Indian central bank: no rate cuts without fiscal consolidation
The Reserve Bank of India kept rates on hold, warning that fiscal consolidation is critical to create the space to cut rates without the imminent risk of resurgent inflation
Its a tough life being a central banker. Especially when you are head of the Reserve Bank of India, faced with the challenge of how to set policy against a complex range of external and domestic risks slowing growth, rising fiscal deficit, a weak currency and stubbornly high inflation.
The RBI kept interest rates on hold at 8.50%, but cut banks reserve requirement ratio by 50 basis points (bp) to 5.50% at its monthly policy meeting on Tuesday, elaborating on the risks to the policy outlook in its latest quarterly monetary policy review, published following the rate announcement.
The message from RBI governor Duvvuri Subbarao was clear: the central bank finds itself increasingly in a bind, cognizant of the need to boost growth, but unable to ease aggressively given ongoing concerns over inflation, FX and fiscal slippage.
And he had a stark warning for the government: we cant continue to do your heavy lifting for you.
Here are some key takeaways from the quarterly review.
The RBIs baseline GDP growth projection for 2011-12 was revised downwards from 7.6% to 7.0%/. Looking ahead to 2012-13, the RBIs baseline is a modest recovery, with growth being slightly faster than during the current year.
However, Subbarao warned of the negative consequences of a slowdown in investment:
|It must be emphasised that investment activity has slowed down significantly. As indicated above, while global factors are contributing, domestic conditions are also responsible and a change in the investment climate is contingent on these adverse conditions being addressed by policy actions. Without this, a continuing decline in investment will push the economys trend rate of growth down, further aggravating inflationary pressures and threatening external and internal stability.|
Despite the slowdown in the growth outlook, the RBI retained its baseline WPI projection at 7% due to a lower than expected moderation in non-food manufactured products inflation, as well as continued double-digit fuel inflation.
The central bank governor went on to illustrate the complexity of the current growth-inflation relationship in India, highlighting both domestic and external factors:
|A significant downgrade in the growth projection would normally have been accompanied by a downward revision in the inflation projection. However, in the current circumstances, two factors have prevented this from happening. First, rupee depreciation has been feeding into core inflation, delaying the adjustment of inflation to slower growth. Second, very importantly, suppressed inflation in petroleum product and coal prices remains quite significant. While a rationalisation of prices is welcome for a variety of well known reasons, it will impact observed inflation in the short-term. This projection is based on the likelihood of some adjustments being made in these prices.|
Looking ahead to 2012-13, while a formal projection will be made in the Annual Policy Statement in April, the Reserve Banks baseline scenario is that headline inflation may show some moderation, though remaining vulnerable to a variety of upside risks.
The seven deadly risks to the Indian outlook
Subbarao then went on to outline seven key risks to the Indian outlook, which are worth elaborating on, as they encapsulate the challenges faced by Indias policymakers and, in many cases, by policymakers across emerging markets.
|Sovereign debt concerns in the euro area pose a major downside risk to overall growth outlook. The absence of a credible solution to the euro area problem is weighing on global growth prospects even as recent data suggest that there is some improvement in the US recovery. Continuing uncertainty in the euro area will adversely affect Indian growth through trade, finance and confidence channels.|
2) Capital flow and exchange rate volatility
|Capital inflows to India have slowed down on account of portfolio re-balancing by FIIs due to global uncertainty. This raises concerns, especially because the current account deficit of India has widened. The exchange rate has already come under significant pressure, which has also added to inflationary pressures. If the global situation does not improve, capital inflows could continue to be adversely affected. In this scenario, the size of the current account deficit poses a significant threat to macroeconomic stability.|
3) The threat of rising oil prices
|Even as global food and metal prices have moderated further, global energy prices have increased. Should crude prices spike due to supply constraints on account of geo-political factors or decline significantly due to a deterioration in the global macroeconomic situation, they will have implications for domestic growth and inflation.|
4) Slowing credit growth
|Credit growth has decelerated more than expected and is currently below the indicative trajectory of 18 per cent. Apart from slowdown of economic activity, it also reflects increasing risk aversion by banks due to increase in non-performing assets. Although banks need to be prudent while sanctioning credit proposals, risk aversion by the banking sector could adversely affect credit flow to productive sectors of the economy.|
5) Upside food inflation risks
|Although food inflation has declined in the recent period, this was mainly due to a seasonal decline in vegetable prices... As such, the decline in food inflation is likely to be limited in coming months. In the absence of appropriate supply responses of those commodities where there are structural imbalances, particularly protein-based items, risks to food inflation will continue to be on the upside.|
6) The unwinding of fuel subsidies
|There is still a large element of suppressed inflation as domestic prices of some administered products do not reflect the underlying market conditions. This is particularly true of coal which had seen an increase towards the end of last year but no increase this year so far. Since coal is an input for electricity, coal prices, as and when raised, will also have implications for electricity tariffs. Further, the current levels of domestic prices of petroleum products do not reflect international prices. Petroleum product prices have also not been revised in response to crude oil prices, contributing to both fiscal slippages and suppressed inflation. |
Revision in domestic administered prices will add to inflationary pressures, although such revisions are necessary to maintain the balance between supply and demand.
7) Fiscal slippage
|The fiscal deficit of the government has remained elevated since 2008-09. If the increase in government borrowing already announced is an indication, the gross fiscal deficit for 2011-12 will overshoot the budget estimate substantially. At the current juncture when there is a need to boost private investment, the increase in fiscal deficit could potentially crowd out credit to the private sector. Moreover, slippage in the fiscal deficit has been adding to inflationary pressures and it continues to be a risk for inflation.|
Over to you, Pranab
Based on this ominous list of risks, Subbarao then goes on to make his main point: fiscal consolidation holds the key to the future monetary policy outlook.
To quote from his conclusion:
|Strong signs of fiscal consolidation, which will shift the balance of aggregate demand from public to private and from consumption to capital formation, are critical to create the space for lowering the policy rate without the imminent risk of resurgent inflation. In the absence of credible fiscal consolidation, the Reserve Bank will be constrained from lowering the policy rate in response to decelerating private consumption and investment spending. The forthcoming Union Budget must exploit the opportunity to begin this process in a credible and sustainable way.|
In other words, dont expect a rate cut before the Union Budget is announced on February 29. And, with legislative assembly elections slated in many states later this year and parliamentary elections due in 2014 and with prime minister Manmohan Singhs approval ratings battered by a string of corruption scandals dont hold your breath that the budget will provide Subbarao and his colleagues at the RBI with the evidence of fiscal consolidation that he is looking for.
Third Quarter Review of Monetary Policy 2011-12 - Reserve Bank of India
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