>India: will higher inflation lead to monetary tightening? (NATIXIS)

Since March, India has been experiencing a clear rise in inflation, primarily, but not exclusively, linked to the increase in food prices. While official forecasts for GDP growth and inflation were revised upwards in October and the stock market registered very robust growth (+120% since March), the issue of a monetary restraint has become a topic for debate.

Yet, it must be recalled that monetary management in India is strongly linked to the funding requirements of the public sector, which have risen sharply this year, and is unfettered by an inflation target. Apart from the negative effect that an increase in funding cost would have on public finances, the RBI must also consider the effect that an interest rate hike could have on the volume of foreign capital inflows. A surge in foreign capital influx into India to take advantage of the interest rate differential would place additional appreciating pressure on the Indian rupee while the current account deficit continues to expand again.

The direction taken by monetary policy will depend on the arbitrage between public sector funding requirements, a stable exchange rate and stable prices, an objective that will most probably continue to be subordinated to the first two, which would therefore leave scant room for monetary tightening.

Upward-bound Inflation
Since March 2009, India has been experiencing a clear rise in consumer prices up by 11% (YoY) in October, as well as wholesale prices, for which the annual growth stood at 4.8% in November (versus 1.3 in October, chart 1). The spread between the CPI and wholesale price can be primarily explained by the weight of food in the basket comprising the IPC. Food prices rose sharply due to a disappointing monsoon between April and August 2009 (mostly in the northern part of the country, where the level of rainfall was the lowest recorded since 1972 and less than 22% of the historic average) resulting in a meager harvest. The prices of sugar, potatoes, onions, rice, peanuts, and many other foods rose sharply.

There is, however, a general trend towards rising prices in India, (perhaps with the sole exception of textile products). The relatively low level of savings in the country (comparatively to China and other Asian countries) means less accumulated capital while the growth rate has become very high (like in China) resulting in pressure on production capacities. While most countries in the world are currently faced with excessive supply of goods, which theoretically rules out a return to inflation despite the monetization of public deficits and monetization of the purchase of foreign exchange reserves (notably in China and commodity exporters countries), inflation in India has surged higher than in other places. India begins gradual exit from soft monetary policy While the official growth forecasts were gradually revised upwards to 7% for the fiscal year ending in March 2010, and the Reserve Bank of India (RBI) has corrected its inflation
anticipations (6.5% for the year 2009/10 in October versus 5% in March), the issue of a tougher monetary policy has become a topic for debate.

The RBI continues to maintain its repo rate at 4.75% and its reverse repo rate at 3.25% since April 2009 but has raised the statutory reserve ratio of commercial banks from 24% to 25%, a
measure in effect since November 8.

An additional toughening would curb the development of bubbles on financial asset prices – already significantly up since April (the stock market gained 117% between March and December, chart 2) and the widespread increase in the prices of non-food assets. On the other hand, a tougher monetary policy cannot halt rising food prices, mostly caused by the scarcity of food supplies.

It should be noted as well that the interest rate is not the principal monetary policy instrument (the RBI’s main target being the growth of monetary aggregates). As the monetary market is mostly adjusted by “quantities”, interbank loans are often made outside the corridor constituted by the RBI’s repo transaction rates (chart 3). This means that interest rate movements only partially reflect the direction of monetary policy.

To read the full report: INFLATION