RBI's dual-track policy imperative

With domestic demand conditions robust and inflation being fed by strong growth, rising oil, and falling rupee, the central bank has to take measures to keep inflation expectations anchored

Formidable external and domestic challenges characterise India's macroeconomic outlook. On the external front, three distinct developments require vigilance. First, oil, India's perennial Achilles' heel, is on the ascendancy, complicating the current account, fiscal, inflation, and exchange rate dynamics. Crude oil prices are up about 25% this year, and the risk is once Iran sanctions are put in place and supply from Saudi Arabia and Iraq fall short, prices could jump another 10-20% in 2019. The government's attempts to hold back imports through higher duties is laudable, but given the relative inelasticity of energy import demand, the risk is that the current account deficit could exceed 3% of GDP next year. The inflationary implications are non-trivial as well, both in terms of RBI's policy objective and the likely political cost.

Second, the Fed interest rate hike cycle poses major risks to capital flows to emerging markets and the cost of hard currency financing. Indian corporates have taken on considerable foreign currency debt in recent years, the cost of servicing which will go up markedly as US dollar rates rise, liquidity tightens, and rupee depreciation continues. In the coming year, no country in Asia has as onerous gross external financing need (the sum of current account deficit and hard currency debt due on a residual maturity basis) as India. Macro vulnerability to further capital outflow and rupee pressure will therefore remain.

Third, the ongoing trade war between China and the US could dampen global investment appetite and reduce the gains from globalisation. As an economy that has progressively opened up in recent decades, trade wars offer no upside to India. 

Given these external challenges, not to mention the ongoing stress in India's bank and nonbank financial sectors, one ought to expect some degree of accommodation on the RBI's part, both in terms of enhancing liquidity provisions and perhaps some forbearance to give the beleaguered corporate sector a bit of breathing room.

At the same time, the RBI has to reinforce its inflation fighting stance. With domestic demand conditions robust and inflation being fed by strong growth, fiscal slippage, rising oil, and falling rupee, the central bank has to take measures to keep inflation expectations anchored. Policy rate hikes, therefore, will have to continue, with the goal to achieving a real interest rate conducive to stemming demand-pull inflation.

Factors like oil, Fed rate hike, and trade wars are not in RBI's control, but it can nonetheless play a critical role in stabilising inflation. The playbook is straightforward; go ahead with rate hikes while communicating clearly that carrying out open market operations or easing collateral requirements are being done to support specific financial stability concerns, but the policy stance remains geared toward fighting inflation. A dual track policy like this need not be contradictory-its chances of success will be contingent on effective messaging.  

The author is managing director and chief economist, DBS Group