The Reserve Bank of India raised its repurchase rate by a half-percentage point to 9 percent on 29 July, giving priority to the inflation fight over India's short term growth rate. Indeed many economists consider that the bank may well increase the benchmark rate again in the next three months. The cash reserve ratio was also raised 8.75 to 9 percent and in the statement which followed the decision the bank said it still had "headroom'' to further tighten monetary policy.
Inflation accelerated during the week largely because of an increase in the price of pulses, fruits, spices and sugar. Manufactured price inflation was up 10.82 percent in the week ended July 19, compared with a 10.72 percent gain in the previous week.
However while the inflation process in India still has some momentum, as the global economy slows - reducing pressure on commodity prices - and monetary tightening reins in domestic demand, the peak can not now be far away. Light, sweet crude for September delivery rose 90 cents, or 0.7 percent, to $124.98 a barrel yesterday (at the 2:30 pm close of floor trading on the New York Mercantile) but prices have been falling generally since hitting the record high of US$147.27 a barrel on July 11. International oil prices have now dropped around 15 per cent over the last three weeks, and if this trend continues then India should obtain some relief.
This is why it is so important to maintain strict monetary policy and avoid second round effects.
Foreign Exchange Reserves
India's foreign exchange reserves fell another $504 million - to reach $306.6 billion - in the week ended July 25 according to data from the Reserve Bank of India weekly statistical supplement.
Gold reserves were unchanged at $9.21 billion while reserves with the International Monetary Fund fell $2 million to $515 million. The nation’s special drawing rights with the International Monetary Fund held at $11 million. Despite the fact that India’s foreign exchange reserves, have increased by $81.3 billion in the last twelve months they have in fact now been falling since May. It could be however that the increase in interest rates and the falling price of oil could now see a reversal in this trend.
Exports Up In June
Indian exporters have started to benefit from the weaker rupee, which has now declined by 7.3 percent so far this year. India's export growth accelerated in June and overseas shipments, which account for about 15 percent of the Indian economy, were up 23.5 percent year on year to reach $14.66 billion, following a 13 percent gain in May. Imports increased 26 percent to $24.45 billion, widening the trade deficit (as compared to June 2007) to $9.78 billion. The deficit was however down on May's whopping $10.77 billion. India's oil imports in June rose 53.4 percent to $9.03 billion as refiners paid more for crude oil purchased overseas. India relies on imports of oil for three-quarters of its energy needs. Non-oil imports gained 14 percent to $15.4 billion.
India has paid an average $8 billion a month for oil imports in the year through June, compared with $5.4 billion in 2007.
Even though oil prices have now moderated from their peak at around US$145, they still remain quite high by historical standards, hence the further widening in the trade deficit. Each US$10 increase in crude oil prices results in an increase of approximately US$7 billion (or 0.6% of GDP) in oil imports and the trade deficit. High non-oil import growth may also cause further widening of the current account deficit at a time when global capital inflows are slowing. Non-oil imports grew at an average of 24.9% during April-May 2008.
The big unknown here is the future movement in the oil price. Despite the recent price easing, India still faces an import bill for crude that may reach $120 billion this fiscal year, compared with $69 billion the year before. This extra burden is about 4% of GDP.
Add the impact of the fiscal deficit to the oil bill, and it is not hard to see that the external deficit could reach 4% of GDP this fiscal year. Reducing this gap is now becoming a priority, especially given the comparative strictness of the ratings agencies vis-a-vis India. Any future downgrades in credit will only make funding the gap more expensive, and as we have seen attracting the foreign capital necessary to bridge the gap has been becoming harder in recent weeks.
Obviously, with the domestic credit induced consumer boom now fading, exports are going to become more important than ever for India's headline GDP growth. India's Trade Minister Kamal Nath recently set the target of more than tripling India's share of world trade to 5 percent by the year 2020 from the current 1.5 percent. This is a worthy target, and perfectly realiseable, but it will require India to conduct a substantial infrastructural overhaul and to intruce widespread regulatory reform. In the shorter term India is targeting exports of $200 billion in the current fiscal year, up 28 percent from the $155.5 billion achieved in the previous year. This is attainable, but with a deteriorating external environment it will be hard work.
India's rupee was up again this week on speculation the demand for foreign currency from oil refiners would reduce following the decline in crude oil prices. The rupee touched its highest in a week on Friday and advanced 0.5 percent to 42.35 a dollar at the 5 p.m. close in Mumbai.
The rupee also strengthened on speculation gains in the benchmark stock index will encourage overseas funds to stay invested in the country. The Mumbai Stock Exchange Sensitive Index, or Sensex, climbed for a fourth week, and was up by 1.86% on Friday at the 3:00 pm close, capping its best run in three months.
Overseas investors have sold $6.9 billion more Indian equities than they bought this year through July 30, compared with $17.2 billion in net purchases in 2007. Overseas investors bought a net 5.97 billion rupees ($148 million) of Indian equities on July 31, reducing their net outflow this year from stocks to $6.62 billion, according to the India's stock market regulator.
India's stock markets were given a boost when a senior oil ministry official said the ministry had requested the finance ministry to ask the central bank to restart its foreign exchange operations with oil refiners. The central bank had said earlier in the week that it would stop a two-month old scheme which provided foreign exchange directly to oil refiners in exchange for their oil bonds. Refiners are the biggest buyers of dollars in the currency markets.
Money Supply And Liquidity Conditions
Short term cash rates held below 7 per cent in India on Friday due to lower demand for funds on the end of fortnight reporting day, since the banks had already made arrangements to fund their reserve requirements in advance. At 12:30 pm call rates were at 6.50/6.60 per cent, higher than the its previous close of 6.00/6.25 per cent, but much lower than Thursday's weighted average rate of 8.34 per cent.
Banks have to report their cash balances to the Reserve Bank of India every second Friday, this has the consequence that demand for fund tends to be lower in the second week of the fortnight as banks generally try to fund most of their requirement in the first week itself. The general impression is that call rates will now climb back towards 9 per cent at the start of a new fortnight next week.
Banks loans fell by Rs 720 crore in the two weeks ended July 18, taking outstanding advances to Rs 24,07,860 crore. Credit rose by 25.8%, or by Rs 4, 93,805 crore, in the 12 months through July 18. Total bank deposits rose by 21%, or Rs 5, 72,859 crore. At the same time, money supply in India grew 20% in the two weeks ended July 18 from a year earlier, compared with 20.5% in the prior two weeks.
So non-food credit growth stood at 25.8%Y during the fortnight ended July 18, up from the end of 2007 low of 21.9%. While much of the increase is probably due to increased credit needs on the part of the oil companies, it also seems that bank credit to other sectors has been picking up lately. The RBI is particularly concerned about the level of credit growth, considering that deposit growth had already slowed to 21% over the same period.
The RBI recently expressed its concern about this situation and stated that "It is noteworthy that the growth in credit during 2008-09 so far has taken the incremental non-food credit-deposit ratio to 82.4%, which appears high, given the prescribed CRR/SLR and banks’ preference for holding excess reserves on a day-to-day basis…In F2009 so far, however, some banks have expanded credit rapidly in relation to the system level growth, with attendant worsening of their credit-deposit ratios. These developments warrant heightened policy concerns in the interest of overall systemic stability and the quality of financial intermediation”.
And the bank warns: “If necessary, the Reserve Bank would consider undertaking supervisory review of those select banks which are over-extended in terms of their credit portfolios relative to their sources of funds”.
The government has continued its loose fiscal policy in recent months. Apart from a higher oil subsidy, there is the off-budget burden of fertilizer and food subsidies to think about, as well as the farm loan waiver costs. The recent decision to raise wages for government employees will also add to the deficit burden. It is not unrealistic to anticipate the combined central plus state government fiscal deficit (including all off-budget spending) in the region of 7.7% in 2008 rising to 11.5% of GDP in F2009.
On the growth front a large gap has now opened up between the increasingly gloomy views of India’s prospects as seen from abroad, and the relative optimism of internal forecasters. The Centre for Monitoring the Indian Economy (CMIE), in Mumbai, still thinks India will grow by 9.5% this fiscal year, while JPMorgan, a foreign bank, anticipates growth in the region of 7%.
While the estimate is undoubtedly unduly high for this (calendar) year, with growth more than likely coming in in the 7.5% to 8% range, the optimism is not unjustified looking forward to 2009 and 2010. If inflation can be gotten under control India may start to hit double digit growth come 2010, and once it breaks the 10% ceiling, it may well stay above it for some considerable time. This is simply because India has a very large untapped capacity for growth, and it is not unrealistic to anticipate that this capacity can be unleased, especially if institutional reform continues, and the fiscal deficit concerns are addressed.
But things are likely to go down before they bounce back up again, since he tightening in monetary policy will achieve the desired effect of slowing aggregate demand and GDP growth further. Also negative global factors are likely to continue to weigh adversely on India’s growth outlook in the short term. Consumption growth has already slowed significantly. Investments growth has also begun to moderate and it is quite probable that the slowdown in the investment cycle will accentuate over the next six months.
Everything really now depends on the outlook for inflation and capital inflows. I believe that Inflation should peak in late summer at levels which are not too far above those we are currently seeing. They should then start moderating and we could well be back down at 7% - 8% by the end of the financial year. In part this depends on oil prices, and year on year base effects, and oil and food prices, of course, also partly depend on growth in India and the other key emerging economies. Thus we have a kind of "inbuilt stabiliser", since as the major emerging economies slow, commodity prices ease back, and as this happens the central banks can begin once more to loosen monetary policy, providing a kind of win-win feedback effect.
This wioll then operate until commodity prices rebound once more and the emerging central banks tighten again, etc, etc. The key point to grasp here is that it is consumers in the heavy energy consumption OECD economies who are going to do the heavy lifting of bearing the pain here, as resources are effectively transferred from their wallets to those of the oil producers, and it is this process, rather than what happens in the emerging economies which is likely to keep a cap on global growth in the coming years.
Thus the RBI is now unlikely to hike policy rates further unless oil and other commodity prices lift up again from the current levels, and if global growth slows further this is hard to see happening. The second risk to the ‘no further rate hike’ outlook is, of course, any large global financial market shock that triggers major capital outflows from emerging markets generally and from India. In such a case, the RBI would need to hike the policy rate to prevent any major depreciation in the exchange rate and consequent adverse impact on the inflation outlook. I feel however that this scenario is being rather overplayed at the present time. There will almost certainly be some kind of "emerging market correction" (in central and eastern Europe, perhaps, or possibly in China) but if this is the case it is hard to see India being in the direct line of fire, since if the money leaves India, one might well ask where it will be bound? Certainly not to Japan, where yields are still more or less on the floor, and the economy almost certainly in recession. It is also hard to see financial turmoil troubled economies in the US and Europe serving as safe havens this time round, so on balance I would put the risk of major outflows from India at a rather low level, which is not, of course, the same thing as being complacent.
More fickle, however, are the foreigners who bet large sums on Indian shares when the stockmarket was in full bloom. They are deserting the country, withdrawing $6.7 billion so far in 2008. The only consolation is that as share prices fall, so does the amount they can repatriate, relieving some of the pressure on the currency.