Surging inflation, depreciation of the currency and depletion of India’s foreign exchange reserves are all signs of concerns. All of the above are interconnected. They fall under the category of macroeconomic indicators of the state of the economy. For India, a leading emerging market economy, with far greater global mobility of labour and capital, as well as that of goods and services besides export capacity in food grains, all these concerns are not new. They were faced by policy makers in the past. So, the points for consideration are:
l Were there not any lessons from the past?
l Are they not guiding us to avoid past mistakes?
l Are we taking more appropriate decisions?
The Reserve Bank of India (RBI), which felt four months ago that the factors behind inflationary pressures mounting during past seven months were only transitory, has now confirmed in its Annual Report FY 2022 (released on May 26), that the ongoing Russian-Ukraine War and the resultant food supply crisis caused by fall in wheat production in Ukraine, supply- demand disruptions and deteriorating logistics, including port congestion and container shortages have played havoc. The report also says that cost pressures from high industrial raw material prices and increase in transportation costs caused by rising petroleum crude and petrol and diesel prices as well as supply-demand chain bottlenecks have been the chief reasons behind inflation.
Additionally for India, the RBI Annual Report for FY 2022 refers to the substantial wedge between the wholesale price index (WPI) based inflation (15.08%) and the consumer index (CPI) based retail inflation (7.79%) in April and highlights the associated risk in the midst of manufactured products inflation of “possible pass through of input cost pressures on retail inflation with a lag, although a slack in the economy is muting the pass through.”
Just as a coin has two sides, the impact of inflation has two faces. One side is the domestic purchasing power of rupee. As inflation reduces the value of currency, the domestic purchasing power of the rupee falls. The other side, which is the external value of the rupee, also decreases. Inflation makes the rupee less valuable, as it buys less of foreign goods.
Retail inflation is the target rate for RBI since 2017. It is measured on the basis of CPI index of all final goods and services, replacing the wholesale price index (WPI) based inflation. The CPI base is rising since May of last year (Table 1). That was the time when the world economy recovered from the disastrous consequences of the worldwide Covid-19 pandemic, despite periodic emergence of new variants of the virus. Anticipating a revival of aggregate demand, the petroleum crude exporting countries started increasing the price of the crucial input, the lifeline of oil dependent developing countries. India’s crude oil imports are about 20% of total imports. Nearly 85% of India’s crude requirements are met by imports.
The world price of crude per barrel rose from $69 in May 2021 to $79 in September 2021 and was volatile with some slight fall until end December of last year. From January this year, the rise in crude prices was unstoppable. From $ 92 in January, it increased to $108 in April. In May, it surged to 117.21. As transport costs (diesel and petrol) are a major component in the pricing from raw material to finished goods, vegetables to food grains and services as well, retail inflation was greatly influenced by the rise in the world price of crude.
Retain inflation shot up to 7.79% in April of 2022, the highest since May, 2014. Food inflation increased for the seventh consecutive month to 8.38%, a new high since November of 2020, with oils and fats (17.28%), vegetables (15.41%) and spices (10.56%) recording the biggest rises. Further, pressure stemmed from transportation & communication (10.91%). The April 2022 inflation of 7.79% exceeded the upper tolerance limit of 6%, (which comprises the target rate of 4% plus a margin 2%) for the fourth straight month. Food and beverages are 45.86% of the total weight index, miscellaneous accounts for 28.32% of which are transport and communication (8.59%), health (5.89%), and education (4.46%). Housing accounts for 10.07%; fuel and light for 6.84%; clothing and footwear for 6.53%; and pan, tobacco and intoxicants for 2.38%.
Delayed response by RBI
The monthly inflation figure for example, for March is known only in the second half of the following month, April. Hence, as the bi-monthly meetings of RBI’s interest rate setting Monetary Policy Committee (MPC) are held in the first week of the month (April, June, August, October, December and February), the policy interest rate is decided based on old data. The MPC in its meeting on April 6-8, 2022 decided on the basis of February inflation, namely 6.07%, not the March inflation figure which was released on April 12 and not available at the time of MPC’s monthly meeting. As RBI felt the breach in the targeted comfort zone of inflation of February was slight, it preferred no change in the interest rate at 4%.
MPC’s emergency meeting
Authorities were shocked when the March inflation data was released on April 12. It was much higher - at 7%. Had the MPC met a week later, the decision would have been different. The lesson is obvious: MPC should consider scheduling MPC bimonthly meetings in the third week of the month. An emergency meeting of MPC on May 4 did what was expected for controlling aggregate demand to curb inflation. It raised the policy interest rate, the repurchase rate (RPO) at which the central bank lends against bonds from the commercial banks to inject further liquidity into the system, making it costlier for banks to borrow as well as lending to investors and consumers. The RPO was raised by 40 basis points (bps) to 4.40%. The cash reserve ratio was also up by 50bps. The factors causing steady rise in retail inflation for the past seven months were no longer considered “transitory” but longer lasting. The RBI Governor Das attributed inflation was caused by “global commodity prices touching historic highs, pick-up in core (fuel and food) inflation, revision in electricity tariffs and the continuing war in Europe.” The Deputy Governor, Michael Patra was more direct and blunt. He added, “Reversing the extraordinary accommodation - in terms of both the policy rate and liquidity-that was undertaken in response to the pandemic- is the right approach.”
Two external members, Professors Jayant Varma and Ashima Goyal wanted front-loading of rate hikes to ensure that stakeholders understand the intent clearly: price stability is the primary goal of monetary authority. Although Professor Varma wanted a rise by 100bps, the MPC decision was to raise RPO only by 40bps.
Impact of depreciating rupee
A great deal of hesitancy and a pleasing approach of “extraordinary accommodation” have dented RBI’s image of autonomy. Short term foreign portfolio investors have been pulling out funds in their perceptions that India was not considered “a safe haven” any more. As macroeconomic indicators deteriorated, investors were rattled by rising exchange rate risks and the hot money has been flowing out. Further, imports have become expensive with the falling value of Indian currency.
Trade deficit for April is $ 20.11 billion compared to $15.29 billion a year earlier. Trading Economics reports that imports jumped 30.97% percent year-on-year to $ 60.3 billion mostly due to increase in purchases of petroleum, crude and products (87.54%), electronic goods (32.88%); and coal, coke and briquettes (146.33%). Exports increased only 30.70% to reach $40.19 billion, mainly driven by sales of petroleum products (127.69%) and engineering goods (21.97%).
Shrinking foreign exchange reserves
Trade deficits have to be financed by running down foreign exchange reserves (forex). Forex are the assets held in foreign currency and in gold. Forex also includes special drawing rights from the IMF and marketable securities denominated in foreign currencies like treasury bills, government bonds, corporate bonds and equities and foreign currency loans. From a record level of $642 billion in September 2021, the forex level has been shrinking. The RBI’s latest upward revision of RPO to 4.40% failed to stop capital outflows. The forex level is now $593 billion.
Table 1 presents monthly data on exchange rate. As compared to the rate of `72.52 per dollar in May 2021, the rupee fell over time and breached the dreaded limit of `75 in November 2021 and thereafter fall in rupee was steady to reach the historically lowest at `77.69 on May 27. Though there are attractive upsides of depreciation such as: (i) goods from India would be cheaper to overseas consumers; (ii) tourists would rush to India and (iii) India would be an attractive place for foreigners to invest in initial IPOs, the advantages are in the long run. The downsides in the short-run weigh more. The costs of imports due to the falling value of the rupee would go up immediately. Further, the response of the export sector will not be quick enough. One immediate negative effect is the rupee depreciation will add to inflation.
The central bank has been intervening in the market by supplying dollars for rupees. Sale of dollars by RBI leads to additions to domestic money supply as traders buy them from financial institutions including banks. If additions to money supply by dollar sales by RBI are not absorbed quickly and efficiently by the central bank by sale of equivalent bonds, increases in money supply will feed inflation. This procedure is known as sterilized intervention.
The current forex level which is reported to be equivalent to 10 months of imports, is not posing any immediate danger. However, fiscal measures are needed. They include measures such as the recent one: reducing the central government on petrol and diesel. If the state governments also fall in line with this fiscal policy decision by reducing their own value added taxes on petrol and diesel, loss of revenue would result in early gains. Retail inflation is expected to decline as petrol and diesel prices would fall. The full impact will be known only in mid July 2022 when the June CPI data are released.
Lessons from the past
The past comparable crisis is that of 2013-14, The slight difference from the year of temper tantrum as that crisis would be ever remembered is India’s external position today is far better than the one that prevailed in 2013.
The global inflationary conditions with high crude prices above $100/barrel and the US central bank’s tightening monetary policy measures were similar to the current FY 22 and FY 23. The rupee too had depreciated; the fall in rupees was from about 56 per dollar at the end of May 2014 to 69/dollar. The policy rate, Repo, was raised by 75 basis points to 8%. What came to rescue was the rise in FCNR(B) deposits, by $30 billion, which helped RBI to stabilize the rupee. Today, India’s forex level can cover 10-month imports as against 7.8-month imports in FY 2014.
The lessons are clear:
The country should build up foreign exchange reserves of sizable level, adequate to cover 18 months of imports of goods and reserve. Since imports would rise as the growth would require more of crude and raw materials and iron and steel. The central government should promote foreign direct investment of long term in nature rather than worry about FPI which are fickle in nature and shiftable.
In the short-run, keeping costs under control, tax rate reductions on key inputs are needed. Reducing import duties on raw material used in steel and plastic industries and raising export duties on exports of iron pellets would be appropriate. Temporary bans on exports of wheat and sugar are fully justified in the face of world shortage in food grains and similar exportable in the interest of food security.