Macro view: At crossroads again

The rising current account deficit and inflation have the potential to reduce accelerating pace of growth.

The current surge in the equity markets, spurred by strong overseas inflows, has created a sanguine environment. However, there are some concerns coming to the surface.

Rising interest rates and a volatile currency could be the likely fallout of the current developments. Overall inflation remaining in the 6 per cent range will force the central bank to remain cautious.

The rainfall, which has been two per cent above normal between June and September, has boosted the chances of agricultural growth from 4.3 per cent to 6 per cent, says Tushar Poddar of Goldman Sachs.

However, inflation is not expected to go down substantially, as structural issues, apart from lack of infrastructure, the minimum support price mechanism and rising rural income levels, would keep the pressure on.

An analysis by Goldman Sachs using the Taylor rule, which shows how interest rates need to vary from the neutral levels, taking into consideration the economy's output gap and inflation gap, suggests that RBI would need to raise policy rates to at least about 7 per cent (from 6 per cent at present), given the inflationary pressures in the economy.

There are other concerns on the current account deficit front, which has now touched historical highs, at $13.7 billion. The situation is not expected to worsen immediately as the capital inflows will sustain the balance of payments situation. However, the widening current account deficit, along with a falling investment/GDP ratio, implies a sharper fall in domestic savings rate to sub-30 per cent levels, says Dhananjay Sinha of Centrum.

Real capital formation in the first quarter of financial year 2011 contracted 20.4 per cent from the previous quarter, and at 14.7 per cent when seasonally adjusted. With chances of rates remaining strong for longer than expected, the growth could temper down — strong domestic demand and sustainability of overseas flows remaining strong hopes.

Trade is expected to remain weak as the overseas scenario has turned competitive, with most countries reluctant to allow capital appreciation. “Any rise in global risk aversion (possibly due to building up currency tensions or renewed concerns about European debt problems) could trigger high volatility in capital flows to emerging markets including India,” point out economists at Edelweiss Research. The policymakers are staring at crossroads, expecting the gushing foreign investors to buy some time to rebalance the fiscal situation.