The government must tighten the fiscal policy swiftly to manage aggregate demand. Otherwise, inflation and current account deficit could only rise if capital inflows spike up.
Low rates in the developed world and quantitative easing increase the possibility of spike in capital inflows to India.
Morgan Stanley’s global economics team expects interest rates in the G3 to remain low for a longer period.
Indeed, our team expects average policy rates in G3 — comprising the US, eurozone and Japan — to remain close to 0.6% until end-2011.
Moreover, the team thinks the Fed could announce additional quantitative easing, which would involve about $1.2 trillion of asset purchases.
Over the last few weeks, there has been a significant increase in capital inflows into the region, and this has raised the debate on managing capital inflows to ensure that it does not add to inflation and asset bubble risks.
So far, capital inflows have not been a concern.
Capital inflows into India have been well below the peak in F2008. In the previous cycle, 12-month trailing sum of capital inflows had reached a peak of $106 billion as of March 2008.
Based on trends in forex reserves and our estimate of current account deficit and revaluation in non-dollar currencies in forex reserves, we believe that during the last 12 months, capital inflows would have been about $65-70 billion.
Moreover, high current account deficit is absorbing bulk of the capital inflows.
We believe that during the 12 months ending September 2010, the current account deficit would have been about $50 billion, largely offsetting the capital inflows.
We believe that the recent appreciation of the rupee against the dollar seems to be creating a notion that the balance of payment surplus has risen sharply.
We believe this trend was a reflection of the weakening of the dollar rather than an appreciation of rupee. On tradeweighted basis, the rupee has not appreciated much during this period.
For example, since July 1, while the rupee has appreciated against the US dollar by 4.8%, it has depreciated against the euro by 6.1%.
While so far capital inflows have been manageable, there is a risk that capital inflows into India may rise further from the current levels if US Fed implements additional quantitative easing in early November.
If capital inflows do rise sharply toward $100 billion or more, the complexities of policy management will increase in the context of current macro environment with strong GDP, high inflation and rising current account deficit.
What will be the policy response going forward if capital inflows rise sharply?
The RBI will hesitate in allowing currency appreciation:On the real effective exchange rate (REER, trade-weighted basis adjusted for inflation differentials) basis, the currency is already close to the 2007 peak.
Considering that the current account deficit is already high, the RBI may hesitate in allowing a major appreciation in nominal trade-weighted exchange rate.
If capital inflows rise sharply in the first stage, the RBI may intervene more in the forex market.
Currently, interbank liquidity is already tight and the RBI has been injecting funds on a daily basis.
Hence, initially the RBI may not even need to sterilise the liquidity arising on account of forex intervention.
In case the magnitude of capital inflows is large, the central bank can start issuing market stabilisation scheme bonds and reverse repos to sterilise the increase in liquidity arising from forex intervention (buying dollars, selling rupees).
In the second stage, as capital inflows continue to rise above $100 billion, there is a chance the government may initiate some soft measures to discourage debt-related inflows.
Aggressive tightening in monetary policy will be a challenge: Although inflation has been moderating, it remains high.
So far, the burden of managing inflation risks has been on monetary policy.
After cutting the repo rate by 425 bps from the peak of 9% between September 2008 and April 2009, the RBI has lifted it up by 125 bps. Short-term markets rate has risen by 225 bps.
However, real interest rates still remain negative and will likely remain very low even as the short-term rates rise further and inflation moderates over the next six months.
Although so far the debt-related capital inflows have been manageable, there is an increased risk that these inflows may start rising if the RBI tightens monetary policy aggressively.
Moreover, as the corporate sector is able to fund itself more easily from the capital market, the ability of the monetary policy to influence aggregate demand will be limited.
Fiscal policy needs to play more active role, going forward: We believe that fiscal stimulus has probably played a bigger role in growth recovery since the credit crisis compared to monetary policy.
In F2008, the consolidated fiscal deficit (including off-Budget expenditure) stood at 5.8% of GDP, the lowest since F1983.
However, pre-election spending, a wage hike for government employees and stimulus related to the credit crisis meant that consolidated national expenditure to GDP shot up by close to 4 percentage points between F2008 and F2010.
Moreover, the government had also provided support through a cut in indirect taxes, which has not been fully reversed as yet.
The consolidated fiscal deficit (including off-Budget expenditure) increased to 10.8% of GDP in F2009 and remained high at 10.3% of GDP in F2010 compared to 5.8% of GDP in F2008.
Although the central government will report a reduction in fiscal deficit in F2011, this has been largely supported by one-off items like collection in 3G and broadband wireless access (BWA) licence fees and higher collections from divestment in SOEs.
The expenditure to GDP (including off-Budget oil subsidy) will remain closer to the peak in F2011 and the aggregate demand push remains intact.
Indeed, in the first five months of the current financial year, the central government’s expenditure has increased by 30% year-on-year.
We believe the time has come for the government to tighten the fiscal policy swiftly to manage the aggregate demand as the private sector spending is rising quickly.
In the absence of this move from the government, we believe inflation and current account deficit could only rise if capital inflows spike up.
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