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True, there were a few clouds in the clear sky even before this: crude oil prices were high at $91 a barrel, but that was not unduly worrisome. Financial market conditions were a little tight, but increased government spending in the last quarter of the financial year was anticipated, and that would improve liquidity. Capital flows were lower, though steady, but commodity prices were rising, and companies said they would pass on cost increases to consumers.
In the first two weeks of January, things changed, and quickly. Fears of an aggressive policy interest rate hike by the Reserve Bank of India (RBI) to dampen persistent inflationary pressures spooked foreign institutional investors (FIIs) and the stockmarket indices fell by almost 5 per cent; food price inflation, reflected in the sharp spike in onion prices, assumed demon-like proportions.
If none of this was cause for serious concern then, it might become one now. In addition to price increases in food, raw materials and other commodities, interest rates are beginning to climb, and could soon become high enough to make credit very expensive.
Output fell dramatically; the index of industrial production (IPP) grew by just 2.7 per cent for November — far below expectations of 6.5 per cent — creating fears of a rapid slowdown. Is the India growth story in for a rude shock?
Tiger By The Tail
Early this month, the International Monetary Fund in its advisory to the government suggested that the central bank keep raising rates to bring down inflation. At its end-January review of monetary policy, the RBI is likely to do just that. The only question is, by how much.
"Interest rate hikes usually dampen inflation," says S. Sridhar, chairman and managing director of Central Bank of India. "But real interest rates have been negative for a long time; another round of hikes could add to inflation."
Inflation has been troubling companies, consumers and the central government; the first is dealing with higher input costs of raw materials, the second with rising food prices, and the government is worried about the political blowback from very high food price inflation.
Real negative interest rates — interest rates minus the rate of inflation — have already pushed banks into raising deposit rates. Of course, they have also raised lending rates as a consequence. On the other hand, firms are elongating working capital cycles to reduce their dependence on bank credit.
Sridhar acknowledges there are uncertainties on the liabilities (deposits) side, making it harder to access longer-term capital. "Most term deposits have shifted to the one-year category," he says. "On the lending side, loans tend to be short-term, too, even as companies have come to depend on bank credit." But the key insight appears to be this: interest rate hikes, which are usually a demand-management tool, are becoming a supply-side constraint.
How much could the RBI's policy rate hike impact the interest rate scenario for the economy as a whole? Indranil Pan, chief economist at Kotak Mahindra Bank, says that for most firms, the prospective size of interest rate hikes lies between concern and worry. "Liquidity is softening a little, but that will not be sustainable for a long time," he says. "The question most of us have is whether the policy rate increase in January will be a hammer or a nudge."
Monetary policy transmission takes place with a lag, usually three months, meaning the impact of any policy rate hike by the RBI in January translates into corporate response in April. But can the RBI contain the present runaway inflation, particularly in food prices?
"We are not at the point where interest rates can derail the economy," says Sonal Varma, economist at Nomura Financial Advisory and Securities. "Growth is not going to stall. What we need is a supply-side policy response to contain current inflation." But consumption could come off in the urban areas, she acknowledges.
In part, Varma's view reflects the perception that if the RBI hikes rates aggressively, growth could be hit. If the index of industrial production numbers for November 2010 are any indication, growth is not accelerating like it was in the middle of the year; moderation has already set in; an aggressive hike would push the moderation into a broader slowdown. And that cannot be good news for anybody.
|KEEPING ALL OPTIONS OPEN: RBI governor D. Subbarao|
Poised On A Knife-edge
For the RBI, the January policy review could well be a difficult one, as it balances the options of maintaining the growth momentum against the imperative of bringing inflation down quickly. To this end, even the government would look to the RBI for solutions. With elections in five states scheduled for this year, the UPA government is hard-pressed for solutions.
Bank credit growth — which is a good proxy for economic activity — has been below target for much of the year, because interest rates have been high. Firms have relied on overseas and suppliers' credit — both cheaper alternatives — to meet working capital demands. As the global economy, particularly the US, improves, those lines of finance may not be as easy to come by.
But what the RBI says and does will matter the most. The central bank has its own surveys and other analytical tools to assess the state of the economy. "If the RBI believes that the growth prospects are good, then higher interest rates will have little effect on credit demand or investment," says Pan.
Central Bank of India's Sridhar believes that there is enough slack in consumption. "Tier-II and tier-III cities are the drivers of growth," he says. "There are lots of substitution effects, as people buy more expensive branded products."
Just before BW went to press, the inflation data came out: the food price index went up nearly 17 per cent. And the fuel price index for 1 January 2011 rose over 11.5 per cent compared to the previous week. As feared, it was bad news, and will impact the RBI's thinking on its interest rate policy. Hold your breath.
(This story was published in Businessworld Issue Dated 24-01-2011)