RBI’s Tightrope Narrows as Oil, Rupee and Inflation Risks Rise

An unprecedented and unparalleled global landscape has diminished the degrees of freedom available to central bankers to navigate a tough environment. Though wobbly oil prices appear to be the primary inflation driver, the cost of adopting artificial intelligence has added a new dimension, pushing up costs. 

If the trend continues, we shouldn’t be surprised if technology costs replace employee expenses as the biggest overhead in company balance sheets, which can jack up services inflation. These dichotomous forces may confuse policymakers. In the just-concluded July FOMC, the Fed decision to hold rates was not unanimous, as three members dissented. 

The European Central Bank too adopted a pause, notwithstanding underlying inflationary pressures. As most advanced economies witness yield hardening due to high debt metrics, emerging market and developing economies, including India, will have to contend with exchange rate pressures due to stress on capital flows.    

Rupee-Dollar movement since the war proves crude oil to be of major significance, with the rupee exhibiting two-way volatility in perfect harmony with crude prices. However, the direction of the rupee is unmistakably clear. The government has provided favourable tax treatment to FPIs and the central bank returned to its 2013 playbook of FCNR(B) swap. But given the structure of our current account, such measures might provide only temporary relief. 

As the RBI has been resorting to intervention in forwards as a considered strategy, the net short forward position has been building up, touching $106 billion, which could impact the import cover of forex, currently hovering around 10 months. 

Resorting more to forwards means little impact on spot dollar/rupee rates of near 96. Spot interventions are avoided as it could squeeze liquidity and hamper monetary policy transmission. However, when forwards and swaps mature, the reversal could pressure liquidity, which would have to be dealt with. 

If we manage to mop up around $80 billion, as analysts now estimate, will it facilitate exchange rate stability? 
Not necessarily. 

Since January, net outflows are $18 billion. A CAD of 1.3-1.5% on a nominal GDP base of $4 trillion plus outflows till July leaves $70 billion-$78 billion to be funded. Moreover, $30 billion of forward maturities up to 1 year implies a semblance of stability in the rupee is difficult unless we manage $100 billion. 

Bloomberg Index inclusion delay too would constrain flows. It is safer to assume the rupee to depreciate by its normal 2-2.5% annual rate unless the current account reverses sustainably to a surplus. 

Managing actual and expected inflation is central to monetary policy. Both wholesale and retail inflation have been moving higher, with the latter showing a significant spurt closer to 10%. Retail inflation, the anchor of monetary policy, however, has shown an increase of a much lower magnitude, which leads us to infer that producers are not fully passing on price pressures to the end consumers, thus showing willingness to take a hit on their margins. 

The recent financials of consumer giants are ample proof of this fact, where margins are clearly under pressure. This could run contrary to the construct that higher WPI inflation translates into CPI with a lag. The recent moderation in metal prices will also have a bearing on retail inflation, going forward. 

But what about El Niño and its likely impact on food and overall inflation?

We have adequate buffer stocks of rice, wheat and staples, but lags in pulses and oilseed output, for which we depend on imports, the cost of which may bloat due to geopolitical tensions and production shortages in the host countries. 
This will definitely lead to price pressures. 

RBI estimates the October-December print to be 5.9%, but depending on how monsoon pans out during the remainder of its term, this may harden further. The flexible inflation targeting regime has given us a wider bandwidth of 2-6% as the acceptable range, and hence 5-5.5% might not be a cause for alarm. This is precisely why India has adopted an ‘inflation range’ instead of a point estimate like the Fed, which has adopted a sacrosanct 2% target. 

An emerging economy like ours indeed merits flexibility as the dynamics are much more complicated. Current crude price levels are in line with the assumptions of the RBI for their inflation forecasts. However, recognising some upside risks due to unpredictable geopolitics, inflation forecasts could be revised upwards marginally. 

To our credit, India has been able to manage the growth-inflation trade-off fairly well. Maintaining a growth rate of more than 7% in real terms amidst geopolitical tensions is no mean feat. However, acceptable wisdom demands a consistent growth rate of 9% for Viksit Bharat to fructify in its true sense. Though per capita income has risen nearly four-fold since liberalisation, we are ranked in the bottom quartile both in nominal and purchasing power parity (PPP) terms. The only antidote to move to a higher orbit is a sustained real growth rate of 9%. This requires the central bank to carefully weigh the pros and cons of monetary policy and interest rate decisions.   

On the liquidity front, the wedge between bank credit and deposit growth remains a concern. Incremental credit-deposit ratios are high, though banks are managing comfortably on metrics like liquidity coverage ratios. But rupee weakness might force spot interventions as well, which could lead to tightness. Comfortable liquidity is defined as a situation where liquidity surplus is around 1% of NDTL. 
However, the structural gaps and tax outflow will necessitate the RBI to continue managing liquidity on a dynamic basis through various tools at its disposal.

In the present times when what is said and interpreted between the lines assumes paramount importance to market reactions, the language and tone of monetary policy would be closely monitored. A volatile and uncertain global order makes the job more demanding and challenging than ever before. RBI will have to exhibit not just monetary stewardship but also its credentials as an astute facilitator of consistent economic growth.

* Views expressed are personal and not those of the organisation.