India's exit strategy - 1/ Does RBI really need to exit? 2/ To float or not to float?

Subir Gokhran spoke to the media on graded exit strategy from easy monetary policy in India. Before getting into the process of exiting from monetary policy, what does the inflation scenario in India look like?

Using the NIPFP-DEA database on seasonally adjusted macro data-series, one can see that the inflation situation is not very grave. The seasonally adjusted three-month moving average of WPI inflation suggests that WPI inflation is already dropping towards the 5% level. Even, WPI for fruits and vegetables are weakening on a point-on-point basis towards 3%. WPI food inflation has weakened too from the peak of over 25% to about 10%, and remains in double-digits.
On the other hand, the real economy has stabilized according to the GDP numbers. The quarter on quarter three month moving average of seasonally adjusted GDP at factor cost is back to its initial growth track of 10% reflecting in part the resilience of the manufacturing sector despite a drop in  consumer goods production, from a peak of 40% 3mma to about 10% 3mma. Going forward, the drop in overall IIP from over 30% growth rate to 5% is of concern as well.

 Growth in Non-food credit, a proxy for domestic credit for productive purposes, has also weakened further from 18% in April 2009 to about 11% in October 2009. This is well below the pre-crisis levels of over 25% growth in point on point estimates, and suggests that a tightening might have to account for both a sluggish pace in growth of non-food credit as well as IIP.

So do we exit?

Inflationary expectations are certainly on the upside with the long term 10-year government bond yields steeper than the short-term yields. However, to view inflation without looking at how stable the recovery process is might land the Indian economy in danger. Tightening monetary policy may yield to higher capital inflows with counter productive results on growth. RBI's de facto peg to the US dollar might be under the line of fire too as the ammunition to mop up excess liquidity from domestic markets as a result of intervention may not be renewed by the Ministry of Finance.

The policymakers lost an opportunity for structural reforms in the agricultural sector while inflation was benign and it has begun to reflect itself in the form of a price spiral when growth is tamed and fiscal deficit has ballooned to record levels. Notwithstanding the lack of foresight during the benign period, RBI is in a quagmire: to contain prices might lead to a threat to the rupee as the RBI intends on keeping it stable and not containing prices will not be politically a feasible option. Although trends show a weakening inflation scenario, food inflation remains in double-digits.

Subir's statement that there needs to be a graded exit from easy monetary policy is a truism; how, when and with what tools of monetary policy (RBI has multiple targets and multiple tools) remains unanswered. The exit from easy monetary policy is quintessential in dealing with inflation, although a stable rupee to support exporters may not be a wise policy combination as the pass through from world prices into the domestic prices can only be contained with an appreciating rupee.

To float or not to float?

While there is no doubt that capital flows into the economy are still weak and nowhere close to pre-crisis levels, a rise in interest rate can lead to a vicious cycle of greater flows, attempt to mop liquidity from domestic markets, raise in interest rates and further increase in capital inflows. Because of little openness with capital outflows, the path for balancing the rupee remains in the hands of the RBI.

Why would the RBI be worried with an appreciating rupee? An appreciating rupee at the time of poor export growth (with negative non-oil exports growth rates), and poor imports (that show a declining trend after recovering from negative growth rates for 11 consecutive months) may impact the Balance of Payments drastically by widening the current account deficit. However, the macroeconomic balance at this juncture will tilt towards domestic considerations such as inflation and will not be held hostage to a small group of export lobbyists. Given this proposition, there is no question whether the RBI can decide to let the rupee be more flexible: It has no choice but to let the rupee move unless it decides to go the Brazil path by imposing capital controls. However, the sentiment as expressed by the Finance Minister Pranab Mukherjee and through the formation of the Working Group on Portfolio Flows under the leadership of UTI Chairman Mr. U.K.Sinha suggests that the government is no mood to exercise capital controls and further complicate a complex web  of controls that prevail in India.

In short, the RBI will certainly begin exiting from easy monetary policy by using its reserve ratio as its first tool of monetary policy, and will by deduction have to allow the rupee to appreciate in the event of such appreciating pressures.