Recent Macroeconomic Developments and its Consequences: Indian Perspective

In the recent months, the macroeconomic environment has been stormy. Global conditions have caused structural breaks in risk perception and appetites which have contributed to a significant rebalancing of Indian portfolios.  This has further led to increased volatility and instability in currency and capital markets.  The decelerating domestic growth and persistent inflation and upside pressure of a depreciating rupee worries all and sundry. However, even though the overall macroeconomic conditions look worrisome we must take a forward-looking view of the policy responses and its consequences on indicators and future risk.

Over the past two years, the performance of major advanced macro- economies has raised concerns over the sustainability of global revival. On the contrary, emerging economies have exhibited reasonable growth, suggesting that their domestic drivers and increased linkages with each other and the advanced economies have facilitated their growth stories. However, these growth stories have been curtailed by slower growth in advanced economies, sovereign debt pressure from Europe and growth volatility in US.   The European debt problem has without a doubt been the overriding global factor in recent months triggering confidence problem and volatility in currency and capital markets across the globe. As the prospects of any solution have ebbed and flowed, so have the asset prices and exchange rates. It was expected that a solution would come out from the crucial December Euro Summit or the recent ECB meeting in January; however these expectations are still to be realized.

The impact of the brewing global instability on India has been enormous. An emerging economy is structurally current account deficit and so is India. This deficit is usually financed by capital inflows, which over the past decade has been stable and large in magnitude and hence had more than offset the current account deficits. However, in the recent months there has been a significant reversal  and the observed effects are much like the 2008-09 global financial crisis (Chart 1). Between July 2008 and February 2009, the Rupee depreciated by nearly 17 percent.  This happened because of lack of capital inflow, which resulted in the current account driving the exchange rate and naturally, this pressure resulted in Rupee depreciation.

Source: Data are based on FEDAI (Foreign Exchange Dealers' Association of India) indicative rates.

For the past few years, the Indian exchange rate regime has been described as ‘bounded float’. Fundamentally, there is no restriction on Foreign Direct Investment (FDI), except for limits on specific sectors and portfolio investment in equities.  However, there are restrictions on debt inflows due to external stability issues.  In particular, these limits relate to quantity, tenor and pricing. Short-term debt is most vulnerable to sudden reversals and hence it’s least preferred; while long-term debt is viewed more favorably as it is seen as a resource channel for inflow into infrastructure despite the associated risk concerns. These debt controls may be viewed as ‘strategic’ capital controls; they are altered infrequently in response to macroeconomic conditions.  However, these and other capital account management tools are used to help in bounded float when volatility increases.  The exchange rate is determined by daily variations in demand and supply and hence a sharp fall in capital inflows leads to a situation of excess demand leading to exchange rate depreciation.

In times of bountiful capital inflows, current account surplus economies build up their foreign exchange reserves, which may be utilized in troubled times to manage exchange rates and meet short-term claims without disruptions or loss of confidence. India has reserves over $300 billion, but because of current account deficit, the reserves are essentially counter-balanced against our external liability position. The recent depreciation did not witness radical utilization of this foreign exchange reserves due to our current account deficit but also because excessive utilization of reserves could have resulted in deterioration of confidence in the economy’s ability to meet short term obligations. Alternately, if foreign exchange reserves were not utilized exchange rates could spiral out of control, triggered by self-fulfilling expectations. Hence, it was necessary to strike a balance.

The Reserve Bank of India (RBI) struck this balance by structural capital controls. In particular, they increased foreign currency supply by expanding market participation. This was done by increasing the investment limit in government and corporate debt instruments by foreign investors, raising interest rate ceilings payable on non-resident deposits and enhancement of the all-in-cost ceiling for external commercial borrowing. In addition, RBI undertook administrative measures to curtail the temptation of market participants to take positions against Rupee. For instance, entities which borrow abroad were now required to use a portion of their fund for domestic expenditure immediately. These measures facilitate a balance between short-term risk of Rupee spiraling downwards and the medium-term risk of a loss of confidence in India’s ability to meet external obligations.

Domestic Liquidity state

The domestic liquidity condition has come to fore-front since the borrowing under Liquidity Adjustment Facility (LAF) has been above the one percent of Net Demand and Time Liabilities (NDTL) threshold. The RBI makes a distinction between the monetary stance and liquidity stance and exploits this distinction by carrying out Open Market Operations (OMO’s) to inject liquidity into the system, despite maintaining an anti-inflationary monetary stance. The RBI did this form of intervention in December 2010 and November 2011.    

In spite of the OMO and advance tax payments in mid-December, domestic liquidity conditions are still expected to remain stretched for some time. Still, RBI must be careful that OMOs and LAF intervention do not result in excessive accommodation but ensures adequate liquidity (consistent with the comfort levels). 

In this regard, RBI has a wide range of instruments which have been utilized. For instances, the banking system as a whole hold 29 percent of NDTL as opposed to the stipulated  Statutory Liquidity Ratio (SLR) of 24 percent . Thus as and when the need arises a liquidity infusion of 2,740 billion is plausible.  However, we cannot rely on this entirely as SLR default is a serious offence for large banks and most banks life keeping the Liquidity in excess of SLR stipulation to avoid default. Alongside this lies the recently established Marginal Standing Facility (MSF) which allows banks to use a further one percent of SLR holdings. However, banks would exploit this only in situations of extreme stress. In recent weeks there hasn’t been any recourse to this window which could indicate that there isn’t much stress, however stress is brewing and we must be cautious. Furthermore, we must keep in mind that the large fiscal deficit cannot be fully accommodated by OMO’s and hence we must manage domestic liquidity condtions such that they do not de-stabilize financial markets and that too without violating the current monetary policy stance. However, an inadequate response can weaken our monetary control and also effect medium term inflation expectations.

Growth and Inflation Puzzle

Growth and Inflation are the two most commonly discussed phrases and the cornerstones of any form of macroeconomic development. Anything and everything has some impact on these two macroeconomic indicators. They also take us from the immediate worries to futuristic troubled waters. Since the last quarterly review by RBI a lot has happened to Rupee and inflation. The headline inflation clocked a two year low at 7.47 percent in December 2011. It stood at 9.11 percent in November 2011 and it is believed that the decline was prompted by cheaper food items. Commodity prices have softened to a large extent. Fuel and power segment inflation stood at 14.91 percent on an annual basis in December as opposed to 15.48 in November. Furthermore, stable crude oil prices in dollar terms favored the domestic inflation in December in-spite of depreciation in Rupee. Any positive news from European sovereign debt problem would also moderate the inflation risk, however the likelihood of such positivity in the near vicinity is bleak.

The Quarterly estimates of Q2 of 2011-12 substantiate the growth moderation story some of it is attributable to external macroeconomic events and interest rate hikes.  RBI intervention of increasing interest rates to curb inflation has moderated demand as growth deceleration precedes inflation deceleration.  If the current deceleration in inflation level continues in the coming months, RBI policy stance would be receiving accolades. However, the growth deceleration is also driven by the global turbulence and an investment lull. The government is initiating a number of reforms (tax reforms, skill formation, increased transparency in the system) to facilitate our growth stories. However, quick resolution and implementation is a key to success.

Even though food price inflation has been on a steady decline it is still a worrisome risk factor. It would persist to be a source of inflationary pressure unless there is radical improvement in technology driven productivity, both at the cultivation stage and more importantly at the distribution and procurement stages.  This would require many multilateral forces to come into action, such as infrastructure, technology, market institution reforms, price incentive realignment and the financial services that can support the realignment. However, these must be brought in rather quickly to achieve the target.

In conclusion, we need to balance the risk of rupee spiral and loss of confidence in Indian economy in the short term. It should be understood that the volatility and liquidity stress would last a while and prudent management of capital accounts and liquidity is essential to tide the worrisome waves.  The good news is that the growth-inflation dynamics is manageable and the coming year looks brighter than the year gone by. However, long term growth does require structural policy change at a rapid pace.