Imports as a means to supplement domestic availability may no longer be feasible

There was no doubt that inflation would remain the primary concern of the Reserve Bank of India. The Third Quarter Review of Monetary Policy says so right at the outset. It is not just that the inflation rate remains uncomfortably high. “It is the reversal in the direction of inflation that is striking,'' the RBI says in the policy.

After moderating somewhat between August and November, 2010, inflation rose again in December on the back of sharp increases in the prices of primary articles and the global oil recently. Non-food manufacturing inflation has remained sticky. The RBI attributes it to buoyant demand conditions and rising costs.

In hiking its March, 2011, Wholesale Price Index-based inflation projection to 7 per cent from 5.5 per cent, the RBI is formalising what it had said in the two earlier policy statements — that it would not be meeting its earlier target. In these circumstances, the hike in the two short-term policy rates, the repo and the reverse repo rates by just 0.25 percentage point each seems modest. However, the relatively soft-touch has not only met market expectations, but also gives room for another round of increase, possibly by March. The tone of the policy statement is distinctly hawkish. Even though the inflation control will continue to be at the top of the central bank's agenda, obviously there are other macro economic factors that the RBI will not ignore. Monetary management is becoming increasingly complicated. Food inflation is refusing to decline. It is also becoming more broad-based covering a number of food items. On the other hand, industrial growth is erratic and demonstrating a high degree of volatility.

Although monetary policy cannot directly address supply side factors responsible for inflation, it can anchor inflationary expectations and check the second-round effects, which are transmitted into the economy through increased wages and higher input costs. Notably, the economy has been growing at a robust pace but may hit roadblocks in the next fiscal. The first half of 2010-11 saw the economy growing by 8.9 per cent, which is close to its trend rate. The GDP outlook for the rest of the year looks promising. However, the RBI has stuck to its earlier projection of 8.5 per cent, with an upward bias. There are concerns over the sustainability of industrial growth. The Index of Industrial Production numbers have been extremely volatile: the November figure was just 2.7 per cent. The central bank expects domestic growth momentum to stabilise, though the GDP growth rate may decline somewhat as agriculture reverts to its trend rate (lower than the above 4 per cent projected for 2010-11).

The Cash Reserve Ratio (CRR) has been left unchanged and this again, like the modest hike in the short-term policy rates, was entirely anticipated. Moreover, given the current bouts of liquidity shortages, sucking out money by hiking CRR is not on the cards. In fact, the RBI had taken special steps to allay liquidity concerns that included a reduction in the Statutory Liquidity Ratio and conduct of open market operations in December 2010 to infuse liquidity. The RBI has done well to highlight the risk factors that can impact adversely on growth (8.5 per cent with an upward bias) and inflation projections (7 per cent end March, 2011). As high food inflation persists even after normal monsoons, the prospect of inflation spilling over to the general inflation process is rapidly becoming a reality.

Second, the global scenario has further dimmed the inflation outlook. Imports as a means to supplement domestic availability for many commodities may no longer be feasible as global growth consolidates and capacity utilisation increases.

Three, the widening current account deficit (CAD) poses a major threat. The overall CAD for 2010-11 is expected to be about 3.5 per cent of the GDP, which is clearly unsustainable. Further, global commodity prices, which had risen when economic growth in the advanced countries was sluggish, are poised to rise further as the world economy consolidates. That has implications for CAD and inflation.

Four, as much as the CAD, the overdependence on foreign portfolio flows to fund it poses a major risk. A faster global recovery may contribute to a reversal of capital flows, which may find investing back home a worthwhile option. This in turn will render the external sector vulnerable.

Five, the need for fiscal policy to work in tandem with monetary policy is once again emphasised. The RBI points out that the recent improvement in the fiscal situation might be transient as it was caused by disinvestment proceeds and one-off revenue from spectrum sales. Rising commodity prices, especially of petroleum, pose significant risks to fiscal consolidation in the year ahead.

The government faces an extremely difficult choice. If it restricts the pass through of international prices to the domestic sector, it will have to provide more for subsidies in the budget. This will constrain its ability to reduce the fiscal deficit.

If, on the other hand, the government allows global prices to be transmitted fully, it runs the risk of increasing inflationary expectations and undermining fiscal credibility.

Six, the combined risks from inflation, CAD and the fiscal situation contribute to an increase in uncertainty about economic stability that will deter consumption and investment and hence pull down growth. A slower growth is really no option. It may dampen inflation, narrow CAD but it can have a significant impact on capital inflows, asset prices and fiscal consolidation, thereby, aggravating the existing risks.


CRR still serves a purposeSeptember 23, 2012