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Wednesday, March 19, 2008

India's Inflation, Capital Inflows, The Rupee and Macro Management Problems

by Edward Hugh: Barcelona

India's inflation unexpectedly accelerated again in the first week of this month, in the process taking the level to a nine-month high , and making it more difficult for the central bank to reduce interest rates in as a response to the now evident slowdown in economic growth. Indian wholesale prices rose by 5.11 percent year on year in the week ended March 1, up from the previous week's 5.02 percent, according to data released by the Ministry of Commerce and Industry in New Delhi last Friday.

What is obvious from the above chart is that the steady uptick inflation since last autumn. Rising energy and food costs are likely to continue, and These will only add to the problems facing the administration. Crude oil jumped to an all-time high of $111 last week, putting pressure on India's government to continue increasing prices following February's initial increase in the cost of retail gasoline and diesel. Central bank Governor Yaga Venugopal Reddy last week said rising food and energy prices pose "acute policy dilemmas". Reddy also indicated that India's benchmark interest rates, currently at a six-year high, won’t be coming down in a hurry, due to the current inflation and the difficulties arising from uncertainty in the global financial markets.

Reddy recently stressed that tackling inflation was a higher priority for the RBI than boosting economic growth, which, as we can see in the chart below has been slowing - although not dramatically so - and growing at the slowest pace since 2005 during the last quarter of 2007 as tighter central bank credit reduced the rate of consumption expansion and a higher rupee slowed export growth. The economy expanded by 8.4 percent in the three months ended Dec. 31 over a year earlier, after rising by 8.9 percent in the previous quarter.

"The large segments of the poor tend to reap the benefits of high growth with a time lag while the rise in prices affects them instantly.....Considerable weight is currently accorded by the Reserve Bank of India to price and financial stability while recognizing its twin objectives of growth and stability."

Speaking following the latest inflation announcement Reddy did hint, however, that the Reserve bank of India (RBI) might offer some relief to banks by widening the liquidity adjustment facility (LAF) corridor. He stressed that this action would be taken as a response to the difficulties being presented by the current global uncertainty. The LAF corridor is the difference between the repo (rate at which the RBI lends overnight money to banks) and reverse repo (rate at which banks park their surplus cash with the RBI). Reddy said that the current 175 basis point difference between the RBI’s repo and reverse repo rates was a direct reflection of the level of uncertainty in financial markets. The repo rate is at 7.75%, while the reverse repo rate is 6.0%. The margin can be widened by either raising the repo rate or cutting the reverse repo rate.

Reddy has also indicated that the current wide gap between the two policy rates is the result of monetary operations and not the consequence of a specific predetermined policy decision.

One of the key questions lying in the background here is the functioning of the market stabilisation scheme (MSS). The MSS is essentially a liquidity absorption mechanism which has been adopted by the RBI and involves the issuance of treasury bills and bonds to suck out excess liquidity as foreign capital inflows continue. The need to service the coupons on these bills has increased the government’s fiscal burden and as a result affected the fiscal deficit target mandated by the Fiscal Responsibility and Budget Management (FRBM) Act.

The scheme has become an embarrassment for policy makers as the MSS target of Rs 250,000 crore exceeded government borrowings of around Rs 111,196 crore. As a result the government’s liquidity management function has gone well beyond mere borrowing to meeting current expenditure needs. The government is absorbing funds to manage liquidity and compensating by making coupon payments on treasury bills and bonds issued under MSS rather than borrowing for planned expenditure. The result is that in order to address the twin requirements of meeting the FRBM target of reducing the fiscal deficit to 3 per cent of GDP by the end of the next financial year and of maintaining inflation within the RBI target range, the government may have to sacrifice public welfare expenditure if inflows continue at the current rates.

Bank Lending and Financial Inflows

Meanwhile bank lending continues to rise, and was up 21.88% year-on-year in the two weeks to February 29, 2008, as compared with the 21.84% growth rate logged in the fortnight ended February 15, according to Reserve Bank of India data released last Friday. Outstanding loans rose by Rs 41,481 crore to Rs 22.51 lakh crore in the two weeks to February 29. Non-food credit rose by Rs 39,988 crore to Rs 22.07 lakh crore over the two weeks, while food credit rose by Rs 1,493 crore to Rs 44,311 crore in the same period. Deposits were up 23.7% in the two weeks to February 29 from a year earlier. Banks' deposits rose by Rs 43,539 lakh crore to Rs 30.81 lakh crore.

At the same time the country's foreign-exchange reserves continued their upward march and increased by $2.2 billion in the week ended March 7 to $303.5 billion, according to the RBI.

The Weakening Rupee

One of the greatest incognitas on the India macro economic horizon at the present time is the future path of the rupee. The rupee has been weakening steadily over the last couple of months, and has fallen more than two per cent against the dollar so far this year (at the same time, it will be remembered that the dollar is also falling quite substantially). Conventional explanations of this movement are the pressure produced on the currency by equity outflows and a temporary but severe shortage of spot dollars in the market. India Sensex, which has been Asia's worst-performing major benchmark index so far this year, fell 1.4 percent again last week, declining for a second week in a row after industrial production growth slowed in January, a reflection the higher interest rates are having on demand for consumer durables. Rising credit defaults in global stock markets have also had an impact on Indian stocks.

Curbs on foreign borrowing imposed by the Indian government last year and the general global credit woes caused by the US subprime crisis have also reduced the appetite for Indian equities in recent weeks. However, despite the decline in demand for equities - and as noted above - the capital inflows continue.

As a rsult, and after gaining more than 12 per cent in 2007, the rupee has fallen steadily in 2008, and is now around 40.5 per dollar, its weakest level since mid-September and well off the near 10-year high of 39.16 reached in November.

The rupee really started to drop significantly in February following the withdrawal by the Indian unit of Emaar Properties of its $1.8 billion initial public offer (IPO) due to the volatile situation in the Indian stock market. Foreign investment in IPOs had constituted a major support for the rupee in January, ever since Reliance Power raised $3 billion within a minute of opening for sale. India's trade deficit, which has suffered on the back of the rise in the rupee - and which swelled to $9.4 billion in January, more than three times larger than in the same month a year earlier - clearly hasn't help underpin expectations that the Indian monetary authorities will feel comfortable accepting the continuing rise in the currency. In February, US investment bank JP Morgan - feflecting widespread sentiment in the banking and investment sectors - lowered its forecast for the rupee to 40 by March 31 from its earlier projection of 38.5.

Foreign funds have pulled more than $3 billion out of Indian shares so far this year, and the outlook remains full of uncertainty. Slowing economic growth, the government's reluctance to push ahead with reforms in the run up to national elections and the benchmark Sensex share index's 25 per cent tumble from its high in January have all served to spook investors. External purchasers seem to have moved large quantities of cash into Indian shares to take advantage of arbitrage opportunities between the cash and futures markets, rather than as the result of any strong convictions about underlying fundamentals.

Not everyone, however, is convinced by the standard explanations, and some analysts are arguing that the weakening in the rupee has been engineered by the Reserve Bank of India, which was busy dollars heavily all through 2007 in an attempt to slow the currency's appreciation as it began to squeeze the margins of export-focused companies in sectors like software and textiles.

Ila Patnaik, a senior fellow at the National Institute of Public Finance and Policy, has pointed out the apparent inconsistency in the fact that the rupee's decline in February came even as India's foreign exchange reserves jumped by $11.7 billion on the month to reach a record of $301.2 billion.

"This suggests that the depreciation of the rupee was engineered," she wrote in The Indian Express last Wednesday, arguing the rise in the dollar value of reserves could not have come from the simple revaluation of other currencies (or gold) in the reserves against the dollar.

Patnaik suggested that the recent hefty US interest rate cuts were drawing cash into higher-yielding Indian assets. India's benchmark lending rate at 7.75 per cent against the Federal Reserve's three per cent offered a 4.75 percentage arbitrage opportunity for foreign investors.

"Interest rates in India are higher and if the rupee was also going to get stronger, dollar returns would be even higher," Patnaik wrote. "In this situation, the RBI may have tried to break the one-way bet by pushing the rupee to depreciate."

So, will the rupee's decline be an enduring phenomenon, or will the market turn? Perhaps in the short term the rupee may well not strengthen significantly, but the long-term outlook for the rupee has to be bullish simply because India's $1 trillion economy, which is Asia's third-largest after Japan and China's, is set maintain robust growth of eight per cent plus in 2008, and in all probability this pace will accelerate further over the next couple of years, as India's growth once more resumes its long upward haul.