The markets appeared confused by the signals from the Reserve Bank of India (RBI) — cutting rates on the one hand and signalling that the space for more easing was very limited on the other. How can one reconcile these seemingly inconsistent messages?
It’s not that hard to reconcile the two when you consider the different cross-currents currently at play. On the one hand, growth is clearly below the trend and output gaps have finally turned modestly negative. As a consequence, producer-pricing power is finally being impinged, as manifested by the muted monthly momentum of core wholesale prices for the last three months. All this would argue for easing monetary policy to spur growth.
On the other hand, Consumer Price Index-based inflation is in double digits, deposit growth at a nine-year low and gold imports continue to surge such that the FY13 current account deficit (CAD) is like to print perilously close to five per cent of gross domestic product, twice as much as deemed sustainable. These are not unrelated facts. Stubbornly high retail inflation has resulted in depositors experiencing low or negative real rates of return on financial assets and increasing the attractiveness of gold as an inflation-hedge and store of value which, in turn, has played havoc with the current account.
Let’s understand why output gaps have closed and pricing power has abated. This has not happened because investment has picked up, capacities have come on-line and pricing power has been competed away. It’s because demand has fallen sharply — part design and part accident. Rural demand has come off, as aggregate growth has slowed and the monsoon and kharif crop have disappointed. Further, slowing global growth has caused India’s exports to fall off a cliff. And, government spending has ground to a halt in the last four months, as authorities try to avoid runaway slippage. So, slowing demand has been the reason inflation pressures have abated.
Now, let’s project forward. High-frequency indicators suggest growth has bottomed and a modest re-acceleration is on the cards.
New export orders suggest a meaningful export pick-up in the coming months. A strong rabi crop should boost rural demand and, in a year peppered with eight state elections leading to a general election, it’s hard to imagine public finances being austere.
All this suggests a consumption-and demand-led recovery could characterise 2013. It will likely be a modest recovery but even a modest one would likely reopen positive output gaps, at a time when there are no signs of an investment pick-up. If this scenario plays out, inflation is likely to re-accelerate in the coming months.
Finally, let’s not forget the CAD. What’s really worrying is it continues to deteriorate, even as non-oil and non-gold imports are on course to contracting this year! If RBI were to slash rates, the current account would suffer from a double-whammy —rising gold imports from lower deposit rates and rising non-oil and non-gold imports, as consumption and demand re-accelerate.
Can India continually finance such a deficit? Only in a perfect world in which global liquidity is awash, tail risks around the globe are minimised and policy at home remains continually constructive.
But if any one of these factors gives in, we could be back to August 2011 or May 2012 — the combination of a sudden stop in capital flows and a bloated current account deficit puts the rupee under enormous pressure and sparks another bout of inflation.
Given all this, I believe RBI did the best it could —opportunistically cut rates to support growth but recognise the role for monetary policy is extremely limited, unless the underlying structural issues are resolved.
Sajjid Chinoy
India economist, JP Morgan
