Friday, July 23, 2010


RBI may need to get more aggressive

Inflation in India has spread beyond food and fuel prices and is becoming entrenched, meaning the Reserve Bank of India (RBI) may have little choice but to tighten policy more aggressively than now expected. A majority of economists polled by Reuters this week expect the RBI to raise interest rates by 25 basis points for a fourth time since March in its quarterly review on July 27. Most also expect the central bank to notch up rates by just another quarter point before the end of the year, given a tightening of market liquidity in recent weeks and uncertainty about the strength of global recovery. However, trends in broad money growth, the credit-deposit ratio and rising imports suggest inflationary pressures are likely to remain and may pose a bigger challenge later on, calling for a more aggressive action.

Pace of import growth may widen trade gap further

With India expected to grow more than 8 percent this year and next, imports are expected to pick up. Since export growth is weak, rising imports threaten to push up the trade deficit up substantially, in turn widening the current account deficit, which reached $13 billion in the January-March quarter, its biggest since 1981. A more decisive monetary tightening to curb domestic demand would help keep India's external imbalances in check.

Reserve money growth threatens to push inflation higher

Reserve money has been rising rapidly in recent months. Before the financial crisis, reserve money consistently led broad money growth, the central bank's key monetary gauge. Between 2000-2007 the annual change in reserve money had a 0.6 correlation with the year-on-year change in M3. That dropped to 0.4 for the 2000-2010 period because of massive liquidity injections during the financial crisis. However, with a rise in economic activity the correlation is likely to get tighter. A pickup in money supply growth, will serve as another important signal of inflationary pressures ahead.

Rising gap in credit-deposit growth to add to price pressures

Bank credit is growing at an annual pace of around 22 percent while deposits grow at a 15 percent clip. So the credit-deposit ratio has widened to 73.44 percent in July from around 70 percent at the start of this year, climbing above the monthly average of the past five years of 69 percent. The Reserve Bank of India will need to raise policy rates to push more money back into deposits and slow credit growth, reducing the disparity between the two. –