Global Insight Perspective | |
Significance | The benchmark repurchase rate has been raised by 50 basis points to 9.0%, while the cash reserve ratio for commercial banks has increased by a further quarter of a percentage point. |
Implications | Although a hike was expected, the magnitude of the increase exceeds expectations, coming after a cumulative 75 basis point increase in the leading rate in the previous month. The move highlight's the prioritisation of price stability over growth in the central bank's outlook, with inflation now running into double digits. |
Outlook | The central bank is expected to retain a tightening bias in monetary policy, although given the intensity of recent rate adjustments, it may now pause to allow the effects to work through the economy. |
Catching Up with the Curve
The Reserve Bank of India (RBI) was expected to raise interest rates as it completed its scheduled quarterly review of monetary policy today (29 July), but in the event it was the scale of the increase that caught watchers by surprise. The leading repurchase rate has been increased by 0.5 of a percentage point to 9.0%, the highest level since 2001. This marks the third increase in the leading interest rate in two months after a 75 basis point increase in June 2008. The tightening of monetary policy was reinforced by a further 25 basis point increase in the cash reserve ratio (CRR) for commercial banks—the third such increment since the beginning of June. The adjustment is due to come into effect by 30 August 2008.
"Intolerable Inflation"
The aggressive hike was implemented as the RBI described the current level of inflation as "intolerable". The RBI has engaged in a gradual tightening of monetary policy since 2002 as growth has ranged above trend. However, the intensity of this tightening has increased sharply following an abrupt acceleration of inflation. In the year through the week ending 12 July 2008, the WPI rose by 11.89% in annual terms, ranging above a decade. Inflation has spiked due to sweeping increases in fuel prices implemented by the government in early June to alleviate the fiscal strain exerted by surging global oil prices. Gasoline (petrol) prices were raised 5 rupees—or 11.0%—to 50.52 rupees (US$1.18) per litre, and diesel prices were lifted 3 rupees—or 9.0%—to 34.48 rupees per litre. The price of cooking gas, or liquefied petroleum gas (LPG), was also increased for the first time since 2002—by 50 rupees per cylinder, or 17.0%—while kerosene prices remained unchanged. The increase in fuel prices added to significant supply-side pressures already generated by surging food prices amid domestic and global production shortfalls.
Aggregate Demand Pressures Remain
However, supply constraints are set within a context of robust domestic demand growth. Domestic spending has been fanned by still-high levels of liquidity in the financial system, which has supported the expansion of credit. In its quarterly monetary policy review, the RBI states that growth in broad M3 money supply is still running at above 20.0% in annual terms, while the rate of expansion in non-food credit has marginally accelerated to 25.9% as of 4 July 2008. The recent reversion to repeated increases in the CRR represents an attempt to drain liquidity from the financial system, which has been fuelled by surging foreign capital inflows generated by portfolio capital, remittances, and rising levels of direct investment. The levels of central bank intervention to stabilise the exchange rate have been reflected in the steady accretion of foreign-exchange reserves, standing at US$307.1 billion as of 18 July 2008. According to RBI estimates, a substantial, if declining, liquidity overhang remains in the financial system, standing at 1.45 trillion rupees (US$33.4 billion) as of 25 July 2008.
Fuelled by the availability of credit, investment growth has steadily maintained a robust rate of 14-19% since fiscal year (FY) 2002/03 and now accounts for around 36% of aggregate GDP. The strength of domestic demand has been reflected in the widening trade imbalance. Although imports have been exaggerated by surging raw material costs, demand for capital and consumer goods has remained robust, accounting for around 60% of overall import growth. Finally, aggregate demand pressures have been further aggravated by the relatively lax fiscal stance as the subsidy burden remains significant and the bill for direct emergency relief, particularly in the agricultural sector, mounts. Fiscal pressure exerted by supply factors is potentially inflationary on two fronts. If the government acts to adjust administered prices to maintain fiscal sustainability over the long term, as in the case of the fuel price adjustments, this results in an immediate spike in inflation. However, if subsidies are left unadjusted and authorities resort to monetisation to finance fiscal deficits, this in turn has a more insidious inflationary impact.
Outlook and Implications
The RBI states that a "tolerable" level of inflation would be below 5.0% in the near term and 3.0% over the medium term. However, given the extent of pressure acting on prices, the central bank concedes that a more realistic target for annual inflation is around 7.0% by the close of the current fiscal year ending 31 March 2008. The central bank is also explicit in its aim to reduce annual growth in the broad money supply to around 17.0%. Adhering to that objective, the RBI has signalled that it will retain a tightening bias in monetary policy as liquidity growth remains above target, even at the expense of some lost momentum in growth. As it raised its inflation projection for the current fiscal year, the central bank also lowered its growth forecast to 8.0% from the previous band of 8.0-8.5%. The official growth estimate for FY2007 (ending 31 March 2008) was raised to 9.0% from the previous advance estimate of 8.7%. Growth is expected to moderate as aggregate domestic demand growth is cooled by interest rate hikes and the combination of robust import growth and slowing exports force the net export position into deeper deficit.
Inflation is expected to intensify before it recedes. The case for a tightening bias is bolstered by the fact that money supply and credit growth remain far in excess of nominal GDP, while real interest rates remain in negative territory. Although energy costs account for 14.2% of the overall WPI weighting, the impact of fuel price rises will ripple through the economy, driving cost-push pressures. Some relief from current inflation may be provided by improved harvests, with monsoon rains currently hitting average levels for the time of year, which should result in bumper harvests in the second quarter of the current fiscal year. However, the aggregate demand pressures highlighted by the central bank, still excessive liquidity and credit growth, and the uncertain outlook for global oil prices reinforce the bias for further monetary tightening, although the central bank may pause to allow for the latest hikes to work through the economy.
Adding to the rationale for price stability is the highly politicised nature of current inflation as low-income households that form the bulk of India's electorate are hit hardest by the surging cost of basic staples. The ruling Congress Party remains faced with the double-punch of slowing growth and elevated inflation as it heads into a critical election cycle, with major state polls preceding a general election scheduled to be held by May 2009. Yet, the risk of a 'bust' in the economy's recent phenomenal growth cycle remains limited. The RBI is rapidly catching up with the curve of recent inflation while external deficits remain highly sustainable relative to GDP, particularly given the current level of liquidity. The scenario for a stable moderation in growth to around 8.0% hardly ranks as a crisis, while maintaining macro-economic stability in the near term will improve the sustainability of growth over the long term.