Inflation busting outplays growth angst

The hiking of the repo rate again by 25 basis points proves that the Reserve Bank of India’s fears of inflation are embedded in monetary policy even if RBI does not go ‘nutters’ on fighting it.

Pushing in additional liquidity through the term repo initiative did win RBI Governor Raghuram Rajan some plaudits last week, as this is expected to reduce overall borrowing costs for the banking system. But corporate interest rate spreads, going by the earnings results still coming in, remain high. While short-term rates are expected to respond positively to RBI’s policy stance, the spectre of car and housing loans getting costlier into the festive season remains.

On the currency front, the rupee has shown a measure of stability against the dollar, thanks in part to the tapering of the US quantiative easing programme. Although chances of it appreciating further will be a huge inflation incentive, the open swap window for banks to bring in overseas deposits till end-November will likely lead to another bout of appreciation, and at the very least, a 50-basis point uptick in Rajan’s bugbear — Consumer Price Inflation (CPI).

The RBI has been raising its inflationary expectations in anticipation of nominal growth and moderate pick-up in future demand. It is right to expect a reasonable momentum in spending through its tolerance for faster inflation in future. The Index of Industrial Production (IIP) figures for September which shows core sector growth of 8 per cent from 3.7 per cent in August and anticipation of higher demand are key reasons for provisioning for higher liquidity. And, electricity output growth of 8 per cent looks justified against the backdrop of it reflecting to an extent in higher coal, cement, steel, refinery products and fertiliser output in September.

Equally significant is the fact that RBI’s ongoing steps to improve liquidity will finally make repo as the operative rate, and make another hike still possible.

Rational expectations

The markets have responded favourably down the weekend to RBI’s inflationary expectations as evident in the monetary policy repo rate hike, though if one doubts its rationality in the short-term, the markets could also anticipate the bullish effects of higher inflation going ahead and go in for another ‘correction’.

There are other reasons for rational expectations from investors. Growth rate expectations are low and overall WPI estimates have been predictably raised.
Fears of a less than sustained recovery in growth and inflation dog the central bank. The fiscal deficit touched 76 per cent of its full-year target last week. Reduction of current account deficit has yielded good results on the ground, but anchoring inflation more efficiently will require growth to pick up in the third quarter of 2013.

When RBI Governor Rajan tweaked the Marginal Standing Facility (MSF) in his previous monetary policy on September 20 to give the rupee breathing space, the act also strengthened industry expectations of the central bank anchoring its inflationary expectations through another policy rate hike. But the economy has aspects to be addressed at different scales other than the initial effects of the monetary policy on cost of funds — “... there are a lot of moving parts here” as ICICI Bank head Chanda Kochchar remarked.

The fact is that liquidity creation which is not backed by demand in key sectors like real estate, retail and consumable durables would need loads of fire to create a little smoke. The government’s additional capital infusion plan of Rs 14,000 crore, aimed at unlocking more funds into the market to stimulate demand, to a great extent runs counter to RBI’s measures to counter inflation, which is to make lending more expensive. While this can increase the capacity of banks to lend, lowering borrowing costs is not always a given in a scenario where NPAs are expected to climb even higher to 4.4 per cent of gross advances this year from 3.3 per cent last year, and mean asset quality of banks is expected to remain systemically weak in the near-term.

The growth agenda

The 25-basis point reduction in the MSF rates has narrowed the rate corridor between the two policy rates. This is a subtle rollback of emergency measures initiated a couple of months back to reign in rupee depreciation. Though MSF still remains the operative rate, RBI’s ongoing steps to improve liquidity will finally make repo the operative rate. Yet, investors are making a case for giving more attention to growth and the multiple levers to restore it, as opposed to focussing on the inflation front alone.

“While in general, economic growth performance in fiscal 2014 is likely to be similar to fiscal 2013 levels, the current account may improve considerably. This will strengthen rupee, which we expect to stabilise at around 59-61 to the US dollar by fiscal 2014,” according to Devendra Kumar Pant, Chief Economist and Head (Public Finance) at India Ratings and Research.

Pant expects economic growth to improve from the third quarter of fiscal 2014. “Three consecutive months of double-digit exports growth and healthy agriculture performance due to 6 per cent above normal rainfall in 2013 would increase demand for industrial goods and services. However, the growth is unlikely to be stupendous,” he said.

RBI has noted that WPI may remain range-bound at its 7-month highs of 6.46 per cent during the second half of 2013-14, with retail inflation exceeding 9 per cent. Cranking the interest rate lever to contain inflation should not be the only option, with the government still grappling with its fiscal consolidation act. Sky-high onion prices are weighing in on inflation, and are expected to stay at tear-jerker levels of 6 per cent and thereabouts.

With protein food prices staying high, CPI-based inflation is expected to breach the double-digit mark in coming months. “Because of the second-down effect of vegetable prices, retail inflation would likely go above 10 per cent in the coming months,” said Soumya Kanti Ghosh, chief economist, State Bank of India, in a report to clients last week.
While faster clearances for infrastructure projects and boosting investor confidence will support growth in the long-run, short-term measures like lowering the MSF rate have not yielded much financing for projects affected by liquidity crunches.

Ideally, the MSF rate cut and additional liquidity through term repo should reduce the overall cost of funds for the banking system. However, overnight rates remain rather high, though into this week, the effects of the MSF rate cut should be more palpable. Further, RBI has pushed its case for sustained growth by enabling banks to draw money from the central bank if necessary for financing projects affected by liquidity shortfalls. Under the circumstances, it is investor confidence and debottlenecking of infrastructure projects which can push growth further. A semblance of normality has returned to the broader economic outlook with the current account deficit becoming manageable and rupee not facing imminent danger.

Yet, RBI’s persistent anti-inflationary stance suggests anticipations of below par or nominal growth in the current fiscal. This despite Prime Minister Manmohan Singh’s assertion that the 8 per cent plus annual growth rates of the 2003-08 period, when a bulk of investments in attractive sectors like coal and telecom were pushed through with scant regard for regulatory ethics, is achievable. The government’s Panglossian trust in achieving 8 per cent annual GDP growth in the “short to medium-term” is misplaced for now, when few people expect even 5.5 per cent growth.

Moreover, despite India’s savings and investment rates still at over 30 per cent of GDP and despite capital output ratios rising, it is clear that a lot of capital is being misallocated or tied up in the wrong projects or delayed in stalled projects. The government will have to get moving on this without leaving a lone RBI to wrack its brains on combating inflation without a growth agenda.