The RBI will need to do a balancing act

India’s current account deficit for April-June 2018 has widened to touch $45.7 billion, a five-year high with little hope of any reduction in trade deficit. The rupee remains vulnerable, given high dollar demand due to global uncertainty, testing new lows with every passing day.

While there has been a slight softening of domestic inflation from 4.84 per cent in June to 4.17 per cent in July and 3.69 per cent in August , there are strong upward pressures in this regard, given the spillovers of rising crude oil prices and the brittleness of the rupee..

The Reserve Bank of India hiked rates for the first time in four years in June and followed it up again in August. The central bank doesn’t target the exchange rate through the RBI’s Monetary Policy Committee (MPC) and attributes any rate moves to its goal of containing rising prices.

Crude fuelling inflation

The biggest factor deciding policy rates in October would, however, be the global crude price which has touched $78 a barrel and has a huge spillover fuelling inflationary trends. Dollar demand is huge, and has been on an upward trend given the convergence of rising oil prices and actual demand pick-up for oil. Since India is a net oil importer with inelastic demand, crude oil price volatility tends to have a significant bearing on macro stability risks and economic growth prospects.

Brent crude is poised to move up further if the geo-political temperatures do not cool down — the embattled Venezuelan economy, a key producer of crude, has nearly halved its output, while the US threat of sanctions on Iran, which supplies almost 2 per cent of global demand per day, has upset the demand-supply equilibrium for oil.

In Mumbai, petrol prices have already touched a new high of ₹87 a litre, and it will not be very surprising if it breaches the three-digit mark by end of this year.Oil prices have risen by more than 20 per cent in the first half of 2018.

While India posted a growth of 8.4 per cent in Q1 of FY 18, the highest in last nine quarters, the momentum is unlikely to sustain given the macro economic situation. The Economic Survey, estimates that a $10 per barrel increase in the price of crude would reduce growth by 0.2-0.3 percentage points, which again would significantly impact the targeted GDP growth of 7.4 per cent for FY19.

Rupee’s SOS call to RBI

Adding to these woes is the depreciation of the rupee. Since May 2014 it has depreciated by 20 per cent, and since the Lehman collapse in September 2008, the rupee has fallen by around 60 per cent. This trend is surely a cause of worry as in the last eight months it has depreciated by more than 12 per cent — the highest in Asia. The increasing possibility of a Fed rate hike at the backdrop of tepid inflation, rising wages, and positive employment figures will put further pressure on the rupee.

While the RBI is mandated towards inflation targeting, its estimates says that a 10 per cent depreciation in the rupee could add up to 50 basis points to inflation.

Given the situation, it is important for the RBI to respond to the rupee’s SOS call. The RBI has always maintained that it intervenes in the foreign exchange market with the objective of managing volatility and not to target a particular level for the rupee. With the trade deficit widening, inflation poised to shoot up again, bond yield moving north, the RBI should intervene to arrest the rupee’s fall by using the tools at its disposal.

Typically, when the rupee weakens, the central bank sells dollars from its reserves to shore up its value. The RBI has intermittently intervened in the market, but has not been successful in stemming the rupee’s fall. Forex reserves have steadily declined to just around $400 billion from a record peak of $426 billion in mid-April this year.

The second option is that the RBI revisits its 2013 policy of opening a foreign-exchange swap window to meet the daily dollar requirements of the oil marketing companies, which have the highest dollar demand. Alternatively, another recourse could be to raise dollars by borrowing from non-resident Indians. However, fourth and the most likely one is to increase the interest rate in the October Monetary Policy Committee (MPC) meeting.

The MPC has hiked rates twice this year. If the situation aggravates one should not be surprised to see an increase of 50 bps, instead of 25 bps as seen in the last two meetings. In Asia, India is not alone in considering a rate hike to defend its currency.

Indonesia raised rates aggressively in the past few months, while the Philippines too tightened policy rates to support their currencies.

Black Swan moment for MPC

This large-scale depreciation in the last few months is leading to the situation of imported inflation. India being a net importer of goods, ends up paying more for its consumption when the rupee slips. This anomaly in trade gets reflected in the rising current account deficit which according to some estimates may go beyond 2.5 per cent in FY 19 from 1.9 per cent in FY 18.

Interestingly, there is a difference between now and 2013 when the RBI last faced a similar situation of rising inflation and depreciating rupee.

In the aftermath of taper-tantrums in 2013, the government then hiked import duty on gold bullion and jewellery. That saw inflows shrink, helping bridge the current-account gap. but this time around electronics imports have outpaced gold.

The MPC essentially faces a black swan moment, with looming domestic and overseas uncertainties. This is perhaps the biggest challenge the MPC faces since its formation in 2016.

In such extraordinary times, besides monetary measures the government can also look at reducing the excise on crude. The government benefited from tepid oil prices earlier and imposed new excise duties on fuel to reduce its fiscal deficit.

However, rising oil prices and inflationary pressures can make life difficult for the government in an election year.

Both monetary and fiscal measures have serious spillovers on the macro economy and hence requires coordination and balance. The RBI will have to use a little of all its tools to fulfil its objective of curbing the inflation whilst satiating dollar demand.

Given that the policy rates have swung in tandem with inflation movement, a third increase on policy rate seems quite inevitable on October 5 when the MPC meets.

The writer is an Economist with EXIM Bank, India. Views expressed are personal

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