On inflation:
Both external as well as domestic supply constraints have contributed to inflation in India. Although domestic factors usually tend to have a greater influence on inflation, in the last couple of years global factors have dominated, mainly because of a convergence of global and domestic problems related to the supply of key commodities and the extent to which the domestic economy could absorb large capital inflows.
On the supply side, the Indian economy is vulnerable to two shocks: fuel and food. High oil prices are a huge external shock we faced over the last couple of years. As far as food is concerned, in the past global food prices used to have a marginal impact because we were reasonably self-sufficient. Last year, however, there was convergence of global and domestic problems. Wheat stocks and production were low in India, and globally because of the climatic conditions in Australia, global wheat prices started looking up. This happened in the case of pulses and edible oils too.
It is a testimony to the resilience of the Indian economy that it has absorbed both these shocks, kept domestic inflation at around 6% and contained the current account deficit within 2% of GDP. In the financial sector, we had large capital inflows. Not all of this constitutes addition to plant or machinery (the productive capacity of the economy): we have had large portfolio flows. In sum, we went through three global shocks that had an impact on domestic prices and output.
On the impact of tight monetary measures on growth:
Global output is expected to slow down by 50 basis points this year, and that impact has been taken into consideration in the central bank’s forecast. [In its recent World Economic Outlook report, the International Monetary Fund predicted slower growth for the global economy, at 4.9% this year against 5.4% last year.]
There may be a feeling that the tighter monetary measures we have taken will moderate growth, but on the contrary, they will impart more stability and lead to more sustainable economic growth. One has to consider that if we hadn’t taken those steps, what would have happened to inflation? What would have been the impact of higher aggregate demand on inflationary expectations and the growth momentum?
In the mid-nineties, when similar monetary tightening may have contributed to the economic slowdown that followed, the situation was entirely different. Capacities had been created then in excess of demand. Today, it is demand that is driving investments. More important, the economy is far more resilient today: it has grown at an unprecedented rate of around 8.2-8.5% on average for four years with an annual average inflation rate of around 5%, with no major macroeconomic imbalances.
On capital flows:
Like most Asian emerging market economies, a key challenge that India faces is how it manages external capital inflows which have contributed to domestic inflation and, in recent weeks, a rising rupee, which hurts exports. Higher interest rates and an appreciating rupee could attract even higher capital inflows.
Globally, there is a debate about whether there is excess global savings relative to investment, or there is under-investment relative to savings, but the fact remains there is an imbalance. Given this imbalance, there is heightened sensitivity (among central banks) to potential inflationary expectations, and the general trend, except in the United States, is towards withdrawal globally of monetary accommodation. As this happens, there could be a withdrawal of resources from emerging market economies, and one has to consider how this could affect India.
Several emerging market countries face this dilemma; they use a combination of measures to manage inflows. These include reserve ratios, interest rates, liquidity management and active management of the capital account. (While the central bank has control over the first three instruments in India, capital account management is predominantly done by the government. For instance, it sets a ceiling on long-term foreign commercial borrowings each year as well as individual ceilings on foreign direct investment in particular sectors.)
The capital account in India is managed, and to that extent there are a variety of instruments that may be used to moderate or accelerate capital inflows, subject to global sentiment, of course. The decision on which tools may be used is something that is decided by broader public policy. High capital inflows impose fiscal costs of sterilizing them, and the decisions regarding the central bank’s ability to sterilize capital inflows and intervene in the foreign exchange market are matters of public policy. In that sense, the manoeuvrability available to the central bank with regard to managing capital flows and the exchange rate is limited.
On forex reserves:
Allowing Indian companies to invest more overseas is an efficient way to use our forex reserves. In the absence of such investment, those dollars would have added to our forex reserves. Our companies require size and domain knowledge, and one way to acquire this is by acquiring companies. Also, the fact that international capital markets are prepared to fund Indian companies shows their confidence in our companies, so one can be sure of a reasonable commercial return. We prefer such capital outflows through the real sector rather than through the financial sector.
Interview by Kala Rao