Will Rising Inflation Deflate India's Economic Recovery

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Will Rising Inflation Deflate India's Economic Recovery?Published in India Knowledge@Wharton

While inflation has been picking up in India, even causing asignificant stock market correction over consumer price worries,government leaders are unlikely to take strong off-setting monetarymeasures in the short term. Instead, they appear to be adopting awatchful stance while taking relatively modest steps to easeinflationary distress. The steps include some changes in bank rules,relieving pressure on some politically sensitive food prices anddivesting of some public sector undertakings, which could cut thespending deficit by up to 2% of GDP.

Like many countries that have relied on monetary and fiscal reliefpolicies to ride out the financial crisis, India knows it will one day

have to wind down its stimulus measures or face a steepinflationary spiral that could derail economic growth longer term. Because the country suffered less thanmost economies during the global downturn, it looks to be recovering quickly, and decisions regarding astimulus exit strategy have become all the more critical. The governor of the Reserve Bank of India(RBI), D. Subbarao, now predicts that inflation will be 6.5% at the end of March 2010 -- more than thepolicy comfort zone of 4% to 5%. Others think it could go to 8%.

The challenge for the RBI now is to avoid withdrawing spending and interest rate support too soon --before the economy is running on its own steam -- or keeping it going too long, which could causeinflation to soar. In India, as in many economies, timing is everything. As the International MonetaryFund noted recently in regard to Asia generally, policymakers must "continue to provide support toeconomies until it is clear that the recovery is self-sustaining" -- and at the same time, ensure that policiesare not "maintained for so long that they ignite inflation pressures or concerns about fiscal sustainability."

The task has shifted from "managing the crisis to managing the recovery...," Subbarao said. "The time hascome to start thinking of an exit strategy" from an expansionary monetary stance.

For most industrialized countries, the immediate worry is more about deflation than inflation, thoughmany analysts expect that to change in the medium term. At the moment, inflation is the bigger worry inIndia, however. Abheek Barua, chief economist at HDFC Bank, says the fact that the RBI has revised itsprojection for inflation to 6.5% -- "with an upside bias" -- by March 2010 from its earlier projection of 5%sends a strong enough signal that it is concerned about inflation. It admits that its "current monetarystance is not the steady state and [it needs] to reverse the expansionary stance. However, the fact that theRBI also introduces a rather detailed discussion on the factors in favor and against exit at the stage seemsto suggest that it is not keen on a quick exit. We predict a hike in the policy rates by 25 basis points [100basis point equals 1 percentage point] in the January 2010 credit policy meet."

Comments by leading officials have been contradictory when it comes to inflation, making it difficult toget a good read on intentions. It does not seem that government leaders will take any strong steps to curbinflation immediately. More generally, officials appear to be adopting a watchful stance, while adoptingsome modest measures to lower inflationary fears.

Modest Measures

Among those measures, the RBI increased the statutory liquidity ratio (SLR) -- the amount a bank needsto keep in cash or liquid instruments -- from 24% to 25%. This was in effect going back to thepre-stimulus regime. "This, however, is just a signal," says one banker. "It won't have any impact on thesystem as banks already have SLRs of more than 25%. Banks are sitting on cash and are being very

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choosy about who they lend to." Adds Barua, "For those concerned about inflation, the SLR increase hasa monetary policy dimension as well -- it sterilizes some of the excess liquidity in the banking system. A1% increase in SLR translates roughly into Rs. 40,000 crore. However since many banks already holdSLR securities in excess of the stipulated norm, the exact impact on liquidity is a little difficult to gauge."

The RBI also withdrew some other "unconventional refinance facilities" for exporters, non-bankingfinance companies and housing finance companies that had been introduced as part of the stimulus. "TheRBI increased provisioning for commercial real estate from 0.4% to 1% and raised the total provisioningcoverage ratio, including floating provisions, to at least 70%," says Nandan Chakraborty, head of research

at Enam Securities. The latter, in particular, "was a big negative surprise for some banks that have a lowerprovisioning, as they have to provide for the remainder by September 2010."

The stock markets read into these measures a coming end to the stimulus package and plunged. A tightmoney policy is not conducive for growth, and the RBI seemed to be sending signals that interest rateswould be hiked in the next few months. On the day of the policy announcement, the Bombay StockExchange Sensitive Index (Sensex) fell 387 points or 2%, the main losers being the State Bank of Indiaand ICICI Bank. Finance Minister Pranab Mukherjee had to step in to assure jittery operators andinvestors that there would be no premature withdrawal of the stimulus.

Since then, the signals have been more mixed, and the RBI has been indicating that nothing will be donein a hurry. At an India-China Financial Conference in Mumbai on November 11, RBI deputy governorShyamala Gopinath said exit from an easy monetary policy must keep inflationary expectations

well-anchored. "India is actively confronted by an upturn in inflation," she told the assembled bankers.The country will have to take its own path. "A withdrawal from the supportive monetary policy maydiverge considerably between developed and emerging nations."

"There is a need to ensure that inflationary expectations are managed appropriately," says ICICI Bankmanaging director and CEO Chanda Kochhar. "The RBI has indicated that its exit strategy from themonetary stimulus conditions will take into account the pace and depth of economic recovery.... The RBI,while indicating the beginning of the exit process, has also signaled very clearly that any such exit will benon-disruptive to the growth momentum."

But a few days later, Prime Minister Manmohan Singh indicated that the sops were soon to go. "There areclear signs of an upturn in the economy," Singh told the India Economic Summit organized by the WorldEconomic Forum (WEF) in New Delhi in early November. "Like other countries, we resorted to a

significant stimulus and we will take appropriate action next year to wind this down." According toBloomberg, India could be the first among the Group of 20 nations to begin winding back its fiscalstimulus.

Too Many Voices?

At other venues -- like the Economic Editors' conference in Delhi, which is often used to transmitgovernment thinking to the media -- there has also been the spectacle of various government ministers andbureaucrats expressing contradictory views. Business channel CNBC-TV18 posed the question directly toMontek Singh Ahluwalia, deputy chairman of the Planning Commission (the Prime Minister is ex-officiochairman): "[At] the WEF, the Prime Minister said we would take appropriate action next year to wind[the stimulus] down, but hours later the minister for commerce and industry struck a very different note.For many people, that sounds as though the government is speaking with two voices?"

Ahluwalia responded by suggesting that the different voices are simply going through the process ofseeking a necessary consensus. And that process will not happen overnight. "There is a lot of concern inthe markets as to whether we are now ready to withdraw the stimulus. Very often, newspaper men askme, 'Are we going to withdraw the stimulus now? Are we going to tighten the monetary policy now?' Thesignal that the government has given very consistently is that neither fiscal nor monetary policy needs tobe changed during the current fiscal year and the time to make further adjustments to one or both of theseinstruments will be during the next fiscal year."

That thinking may go out of the window if inflation starts to rise. In October, the government startedcalculating the Wholesale Price Index (WPI) on a monthly rather than a weekly basis. Inflation rose


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1.34%. In September, it had been 0.5%. Meanwhile, industrial production in September rose 9.1% overthe corresponding month of the previous year. "The finger is on the [interest] rate trigger now" due to thecombination of stronger-than-expected industrial output figures and mounting inflationary concerns,HSBC economist Robert Prior-Wandesforde toldAFPin Singapore. He predicts inflation will be at 8% byFebruary or March.

Inflation forecasts by others have risen sharply. The IMF, which in March 2009 projected inflation of just2% for the fiscal year ending March 2010, now sees inflation at 8.7% for the calendar year of 2009. InOctober, itsRegional Economic Outlookwarned: "In India ... industrial production is recovering rapidly,

and core inflation and inflation expectations are rising."

A July 2009 report by apex chamber of commerce Assocham, titled "Inflation concerns for the Indianeconomy," notes that inflation is likely to average near 5% in 2009-2010. The report, which now looks abit dated, rightfully pointed to some of the principal causes of inflation: poor monsoons in India and "thesurge in the international commodity markets led by energy (crude oil, natural gas and coal), metals(copper, aluminum and iron ore) and food (cereal and meat)." The fiscal stimulus will do its bit, too."(The) heavy fiscal stimulus totaling close to 4% of GDP and monetary measures to ease money supplywould commensurate (sic) into a fresh lease of demand that would give a push to the general price level inthe economy," the report notes.

At the WEF meeting in Delhi on November 8, Ahluwalia of the Planning Commission said: "I think weare on target for anything near 5%-6% inflation. I would like it to be 5% rather than 6%. But at the point

when growth is distinctly below potential, the balance of the concern is essentially maintaining thegrowth rate. The real concern on the pricing front is that you have food price inflation somewhat high.But that reflects partly the bad monsoon. I expect by the end of this financial year, food price inflationwill come down." The monsoon rainfall this year has been 23% below normal -- the worst in 37 years. Itwas followed by floods, which further damaged crops.

Sharp Rises in Food Prices

Food inflation is the major culprit behind the rising numbers. In October, food prices increased by13.32% year-on-year. Rice was up 13.22%, pulses 22.81%, sugar 45.70% and potatoes and onions awhopping 96.43% and 37.60% respectively. In India, governments have fallen because of onion priceincreases. It matters because it hits the common man. Sharp rises in food prices, especially for "rice andpulses, other primary food products and of sugar is a major policy concern," says C. Rangarajan,

chairman of the Economic Advisory Council to the Prime Minister in an October report. "Even in thewinter of 2008-09, as world prices of manufactured goods and internationally traded basic foods weredeclining, the domestic prices were increasing. The weak monsoon rains and available acreage datasuggest a lowerkharif[crop season] output rendering the management of inflation in food products asevere challenge in this fiscal year. While the current weather conditions favor a strong rabi [winter]crop, the possibility of adverse weather conditions in rabi cannot be completely ruled out."

Rangarajan's prescription: A strong supply response -- a more coordinated release of stocks through thepublic distribution system, open market sales of public stocks, precautionary arrangements for importingsome food grains and attention to ensuring a strong rabi harvest.

India has already allowed the duty-free import of one million tons of sugar. The cap is likely to be raisedto two million tons, and the import duty on rice has been scrapped. Government organizations havefloated tenders for 30,000 tons of rice and 18 bids came in earlier this month. As expected, global priceshave firmed up now that India is shopping. According to finance minister Mukherjee, however, India hasadequate stocks. It can even export if need be, he says. India has a buffer stock of eight million tons ofwheat and seven million tons of rice.

The government is also taking action regarding the fiscal deficit. The stimulus is headed towards creatingan untenable spending deficit of 6.8% of GDP in 2009-10. "Fiscal deficit can be financed throughdomestic borrowing, external borrowing or by printing money," according to a paper by AlamuruSoumya, a consultant at the Indian Council for Research on International Economic Relations, aDelhi-based think tank. "Excessive domestic borrowing may put upward pressure on interest rates andexternal borrowing may result in an external debt crisis. Printing money may lead to high inflation."


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The government proposes to bridge this gap through disinvestment of public sector undertakings (PSUs).In early November, the Cabinet Committee on Economic Affairs (CCEA) decided that all listed andprofitable Central PSUs would have to maintain a minimum of 10% public shareholding. The CCEA alsoproposed that unlisted PSUs with a three-year track record of net profits and positive net worth should getlisted.

The government can raise US$12 billion through this disinvestment, former Securities & Exchange Boardof India member J.R. Varma told CNBC-TV18. "It's doable," he says. An Assocham report puts the

figure at US$16.6 billion. The union Budget earlier this year had estimated the takings from PSUdisinvestment at a paltry US$200 million this year. There are hurdles however. This money cannotautomatically be used to balance the deficit. It needs special Parliamentary dispensation. That mayhappen. Curiously neither the Left nor the Right has protested against the disinvestment initiative. "Thisis the single largest disinvestment decision that any government has taken so far, and could generate up to2% of GDP," wrote editor T.N. Ninan in business dailyBusiness Standard. The stock markets havebounced back on news of the disinvestment.

For the government, this is a time to wait and watch. Ahluwalia says he is not too worried. "[Right] now, Idon't think we are in a position where the inflation issue is anything other than something we keep a closewatch on," he told the WEF.

"Inflation management has moved up in the hierarchy of RBI priorities," says Chakraborty of Enam

Securities. He expects the RBI to raise banks' cash reserve ratio -- or the amount banks have to keep withthe central bank, currently at 5% -- by December-January. "However, weak growth, due to the impact ofthe monsoon, will keep policy rate increases at bay till the end of the fourth quarter [January-March2010]."

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Will Rising Inflation Deflate India's Economic Recovery