Monetary Policy
A combination of stubborn inflationary pressures, weaker than expected monsoons and burgeoning twin fiscal and current account deficits have contributed to the RBI’s restraint in monetary policy easing. The RBI in its latest mid-quarter monetary policy review kept key rates unchanged, stating that the primary focus of monetary policy remains fighting inflation. The repo rate was kept status quo at 8 per cent. It did however,lower the cash reserve ratio (CRR) of scheduled banks by 25 basis points. The CRR cut is expected to inject Rs. 170 billion as additional liquidity in the banking system.
This move by the RBI came in the face of government pressure favoring monetary easing, especially a day after the government announced major reform measures such as opening up Foreign Direct Investment in Multi-Brand Retail and Civil Aviation, in addition to increasing the price of diesel and putting a cap on LPG cylinders to help reduce the LPG burden. However, the RBI preserved its independent status by maintaining its primary focus of combating inflation. Indeed, the wholesale price index surged by a higher than expected 7.55 per cent in August, lending credence to the RBI’s decision. In April, the RBI had implemented a frontloaded policy rate reduction of 50 basis points on the expectations of government policy support for addressing the deceleration of investment and growth. Therefore, the RBI had already priced in these latest government reforms in its monetary easing move in April.
Global Inflationary Risks
In the global context, economic growth has remained sluggish, which has resulted in the US Federal Reserve announcing the biggest monetary expansion of all time with the ‘QE3’ bond purchase programme in September. This move is widely expected to infuse enormous liquidity into financial markets and is intended to provide further stimulus to economic activity. While these measures could mitigate short-term growth risks, the impact of these measures is likely to exert heavy pressure on global commodity prices. Therefore, inflationary pressures in the coming months could pose significant upside risks.
Economic Sluggishness in India
On the economic front, the latest data available from Q212 shows continued weakness in economic activity, with industrial production (IP) managing to muster just 0.1% year-on-year (y-o-y) growth in July. In August, the manufacturing Purchasing Managers Index (PMI) fell to its lowest level during 2012 so far, as a result of output disruptions due to power shortages and declining export orders. India’s gross domestic product (GDP) grew at 5.5 percent during the second quarter of 2012, compared with the previous 5.3 percent in Q1 2012 as reported by the Central Statistical Office (CSO). This growth rate falls well short of the RBI’s revised annual economic growth estimate of 6.5 percent.
Inflation readings in India have been stubbornly high for many months despite the pervading weakness of economic activity. While this has put the Reserve Bank of India (RBI) in something of a tough spot, India’s stagflationary plight should eventually give way to slower inflation, which would prompt the RBI to cut rates on signs of a moderation in headline prices. Indeed there are three major reasons why the RBI will turn to a dovish monetary scenario in the coming months –
1) Commodity Price Pressures To Moderate: Much of the recent run-up in headline inflation can be put down to the re-emergence of food price pressures. To be sure, India had been dealt the twin blow of a spike in global grains prices and poor monsoon rains in July and August. Both of these factors have mitigated somewhat since then. The S&P Grains Index is down 10% from its mid-August 2012 high. Meanwhile, India’s monsoon picked up significantly in the latter weeks. By September 25, rainfall was just 6% below average levels (versus 22% in mid-July).
2) Stronger Currency To Contain Imported Inflation: Another reason why the RBI had been reluctant to act on monetary easing earlier on in the year was the depreciating Indian rupee. However, the INR has made a forceful comeback since August with scope for further gains. This should help soak up imported price pressures. It is essential to note that the price of oil in INR terms has tumbled 14% since mid-August, and barring any conflict in the Middle East; further decline in oil prices appear on the cards over the medium term.
3) Signs Of Fiscal Consolidation: The RBI has long highlighted the need for the government to do its fair share in containing inflation by reining in the fiscal deficit. Indeed, the central bank has been quite explicit in its requirement for signs of fiscal consolidation before embarking on monetary easing. As such, the recent signals from New Delhi are quite encouraging. Efforts to rein in the budget shortfall by lowering diesel subsidies and expediting divestment plans are unlikely to lead to a massive narrowing of the fiscal deficit in the near term. That said, any improvements on the fiscal front should give the RBI some additional room for easing.
Conclusion
Faced with rapidly slowing economic growth and reducing consumer spending on one hand and stubborn inflation on the other, the RBI has once again found itself in a bind with regard to monetary policy. To be sure, that the RBI resumes monetary easing is far from a done deal, and we may have to wait beyond the upcoming October 30 meeting for the first rate cut. Moreover, any renewed uptrend in global commodity prices or an unwinding of fiscal measures could force the RBI to stay put through the remainder of the fiscal year.
Fiscal Policy
On the fiscal front, the government had set an ambitious fiscal deficit target of 5.1% of GDP in FY2012/13; however, its past record on target execution has not been accurate with significant fiscal slippage. Indeed, it’s original budget shortfall target for FY2011/12 was 4.6%, only to be revised to 5.9% at the end of the year. The main driver of this fiscal deficit is inflated government expenditure and specifically expenditure arising out of subsidies.
Indeed, there is little chance of the government hitting its fiscal deficit target of 5.1% of GDP. According to latest data from the Controller General of Accounts (CGA), the government has burnt through 63.5% of its budgeted outlay in only the first five months of FY2012/13 (April-March), pointing to another year of fiscal disappointment. What is more, the recent reform announcements are unlikely to have a material impact on the near-term fiscal performance. For instance, the government’s 14% hike in diesel prices is expected to generate roughly INR160bn in cost savings, which, while encouraging, is a drop in the ocean compared to the total subsidy bill of INR2.3trn.
The recently released Kelkar Committee Report on Fiscal Consolidation has clearly emphasized the urgency of the situation by stating that India is on the edge of a “fiscal precipice” and should urgently slash fuel, food and fertilizer subsidies to curb a budget deficit that could hit 6.1 percent of gross domestic product this fiscal year. Even the Finance Minister’s projections have concurred with the Kelkar Committee’s report. Finance Minister Palaniappan Chidambaram has cautioned that the central government deficit may hit 6.1% of GDP this fiscal year, in what has been regarded as a sign that fiscal restraint is back on the policy menu.The RBI deputy governor SubirGokarn recently stated “We need to address the fiscal situation and we need to address it fully, recognizing that not dealing with subsidies is going to provide us very imperfect incomplete solutions,” said “Whatever else we may think of in terms of dealing with the fiscal situation, tackling the subsidy bill is going to be a central part of the strategy.”
Growth in Revenues essential for containing deficit
Any major improvement in the government’s H2 FY2012/13 performance is likely to come from the revenue rather than expenditure side – with divestment proceeds doing much of the heavy lifting. The government expects to raise around INR350bn from re-issued telecoms permits and a further INR300-400bn from the sale of shares in four state-owned companies. Absent a major turnaround in financial markets risk appetite and subdued global economic signals; expectations on the disinvestment front would need to be toned down. Additionally, tax buoyancy has declined significantly over the past five years. Indeed, after reaching a high of 11.9 per cent in 2007-08, there has been a decline in the Tax-to-GDP ratio, to 10.1 per cent in 2011-12, by actuals for the year.To achieve a sustainable fiscal consolidation it is essential to return to the highs of Tax-to-GDP ratio achieved in 2007-08. In this regard, the long-awaited tax proposals, the GST and Direct Tax Code, are essential in bringing about structural reforms.
Sovereign Ratings under threat
Another weak fiscal performance by the government could further stifle the recovery in investment activity and, by extension, economic growth. A cosmetic improvement in the fiscal accounts, coupled with the positive reform signals, should be sufficient to keep the rating agencies happy for now. Earlier in 2012, both Fitch and Standard & Poor’s downgraded the outlook on India’s ‘BBB-‘ investment grade sovereign rating on the back of stumbling growth and a weak policy environment. Not to mention, rating agencies have hinted at the possibility of a further ratings downgrade of India’s sovereign bonds to junk status.However, the low foreign ownership of government bonds, the lack of near-term funding pressures and, most importantly, the renewed reform momentum have temporarily reduced the likelihood of another downgrade. Indeed, Prime Minister Manmohan Singh’s quick fire policy announcements in September and October should, therefore, buy some time for the government to delay a more pronounced deficit reduction plan.
Long-Term Consolidation
It is widely believed that India’s recent push for fiscal consolidation has been partly fashioned to create space for a populist-spending spree in FY2013/14 (April-March) ahead of general elections. With this in mind, even if the government is successful in making progress on deficit reduction in FY2012/13, this is likely to be unwound in the following year. In such a scenario it remains highly likely for the fiscal deficit to widen in FY2013/14, with an acceleration of expenditure growth partially offset by the potential implementation of the goods and services tax (GST) and direct tax code (DTC) bills.
Therefore, the longer-term path to deficit reduction could occur at a gradual pace, meaning that India’s public debt profile will remain an enduring concern. Whichever party takes the reign, a pre-election fiscal blowout will not be looked upon kindly by ratings agencies and investors alike, and the path thereafter will be for consolidation – albeit at a gradual pace. Such a scenario suggests that India’s public debt profile will remain a long-term concern. Therefore, total public debt is likely to head upwards from the approximate figure of 74.5% at present.
In summary, persistent inflationary pressures alongside risks emerging from twin deficits – current account deficit and fiscal deficit – constrain a stronger response of monetary policy to India’s growth risks. The RBI must ensure that its monetary policy remains aligned to fiscal consolidation, for it to have a measurable impact in reducing inflation and setting India back on a high growth trajectory.
Policy Pit 