RBI policy in a season of contradictions: Mixed signals ahead of December 5

HSBC economist argues GDP overstated, inflation structural, and currency depreciation acts as a needed shock absorber

Inflation is at an all-time low, the trade deficit at an all-time high, and growth above the aspirational 8 per cent.  

The economy appears to have moved from displaying hints of stagflation a year ago to being in something of a sweet spot now. Yet a few details feel unsettling in the run-up to the policy meeting on December 5. 

The strong 8.2 per cent growth seen last quarter benefitted from both cyclical forces and statistical quirks. Strong rains, monetary easing, fiscal spending and goods and services tax (GST) cuts all helped. But a low base and deflator issues may have exaggerated the headline number. Two complications — the use of single rather than double deflation, and the over reliance on Wholesale Price Index goods data to deflate services — may have understated the deflator and overstated real gross domestic product (GDP). Our estimate of actual growth is closer to 7 per cent: still strong, but lower than the released figure. 

Growth could soften in the first quarter of next year as GST effects fade, fiscal spending tightens to meet deficit targets, and exports lose momentum under the new 50 per cent tariff. Yet deflator anomalies may continue to overstate real GDP for the rest of the year. Policymakers will have to carefully assess the actual growth on the ground. 

Next up is understanding the near-zero inflation print in October of 0.25 per cent. This is not only about temporary GST cuts or low food prices. The fall in core inflation this cycle appears more enduring than in past episodes thanks to disinflation from China and greater confidence in inflation targeting. Lower inflation gives the Reserve Bank of India (RBI) a longer runway should it wish to remain growth supportive. 

Meanwhile, the record $42 billion trade deficit in October was driven by high gold imports and weaker exports. With global gold prices likely to stay high, the import bill may remain elevated. Export performance has been mixed. In September, exports to the US fell 12 per cent year-on-year while exports to the rest of the world rose 10 per cent. In October, both declined sharply. Part of this may reflect Diwali-related production disruptions, but part of it may also be rising competition in global markets. 

Integration with regional supply chains is the best structural path to improving India’s export prospects. But this takes time. In the short run, FX depreciation is the most fitting shock absorber, helping restore competitiveness in the face of elevated tariffs.

India’s rising trade deficit, together with weak net FDI and FII inflows, is putting depreciating pressure on the INR. On a trade-weighted basis the currency has already fallen around 10 per cent this year. The real effective exchange rate tends to mean revert, making the exchange rate an automatic stabiliser for external balances.

 

So amid this complex backdrop, what should the RBI do? We believe it should cut rates in December. Low inflation is the more convincing dynamic, especially given the deflator-driven uncertainty in growth. With medium-term inflation likely subdued, the RBI can cut and sound dovish. Just as it would hike when inflation rises above 6 per cent, a  25 basis point cut now with inflation far below 2 per cent would reinforce its inflation-targeting credibility.

The writer is chief India economist and macro strategist, Asean economist, HSBC