The meetings of G20 Finance Ministers delivered a unified message. It was unanimously agreed that stimulus injected (read interest rate cuts, liquidity injection and additional expenditure) will be retained until an economic recovery is secured. As Asian economies like India are expected to bounce back sooner than their western counterparts on structural advantages, “exit strategies” or withdrawal of the stimulus measures will, thus, come first to this side of the world.
Undoubtedly, interest rates in India, too, have bottomed out. Here, the key debate is on the timing of the roll-back of expansionary policies. The decision would depend on evolving dynamics of inflation and growth domestically against a broader global backdrop. Unlike last October, when growth and monetary stability was a clear priority over inflation, the policy choice this time is trickier and tougher. Any premature withdrawal can blow out the gains achieved so far.
Inflation is back to haunt us again. The weekly negative print is of little solace as the common man continues to pay higher prices. This is also evident in the monthly CPI doubledigit prints. With less than normal monsoons, it is clear that prices will remain at elevated levels in the future. In fact, inflation is steadily on its way to cross the Central bank’s comfort zone by the end of 2009.
More risks exist should global commodity prices inch up further. Abundant liquidity in the money market and expectations of such flush conditions prevailing against a backdrop of a run-up in the asset markets (Sensex up by 100 per cent since March) can fan inflationary expectations. Though this upsurge in inflation is unlikely to be a demand-pull variety as domestic growth is still in its nascent stage, managing inflationary expectations is important for the Central bank for price stability in the medium term. Hence a case for a rate rise and withdrawal of liquidity does exist.
Although incipient signs of a recovery, especially in the industrial sector, have partially restored confidence, domestic developments have marred the overall growth prospect. Specifically, drought-related uncertainties and sluggish growth in domestic demand have increased the downside risks to growth. Should the monsoons turn weaker, impinging adversely on winter crops, too, rural consumption spends, which contribute 33-36 per cent of overall GDP, will be impacted.
We believe that the Central bank will wait for inflation to surpass its comfort zone (not expected before 2009 end) before withdrawing liquidity enhancing measures. Several uncertainties on the domestic and external front still act as strong headwinds and the Central bank will not likely to introduce another uncertainty in the form of volatile liquidity conditions. Any hikes in policy rates, in our view, would wait till Q1 FY11 when recovery process is more firmly entrenched. However, even then, aggressive hikes are not expected as growth, though better, will still be away from its potential. The hikes will be more an attempt to cycle back to normalisation. We, thus, expect 75 BPS increase in both the repo and reverse repo rates in FY11.
In a nutshell, the classic Central bank dilemma is back again as supply-side inflationary pressures queer the pitch and markets are once again headed for interesting times.
Hemant Mishr is Head (Global Markets, South Asia), Standard Chartered Bank.