The thirst of robust economic expansion and higher commodity prices will technically push inflation on the upside and interest rate in India is expected to remain high for the next couple of fiscal years as the RBI seeming to keep interest rates on the higher side to maintain the cost of credit exorbitant to lessen the demand.
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It was the confrontational step of the Reserve Bank of India by revising another 50 bps in its policy rates to address the wild price rise situation in order to eliminate the risk of higher inflation and to persuade the Indian economy to grow fast but sustainably. VMW has analyzed the inflation problem from the household’s kitchen to the corporate decision maker and found that the food prices are not rising as fast as the non-food articles do, due to increase in international commodity prices. Food prices in March rose by 9.47 per cent while the prices of non-food articles rose by 25.88 per cent largely inflated by expensive crude oil and other important imported commodity products. So far, the effect of RBI’s rate tightening and expensive commodity prices – rallied on the economic euphoria – can be seen on the Capital Goods sector of India. India’s IIP index has been fluctuating, and the capital goods, index in particular, has performed deplorably (see figure below) due to higher cost of credit, tolling in the company’s income statement in terms of higher interest payments. Construction, Energy, Real Estate, Diversified and Infrastructure companies have piled up billions of dollars in terms of debt to function their operations and to execute their awarded projects.
The important wings of the Indian government and the Reserve Bank of India are expecting the inflation around 6 per cent by the end of the fiscal year 2012. However, the VMW’s estimates are bucking the government and RBI’s estimates – expecting the inflation to remain above 6 percent and even in a double digit by the end of this year (up to 11 percent). The only fundamental cause is the India’s hunger of economic expansion at a faster pace, and the same would not pull down the inflation to lower levels, since it will dramatically push the demand in the economy for pricey imported commodity. Moreover, the US Federal Reserves’ monetary expansion program, known by Quantitative Easing or QE2 is scheduled to end by Jun, 2011 and, perhaps, it will not reduce the impact of higher inflation in the economy right away and high supply of a dollar could depreciate it against the other major currencies, which will push the international commodity prices. The expensive imports will prevail upon the higher current account deficit until the export figures too remain blunt. Henceforth, the Current Account Deficit remains a prime concern for the economy. Although, RBI is not considering it as a major threat but the VMW is deliberating the same, and the prime predicament could be the lower portfolio investments since Foreign Institutional Investors’ flows (FII) are the immediate source of financing the Current Account Deficit and Foreign Direct Investments are not as easy as the FII flows are due to scores of roadblocks to the investments and instability in national politics and India’s foreign policy.
Inflation always Remained High in India and Now Needs Government Intervention Plus Tighter Monetary Policy from RBI’s Side.
Now, in our research lab, we have analyzed the inflation problem. Look at the GDP Deflator and the WPI Inflation rate – how these trend lines have emerged over the past six fiscal years. GDP deflator is one of the other important tools to measure inflation, and it show, the inflation problem was relentlessly haunting the Indian economy. The most significant discovery is, the RBI loosened the policy rates during FY08, when India faced the condition of deflation due to change in the base year and was not reflecting the correct picture. However, GDP deflator remained at the alarming levels. At the same time, in FY09, RBI has raised the interest rates to prevent India to be a victim of the global financial crisis.
Here, we are not suggesting the RBI to track the GDP deflator, but to align its monetary policy to fix the “structured inflation problem”, caused by huge government borrowings, and at the same time, to make the economic growth sustainable and to refrain from the economic overheating. Plus to this, there is an urgent need of government intervention in terms of policies to overhaul the distribution of agricultural produce, to check the government borrowings and bringing down the fiscal deficit, which is now estimated at 5.6 percent until Feb, 2011 and 5.8 percent for FY2011. This will also subdue the prices.
Future of the Interest Rates in India
Rise in crude oil prices and other imported commodity price holes the Indian Economy up. It is one of the biggest risks to India since the country is not completely reliant on its own energy output and imports more than 70 percent of crude oil from GCC countries and other OPEC members. It’s expected that the global economic recovery would not stall but the pace will come down most importantly when the United States has stepped up its efforts to bring down the fiscal deficit to 4.1 percent by 2014. Nevertheless, the real economic output could remain under pressure due to the effect of increasing government debt. Since, we have focused on the final output (GDP) and it shows the prices of final produce in a particular financial year are increasing by more than 7.0 percent, whereas the WPI inflation is fluctuating throughout the discussed fiscal years. Provided herein is India’s stock of money or M3 for the last three fiscal years, which reverberates above 20 per cent. However, it is now falling significantly back to 15 per cent, and it shows the RBI’s action in policy rate is working, which means the monetary policy has a certain effect on the core inflation problem and would make an impact on the demand side but it is not sustainable as the government’s borrowing plans are on track.
Lower money supply has side effects too as it will increase the cost of credit further, and it will reduce the access to credit. Moreover, the stock markets could not function properly in this environment since the economic activity declines, which will eventually reduce the value of people’s retirement savings. However, the RBI has only one choice – tight monetary policy to tame inflation by giving up the India’s ambitions of double digit economic growth.
This VMW Research is originally published at UNIDOW.com
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