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BW Businessworld

Sounding A Warning Bell

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Amidst the plethora of forecasts on near-term growth prospects, the Reserve Bank of India's (RBI) annual report sounds a little more nervous than one would expect. In the  assessments and prospects section of the report, the central bank is voicing doubts about the expected pace of economic recovery, and the implications for monetary policy in the coming months.

The RBI raises three questions. First, what happens if the recovery is not quick enough? In other words, what are the challenges if growth weakens and inflation rises higher and faster? If inflation rises and interest rates follow suit, credit growth to the corporate sector could get dented; the pace of recovery would weaken.

Second, what will weaker growth do to the plans for exit from loose fiscal and accommodative monetary policies? Continuing either or both beyond a point would only serve to heighten potential conflicts between monetary and fiscal policies. Third, how long will the global crisis continue to be a factor? The impact of global growth and monetary conditions on domestic policy cannot be ignored, especially where they concern capital flows.

The report contains a fairly detailed analysis that compares past experience of the pace of recovery from economic slowdowns. By that reckoning, things are looking up, going by some measures like the index of industrial production (IIP) which showed some surprising numbers for June. Going by what was said in the trade policy announcement on 27 August — the IIP grew by 7 per cent in July, but the final numbers and compositional breakdown will be available in mid-September — they will be pleasantly surprising for July as well.

Click here to view enlarged imageBut by another measure, things look less certain: up to May 2009, the Industrial Entrepreneurs' Memoranda, which is submitted to the government, recorded 1,342 proposals (3,979 in 2008) with a proposed investment of Rs 4,04,380 crore (Rs 15,22,566 crore in 2008). But there were zero follow up letters of intent issued (4 in 2008, and 8 in 2007). Business confidence notwithstanding, much of corporate India is also unsure about future prospects.

The RBI is clearly worried about the timing of the withdrawal of ‘monetary accommodations': in other words, how long it can continue to support the high levels of liquidity in the system before inflationary pressures begin to be felt. The problem is compounded by the government's large borrowing programme that could further attenuate inflationary expectations.

And let's not forget about global markets, and in particular commodity prices. If they remain firm or begin moving up, higher input costs for Indian producers could also become factors in driving inflation upwards. As the global financial crisis continues to resist all efforts to overcome its consequences, the RBI is also reviewing its reform commitments over the medium term.

Overall, the tone of the annual report suggests one possible outcome: the central bank could begin monetary tightening earlier than expected. Most analysts and market observers expected a hike in policy rates after the next quarterly review of monetary policy at the end of October. Now, they may recalibrate those expectations and prepare for monetary tightening sooner. Corporate India may have to do a tactical rethink too.

(This story was published in Businessworld Issue Dated 07-09-2009)