As India's Economy Simmers, What Will the RBI Do?

With the government planning a fiscal push, it is likely that the central bank will be concerned with price stability and not rate cuts in its October policy meeting.

A man pulls a hand-drawn cart in front of the Reserve Bank of India (RBI) building in Mumbai January 24, 2012. Credit: Reuters/Danish Siddiqui/Files

A man pulls a hand-drawn cart in front of the Reserve Bank of India (RBI) building in Mumbai January 24, 2012. Credit: Reuters/Danish Siddiqui/Files

Late last week, the Indian rupee saw a big fall, sinking to a six and a half month low. It was Rs 65.15 per US dollar. The fall was by 34 paise.

Exchange rates fall or rise following any disequilibrium, creating news. The change is swift and automatic in a floating rate regime, whether dirty or otherwise. If one currency falls, the bilateral currency against which the value is expressed rises: it is a natural, see-saw effect.

Such a fall in the value of currency is bad for a country with an already-expanding trade deficit, as imports would become more expensive than before; and good for the country with a trade surplus, as its imports become cheaper. Further, the popular perception is that a country with an appreciating exchange rate should be economically stronger.

The American dollar rose, as the US Federal Reserve (the Fed) indicated that it would gradually start reducing its shrinking $4.5 trillion balance sheet. These indications are mainly on the back of growth at 3% in the second quarter of 2017, above market expectations of 2.7% and also observed to be the strongest growth rate since 2015; and a low level of unemployment (4.4%).

Although actual inflation is still below the target, advance notice from the central banks is now the common trend in central banks’ clear communication to economic agents, unlike in the Greenspan-esque years.

Options before RBI 

The monetary authorities know the impact of a likely hike in the US Fed policy rate with hints on upward increases to come. They also know the central banks of other advanced countries including the euro zone would also plan to make revisions at least for one reason: to stem the likely reversal of capital flows.

A small interest rate differential following the Fed action to raise the interest rate would be enough: the capital outflows to emerging markets seeking higher returns would now be attracted back to US. Other central banks too would try to follow suit to nullify the effect of the US Fed action.

Also read: Faltering Growth – Will Modi’s Fiscal Push Do the Trick?

Since the emerging economies including India are presently far better placed than before, they do not have to worry much on the foreign reserves front.

India now has a record level of foreign exchange – $400 billion. The dollar shortage is not a problem of the kind faced in 2013, following the first wave of “taper tantrum signals” which haunted all emerging economies. India and other emerging economies can safely withstand any immediate short-term capital outflows. Further, the RBI, which has been intervening in the foreign exchange market for stabilising the nominal exchange rate of the rupee, need not worry on that account. It can stop its intervention for now and wait.

A shopkeeper poses for a picture as he counts rupees at his shop in Jammu. Credit: Reuters/Files

A shopkeeper poses for a picture as he counts rupees at his shop in Jammu. Credit: Reuters/Files

Furthermore, the rising liquidity concerns consequent to the purchase of dollars under its intervention will abate. The exporters will also be happy that the nominal exchange rate has fallen on its own, thanks to the US Fed action. They had a grouse that the RBI was not helping the economy. Of course exporters know well that it is not the depreciation of currency due to market forces under a flexible exchange rate regime or man-made devaluation under a fixed exchange rate regime which would determine the rise in exports, unless Indian exports are competitively more attractive.

The government policy makers are also aware. Although the Chinese currency recently appreciated more than the Indian rupee, giving some price advantage to Indian exports, no notable gains were recorded. It is obvious that the range and quality of India’s manufactured exports were not good enough.

Different concerns

The concerns of the RBI lie elsewhere – in price stability.

A falling exchange rate means there will be a rise in import inflation. The import content of India’s exports is estimated to be around 25%. In addition to raising the domestic prices of imported consumer goods, depreciation would also push the price of exports, impacting export competitiveness dearly. Reduction in export earnings resulting from import inflation would only widen trade deficits.

Currently, in the context of a downward trend in growth rates for the past five quarters, the government is reported to be planning for a Rs 50,000-crore fiscal push for kickstarting the economy, without minding “a little widening deficit”. Most policy makers are keen to play down the dangers of expanding trade deficits. They want to totally ignore the existence of twin deficits or the adverse implications.

Also read: Will the Fiscal Stimulus Package Put the Indian Economy Back on Track?

Even those who are aware of the implications of a contemplated bigger budget feel confident the record level of foreign reserves at $400 billion can bail out the Indian economy.

One thing is for sure, they are aware that international business confidence is not built around the current level of foreign reserves: it is on future market expectations, which are based on current policies.

The present indications are ominous:

  • Around 92% of the fiscal deficit target of 2017-18 has already been reached.
  • Fiscal deficit is expected to be 5.05% by end March 2018.
  • Debt at 69% of GDP would rise further.
  • Imports, which exceed exports, have been funding more of domestic consumption rather than growth-enhancing investment.
  • The current account deficit, which was 0.55% of GDP in March 2017, is bulging. It was at 2.38% of GDP in June 2017.
  • Inflation in the second quarter of the fiscal year 2017-18 is 3.7%, and is tipped to be above RBI target of 4%. It will be 4.3% in the third quarter and 4.6% in the final quarter.

A disaster is waiting to happen from policies of fiscal extravagance, which will have immense inflationary potential, both domestic and imported.

With the global headwinds becoming wilder as oil prices rise due to North American natural disasters as well as the tensions mounting in the Korean peninsula, the RBI will be now more concerned with price stability.

It is likely some members of the Monetary Policy Committee, though maybe a minority, will even be in favour of a rise in interest rate. It looks more likely that interest rate cut is not on the cards.

T.K. Jayaraman is a research professor at the International Collaborative Partner programme, University of Tunku Abdul Rahman, Kampar, Perak, Malaysia.