Reigniting India's economic miracle

Australia should hope that India resolves its fiscal and trade problems in the not too distant future.

India is rapidly gaining an elevated status, being Australia's fourth largest export market with coal, gold, education-related services and copper the main export items. Indian direct investment into Australia was just under $11 billion in 2011, dwarfing Australian investment into India which was $4.3 billion.

India is the third largest economy in the world, according to World Bank data, behind only the US and China. India's economy is 40 per cent bigger than Germany's and it is roughly double the size of France and the UK.

It is big, it matters, it is growing and it has the structural dynamics that will see GDP rise, on average, by around 7 per cent per annum for the next decade or two. An economic powerhouse already, it will increase its influence in the global economy and, in time, financial markets as it further develops.

That's why the recent moves by the Reserve Bank of India (RBI) are of such importance.

The Reserve Bank of India decision to ease monetary policy via a 25 basis point cut in the cash reserve ratio to 4.25 per cent was made with the express intention of supporting liquidity and bank lending. At the same time, residual concerns about the inflation outlook saw RBI Governor, Dr Duvvuri Subbarao, unexpectedly hold the lending rate at 8.0 per cent, but in doing so, he suggested that "the baseline scenario suggests a reasonable likelihood of further policy easing in the fourth quarter”.

In other words, there is a strong easing bias that the Reserve Bank of India will likely act upon when it gets confirmation that inflation is ticking lower.

The policy easing is driven by the rapid slowing in GDP growth. Over the past year, annual GDP growth has fallen from a peak of 9.2 per cent to 5.5 per cent. This slower baseline saw the Reserve Bank of India cut its GDP growth forecast for 2012-13 from 6.5 per cent to 5.8 per cent a pace that is widely judged to be below trend. The RBI noted that "global risks have increased and domestic risks have become accentuated owing to halted investment demand, moderation in consumption spending and continuing erosion in export competitiveness accompanied by weakening business and consumer confidence”.

A sticking point in the monetary policy deliberations and a key reason why the Reserve Bank of India held the repo rate steady was "sticky” inflation. Annual inflation as measured by the wholesale price index (WPI) remains above 7.5 per cent, driven by higher prices for fuel and manufactured products. While the sluggish global economy and the recent fiscal tightening are expected to dampen inflation into 2013, the RBI would prefer to see inflation turning lower before trimming the repo rate further. That said, it is forecasting the annual rise in the WPI to cool to 7 per cent in 2013.

Perhaps most disconcerting for those looking for further policy easing, the Reserve Bank of India highlighted its resolve to contain inflation by noting that "the persistence of inflation pressures, even as growth has moderated, remains a key challenge. Of particular concern is the stickiness of core inflation, mainly on account of supply constraints and the cost-push of rupee depreciation.” While the RBI has an easing bias, aggressive interest rate cuts are unlikely.

Some of the RBI inflation concerns have been driven by the weakness in the rupee, which has fallen by around 20 per cent against the US dollar since the middle of 2011. International investor and credit rating agencies are wary of a persistently wide budget deficit and an on-going current account deficit.
Persistent "twin deficits” run the risk of driving India's credit rating to below investment grade status.

Both Standard & Poors and Fitch have highlighted the risk of a sovereign downgrade unless there is near-term progress in narrowing both the fiscal and trade deficits.

This is where the policy pressures are paramount. The negative credit rating outlook risks further rupee weakness and with that, upward pressure on inflation. The recent fiscal initiative to reduce the budget deficit from above 5 per cent of GDP at present to around 3 per cent of GDP in 2017 may be too little and too slow. In the interim, the economy has slowed appreciably and the Reserve Bank of India is clearly reluctant to ease monetary policy too quickly for fear of seeing the rupee weaken further.

These policy dilemmas are likely to persist for some time, a position made all the more tricky by the weakening global economy.