank diagnosed its causes more accurately while keeping currency risks under watch
Even as the world grapples with a surge in inflation, it seems India’s price rise may have already peaked. While it is certain that inflation will stay elevated in first half of 2022-23, with readings more than 7% till September, the second-half prognosis looks bright with March 2023 inflation likely to be in the 5-5.5% range. This would mean that monetary policy might be less aggressive than anticipated earlier.
The problem, however, lies with central banks in developed economies that should have normalized monetary policy from mid-2021 onwards. US inflation data for June at 9.1% reveals how far the US Fed is behind the curve. Interestingly, even as the US unemployment rate is at its lowest levels, its labour market vacancy rates are high. This indicates that the Fed’s inflation fight will require a clear decline in labour market vacancies and an increase in the joblessness rate. Those vacancies will need to be filled through a careful matching of skills. Thus, the outcome of the Fed’s continual rate hikes may not be an outright recession, but more of a slow-growth phase with high inflation.
All this means that the world will witness conflicting macro readings in the next several months, with inflation in developed countries staying elevated and facing an uncertain trajectory, while inflation in developing economies like India is likely to decline. Clearly, central banks in developing economies, like RBI, have outsmarted their counterparts in developed economies. In hindsight, the most important thing in diagnosing the causes of inflation is to first identify whether it is demand-pull or cost-push inflation. It is anybody’s guess why the Fed did not raise rates when the US saw a discernible upward shift in job vacancy rates from April 2021 onwards even as unemployment rage declined. Instead, the Fed characterized it as cost-push inflation and even divided it into transitory and permanent components.
In essence, central banks in emerging economies, like RBI, had correctly diagnosed inflation as being more cost push. Our analysis using 299 commodities in the headline Consumer Price Index (CPI) basket reveals that supply-side factors are responsible for almost two-thirds of today’s elevated CPI inflation. This in part reflects supply constraints from continued global supply disruptions related to the pandemic and Ukraine war. Demand factors contribute only one-third to CPI inflation. In India, CPI inflation attributable to supply-side factors started moving up last September while demand-led CPI remained mostly constant. While RBI may have to raise rates further, a clear downward trend in inflation attributable to supply factors bodes well for our inflation trajectory.
The moot point in all this is that our rupee could remain under pressure and future rate actions by RBI could be dictated by factors other than inflation! This is an irony in itself.
Meanwhile, even as the rupee has been under pressure, though it has done better against the US dollar than other emerging market currencies, some ignorant and factually incorrect analysis has appeared of India’s external debt status. RBI’s status report on ‘India’s External Debt as at the end of March 2022’ indicates that the short-term debt on residual maturity constituted 43.1% ($267.7 billion) of total external debt ($620.7 billion) at end-March 2022 (44.1% at end-March 2021), and stood at 44.1% of forex reserves (43.8% at end-March 2021). The share of short-term debt (with original maturity of up to one year) in total external debt was at 19.6% at end-March 2022. Similarly, the ratio of short-term debt (original maturity) to forex reserves increased marginally to 20% at end-March 2022 (17.5% at end-March 2021).
In interpreting this ratio of short-term to external debt, needless confusion was created that it will significantly erode India’s forex reserves next year and put further pressure on the rupee. This is a fallacy, as short-term debt is purely an indicator of a country’s liquidity risk and must never be confused with solvency risk. The correct measure for liquidity risk is our import cover ratio, which is currently at 9.5 months, just a tad lower than the world average.
Short-term trade credit, with a share of 95-98%, has been the largest component of short-term debt since 2014-15. Tenors of 6 months to 1 year have been the largest component of short-term trade credit. Such credit has always been a widely used route for Indian importers to meet their payment obligations at competitive costs through banks and institutions overseas. Buyer’s credit is usually opened by them based on stand-by letters of credit issued by domestic banks, so the probability of default is almost non-existent on this front, as ultimate payment responsibility lies with the Indian bank of the importer. Also, payment obligations are hedged as per RBI directives (unless a natural hedge is available); so rupee volatility or a rise in interest costs can affect sentiments for availing fresh trade credit but would have a negligible impact on existing obligations. It’s mostly large corporates that avail of trade credit and they routinely roll it over every year, and this could be anywhere between 10-15%, as per the latest data.
Clearly, India is much better placed on macro indicators, especially on the external front, than some critics argue.
These are the author’s personal views.
Soumya Kanti Ghosh is group chief economic advisor, State Bank of India
