Home / Opinion / Views /  Why the RBI is unlikely to slow down in curbing inflation

Global growth is slowing rapidly, inflation is stubbornly high and central banks in developed nations are hiking interest rates by magnitudes not seen in decades. All this has ramifications for emerging markets in the form of currency pressure and tighter financial conditions, compounding their own problematic growth and inflation mix.

Against this backdrop, we do a pulse check on the state of India’s economy, in the run up to the Reserve Bank of India’s (RBI) 30 September policy meeting.

Is growth slowing? India’s economy grew 13.5% in the June-end quarter, high because of a low base, but lower than what the markets and RBI were expecting. A careful look suggests some problems with trade, transport and retail, as that sector was 15% smaller than three years earlier, in the pre-pandemic world. It’s also a sharp reversal from a quarter before, when it was looking in far better shape. So what went wrong?

Sometimes, there’s simply a glitch, and data is not collected properly, so the gross domestic product (GDP) print undergoes revisions later. At other times, new data sources are introduced to make statistics more accurate, particularly to capture India’s informal sector better. Such ‘improvements’ on the back of new data sources (like the goods and services tax transactions database) can be a possible explanation.

If that’s the case and there’s new and better data leading to weakness, one must brace for the possibility that the informal sector is not doing as well as the formal sector, and that is indeed depressing overall growth. We may get a better idea of this with the next GDP print.

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Either way, for two reasons, growth is expected to slow over the next few quarters. First, exports, which have been a major driver of India’s post-pandemic recovery, are likely to slow because overseas buyers are scaling back. Mid- and low-tech exports have been slowing since June, while volumes of high-tech exports showed the first signs of weakness in August.

Second, the growth fillip from pent-up demand for services may begin to fade. Ever since high-touch services came back into play, so have urban jobs. On average, as Indians move back from their villages to the cities, their wages rise 2.5 times, which boosts consumer spending. But urban jobs are almost back to pre-pandemic levels now.

Where will inflation land? Price pressures emanating from the commodity price shock in March 2022 have moved from the wholesale level to the consumer level (as producers recoup some of the lost profits), from rural to urban inflation (as electricity prices gradually rise), and from goods to services inflation (as services producers pass on price increases). And even before the entire inflation pass-through was complete, a weak grain crop was emerging as a new shock. Cereal prices have risen 16% year-on-year thus far in September. Food price increases, in particular, can mess up inflation expectations, which are already 150 basis points higher than pre-pandemic levels.

Even if consumer price inflation falls from an expected 7.2% in September to 6% by March 2023, it will be well above the 4% target.

Can inflation and the fiscal deficit fall below 5%? We forecast India’s inflation to fall to 5% in 2024-25, but any lower looks unlikely. At some point, policymakers will have to decide if they still need to meet the 4% target frequently, or whether the 4% inflation target should be revisited once the dust settles. The reason is that there’s just too much going on in the world—a realignment of supply chains, changing preferences in the labour markets and fiscal excesses.

On the fiscal front, the good news is that despite pressures to raise current expenses, central government capital expenditure has risen over the last three years. On the other hand, 50% of the net tax revenue is being deployed for debt servicing. Hence, there is an urgent need for fiscal consolidation. The challenge will be to lower the fiscal deficit by raising revenue rather than by cutting capital expenditure.

How wide will the external deficits be? With oil prices falling, we expect the trade deficit to narrow over the next few months—but, with global growth weakening, exports could also fall over time, potentially more than offsetting the gains from weaker oil prices. Hence, we still see the external sector deficit lingering for longer, though thankfully foreign exchange reserves are still elevated at $546 billion.

Also, the dollar may stay stronger for longer, given weak global growth, a risk-off attitude by investors, and commodity prices remaining elevated.

That’s already led RBI to intervene aggressively to keep the rupee from weakening too fast. The dollar has strengthened 20% since the start of the year, but the rupee has weakened only 10%. Further gradual depreciation could boost exports at a time when global demand is weak.

What should RBI do? The inflation-growth mix is likely to remain tricky. For now, we believe big-quantum rate hikes will likely continue for now. We expect a 50 basis points repo rate increase at the meeting on 30 September, followed by another 50 basis points increase in December, taking the repo rate to 6.4%.

Banking sector liquidity has tightened considerably, pushing the call money rate above the policy repo rate. There are many factors for this, including large government balances at RBI, which have been around for a while, and it is uncharacteristic for this time of the year. The recent trend of spending more towards the year-end is also creating liquidity problems at a time of foreign exchange interventions. We expect RBI to bring this up in its discussion with the government.

Pranjul Bhandari is chief India economist at HSBC.

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