By Kala Rao
India’s breakneck economic growth may yet falter under its own momentum. Policy-makers must steer carefully
India’s economy is on fire: for the year ending March, it had clocked up its fastest ever growth, at 9%. Driven by booming investment and consumption, the south Asian nation is hot on the heels of its northern neighbour, China, in its inexorable expansion.
But the economy is showing worrying signs of overheating, while analysts are again raising the alarm. The spectre of inflation has never been far behind – nor the risk of a hard landing.
Inflation controls were pushed firmly back into the spotlight in February following the defeat of the leading Congress party in two state elections – a fact largely blamed on high food prices. In a misguided attempt to get tough on consumer prices, the government barred new contracts in rice and wheat futures in February. The wholesale price index had risen to 6.7% at the end of January before moderating to around 6% in early April – still alarmingly higher than 3.8% a year ago.
The Reserve Bank of India (RBI), the central bank, began to tighten interest rates in the middle of last year. On March 30 this year, the RBI raised the proportion of bank deposits impounds to 6.5%. Loan growth – particularly to the red-hot property sector – is expected to slow down to about 25% this year.
On April 24, RBI governor Yaga Venugopal Reddy, in his monetary policy announcement, said he expects economic growth to moderate to 8.5% and inflation to be at around 4-4.5%, suggesting that an economic slowdown is imminent.
Whether or not the slowdown will translate into a hard or soft landing is the subject of considerable contention. “The speed limit [for growth] is lower in India than in China, because China invests about 45% of its GDP while the level of investment is lower in India,” Charles Collyns, deputy director at the IMF’s research department, said at a seminar in Mumbai in April. India needs to invest more in infrastructure, education and reform agriculture to remove supply bottlenecks, he added.
Restored vitality
Those investments are starting to happen. Chanda Kochhar, deputy managing director at ICICI, India’s second largest commercial bank, reckons that there are infrastructure projects worth about $450 billion in the pipeline. “We see a rejuvenated corporate sector with healthy balance sheets, which are looking to consolidate across the value chain,” he tells Emerging Markets.
Yet critics maintain that RBI’s monetary tightening measures put a squeeze on credit just when investments are taking place that will adjust supply to demand, and this could lead to a hard landing for the economy. “India’s bigger concern is not inflation but to stick to growing at 8-8.5% each year, to produce about 10 million jobs every year for about 400 million kids who need them,” says R Ravimohan, managing director of Crisil, India’s largest credit rating agency. The impact of monetary policy on economic activity is minimal, given that the causes of inflation are shortages of food, oil and falling productivity in agriculture, he adds.
The central bank’s response [see “The steadying hand”, page 15] is that its monetary tightening measures lend more stability to the economy’s growth momentum by keeping aggregate demand in line with the economy’s supply constraints. India has previously faced three major shocks of spiralling fuel and food costs and surging capital inflows, all of which contributed to the recent spike in domestic inflation. Nuanced demand management has helped keep annual growth at around 8.2-8.5% on average over the last four years and annual inflation at around 5%.
Raising the rupee
India’s capital inflows have contributed, in large part, to a surge in domestic money supply, and some analysts argue the rupee should be allowed to rise so that imports get cheaper. Managing those inflows – net inflows in the nine months to December 2006 rose to $27.3 billion – poses a considerable challenge to monetary authorities. The central bank has intervened in the foreign exchange market to keep the rupee from rising too sharply and sterilize those inflows, causing the forex reserves to rise sharply. As the central bank reached close to the limit on resources available to it under the market stabilization fund, which is the stock of government rupee bonds it can sell to banks to sterilize inflows, the rupee rose by about 6% in March and April.
Higher domestic interest rates and a rising rupee could well attract even higher capital inflows. The RBI has been juggling the “impossible trinity” of an independent monetary policy, an open capital account and a managed exchange rate for some time now, JP Morgan’s Rajiv Malik tells Emerging Markets.
“It appears to be indicating greater comfort with higher currency volatility, but the central bank’s complete hands-off approach is likely to be unsustainable after concerns over inflation ease. Lower inflation will shift government’s focus to exporters’ woes owing to currency appreciation,” adds Malik.
In an attempt to stem capital inflows, the RBI recently cut interest rates offered to expatriate Indians on bank deposits. To counter capital inflows, in the recent monetary policy announcement the central bank has opted for a gradual opening up of avenues for capital outflows by Indian companies, individuals and mutual funds. The limit on overseas investments for companies was raised from twice to three times their net worth; individuals may invest up to $100,000 overseas each year, and the limit on overseas investments by Indian mutual funds was raised to $4 billion.
In a sense the central bank uses existing forex reserves more efficiently by creating domestic demand for foreign currency from Indian companies and savers. The RBI expects these measures will tame inflation and manage a soft landing for India’s economy; but if that does not happen, its critics are waiting with sharpened knives.