RBI Annual Report 2009-10 highlights - Fiscal consolidation holds key to managing dilemma of growth vs inflation - Motilal Oswal

The 2009-10 Annual Report of the Reserve Bank of India contains a multitude of analysis, empirical investigations and data points. We present some highlights.

Assessment and outlook

- The Indian economy is characterized by favorable growth outlook but continued concern over inflationary situation. RBI has stressed on the aspect of "quality of adjustment" while extolling need for fiscal consolidation.

- Going forward, as the monetary position is normalized, addressing structural constraints in several critical sectors is necessary to sustain growth and also contain supply side risks to inflation.

- Increased volatility of capital flow is expected (but not lower as has been mistakenly reported in a section of international press). Specifically, the uncertain global environment warrants adoption of caution in the formulation of policies during 2010-11.

Near to medium-term challenges

- In case of a negative supply shock, a central bank encounters the dilemma of stabilizing output versus containing inflation as growth and inflation move in opposite direction in such case unlike other shocks where growth and inflation move together. Agricultural growth falling behind population growth and timely use of buffer stock are of particular concern for agricultural shocks. On the other hand import dependence on oil (80%) adds complexity to management of inflation.

- Important challenges to the transmission of monetary policy: (1) Administered interest rate structure on small savings, (2) Transition from BPLR system to base rate, (3) Asymmetry of interest rate cycle to an interest rate hike as opposed to a decline, and (4) Increased significance of non-banking sources of finance.

- Improvement in the fiscal situation is important not only as a counter cyclical policy but also for its implications on inflation and capital flows given the increased sensitivity attached by international investors on the sovereign debt issue.

- Volatile capital flows have been a potential source of instability for EMEs. A judicious mix of flexible exchange rate, sterilization of the impact of inflows on domestic liquidity, cautious approach to liberalization of the capital account, and the cushion of foreign exchange reserves has been used to deal with the adverse ramifications of capital flows. There is a possibility of yet another phase of surge in capital flows to India, in response to global search for yield in an environment of easy liquidity conditions in advanced economies and the prospect of relatively higher return on investment in India in view of its superior growth outlook.

- Higher investment in technology and infrastructure would be critical in improving productivity that has witnessed a declining trend since mid-nineties. Given the scale of infrastructure planned, along with banks the role of non-banks would have to be enhanced.

- Globalization will continue to be a source of opportunity to maximize the country's growth potential, but there would be increasing pressures on current comparative advantages of India, besides raising the scope for faster transmission of shocks from the global economy to the domestic economy.

Some interesting findings of the Report

- The potential growth path could be raised to double-digit level with (1) fiscal consolidation, (2) favorable demography, and (3) further structural reforms.

- There is a weakening of inter-sectoral linkages in the post-reform period in India between: (a) industry and services sector and (b) industry and agriculture sector. The share of agro inputs in manufacturing has declined from 20% in FY94 to 5% in FY07. On the other hand, the services sector linkages have increased relatively more with the rest of the world than the domestic economy as evident from an increase in the proportion of services exported to total output of the services sector by nearly four-fold from about 3.2% in FY91 to more than 12% in FY10.

- Total factor productivity (TFP) growth in India came down to 1.7% during 1997-2005 from 2.6% during 1992-97 accounting for the decline in growth to 5.7% from 6.5% during the two time periods.

- Impact on inflation of commodity futures trading is somewhat inconclusive with sugar and urad seeming to exhibit two-way causality between the spot and futures prices. Commodity prices in India seem to be influenced more by other drivers of price changes, particularly demand supply gap in specific commodities, the degree of dependence on imports and international price movements in these commodities.

- Over longer period (April 1994 to March 2010) food and fuel inflation is found to have an impact on core inflation signifying the role of inflation expectation in actual inflation. About one-third of the variation (oil 20% and food 14%) in the headline inflation is explained by supply shocks (in these two categories). Empirical results also indicate that about 54% of the variation in the headline inflation is caused by residual shocks to the headline inflation itself, which is suggestive of the role of inflation persistence and inflation expectations in explaining the inflation process. Also since November 2009, the relative price variability has declined (within the WPI basket), despite inflation remaining high, indicating that inflation has become increasingly generalized, and hence, requires appropriate monetary policy actions to anchor inflation expectations.

- The presence of conventional monetary policy transmission in India is validated with recent data. It has been found that increase in call rates (induced by policy rate changes) leads to higher average lending rates, with about two quarters lag, which in turn lowers the growth in non-food credit in the fifth quarter and GDP growth in the seventh quarter. The estimated impact, though, seems to be modest and tapers off gradually. More importantly, the causality running from GDP growth to credit growth turns out to be statistically significant, suggesting credit following, rather than leading the pick-up in growth momentum and the much greater significance of non-bank sources of funding in recent years.

- A 1% change in fiscal deficit is estimated to cause 0.5% change in seigniorage 'S', defined as change in real reserve money and 0.04 percentage point on the price level. Fiscal deficit is found to have strong anti-inflationary attribute; although fiscal deficit being high during a high growth phase could create crowding-out risks.

- Various studies estimate the impact of exchange rate pass-through to domestic inflation in the range of 0.4-0.9% suggesting that 12.9% appreciation experienced in FY10, would have helped in moderating the inflation by 0.5-1.2%.

- Growth in domestic GDP worsens trade balance (possibly through boosting import demand relative to exports from the supply side), while growth in world GDP improves India's trade balance (through the impact on exports on the demand side). However, currency appreciation worsens the trade balance significantly; a 1% real appreciation in currency would invoke almost 0.7% deterioration in trade balance.

Source : Equity Bulls

Keywords