What’s eating Raghuram Rajan?

The fact that a strong government at the Centre now sets economic policies and has produced a budget, ostensibly growth-reviving but considered inadequate for targeted fiscal deficit reduction, and consumer prices softening but still above comfort zone, does not make ideal setting for the central bank to reverse gears abruptly.

More than that, Raghuram Rajan, Governor of RBI, who had the customary pre-policy consultations with Finance Minister Arun Jaitley, before his second bi-monthly monetary policy review on 5 August, has to confront possible spillovers from the latest bout of volatility in global markets and interest rates tightening abroad.

India is certainly better cushioned than over the past year, with a steady rise in its reserves now at $320 billion and a manageable current account deficit, after the strong corrective measures of 2013-2014. There are also emerging signs of an improvement in business sentiment and the outlook for a growth above five per cent in current fiscal despite a relatively poorer monsoon so far.

In the first two months April-May, industry rebounded from stagnation, inflation at elevated levels had softened somewhat by June, and exports recorded a nine per cent growth in April-June. However, the rupee has again come under pressure from global headwinds, though held fairly steady by RBI for weeks, and despite a significant inflow of portfolio investments thus far in 2014.

But of more concern was the first quarter fiscal deficit at 56 per cent, crossing the half-way mark of BE for 2014-2015, though this is due to lower revenue receipts in early months, not unusual, and government had not raised non-tax revenue like disinvestment in this early period. The Modi government itself took over only in the latter half of May.

Market watchers and analysts feel that in the midst of global market turbulence - partly triggered by growing expectations of US Federal Reserve beginning its gradual exit from monetary accommodation earlier than mid-2015 as currently assumed - a rate cut by RBI from the present 8 per cent is unlikely.

While the Fed has been tapering down its asset purchases (‘Quantitative Easing’) and it is expected to be completed in October, the prospect of an earlier than scheduled start of rise in interest rates is not ruled out. There is strong advocacy in US financial circles that prolonging the near zero rates, when the economy is growing and labour market improving, would lead to financial stability risks.

US economy made up for its weather-induced contraction in first quarter of 2014 with a four per cent GDP rise in second quarter while unemployment has declined to 6.2 per cent.  Inflation has also moved ‘somewhat closer’ to the long-run objective of two per cent, the Federal Reserve said in a statement after its 30 July meeting. But it also noted there was still significant underutilisation of labour resources.

Rajan’s forthcoming review has assumed importance for not only the monetary stance it is to adopt but more on how the inflation-fighting RBI has viewed the first budget of the Modi government, the fiscal target and supply-side measures outlined. Perspectives on the global outlook and the spillovers from and to other systemic economies enumerated in a series of reports from IMF in the last week of July are of considerable relevance for central bankers. Rajan’s assessments on these would be keenly awaited.

Government’s views on the future framework of monetary policy, its plans for the banking sector in relation to infrastructure financing and other priorities, notably financial inclusion, would have been discussed between FM and RBI Governor at their meeting on 1 August. Jaitley is to meet the Central Board of RBI on 9 August for the customary post-budget briefing,

Financial inclusion has been increasingly on India’s agenda over the last couple of years and RBI has already given considerable attention on developing the channels for promoting small banks and other instruments to mobilise savings and disburse credits in unbanked rural and semi-urban areas. But this is one of the themes that Prime Minister Modi seems to have hit upon for his first Independence Day Address on 15 August. 

Global uncertainties about which Jaitley himself made references in his budget speech would be assessed in the RBI Policy Review. Unlike the US economy which is picking up steam, though it has also to manage the exit from zero interest rates, the euro area is yet to ensure a strong and durable recovery. Given continuing low inflation, the European Central Bank will keep up its substantial monetary easing. China’s economy is also growing below potential and, IMF says, it will have moderate spillovers for trading partners.

In its External Sector report covering 29 systemic economies, IMF says global financial environment is likely to remain complicated for some time, and economies will need ‘to digest the effects of asynchronous monetary exit and gradually tighter conditions. Capital markets, and demand for EM assets, may remain prone to volatility and sell-off episodes’. Uncertain external environment poses risks related to external financing needs, capital flow reversal and disorderly currency movements. At the same time, with relatively easy financial conditions overall remain relatively easy, there may be risks of asset price and demand booms.

In the case of India, IMF refers to ‘too great reliance on debt financing and porfolio inflows would create significant external financing vulnerabilities. It calls for sustainable fiscal consolidation, including by passage of a goods and services tax and comprehensive subsidy reforms to reach the fiscal deficit goal of three per cent of GDP by 2017-2018 (under the Jaitley road map).

Easing domestic supply bottlenecks would also be key to containing the CA deficit preferably below three per cent and stabilising at 2.5 per cent of GDP over the medium-term. IMF notes current reserve levels are adequate and regards the flexible exchange rate policy followed by RBI as sound. CA financing mix would be improved by enhancing the environment for FDI. However, given the potential risks to corporate balance sheets, further relaxation of limits on ECB should be implemented cautiously, it says.

On the exchange rate, the assessment is given volatile portfolio debt flows, the exchange rate has been sensitive to these flows and changes in global risk aversion. In the past year, the authorities have taken multiple steps to bolster the available supply of external finance, and RBI has made interventions to prevent disruptive movements in the exchange rate. Reserve levels are adequate for precautionary purposes, both for import cover and meet short-term debt obligations.