Inflation hits 13-yr high; What's the remedy now?

Sanjeev Sanyal, Regional Economist,  Deutsche Bank (Asia) feels inflation in double digits already, is a huge surprise. Everybody was expecting a significant increase in the inflation rate, but it is well above everybody’s expectations. He sees at least another quarter and a little bit more of double digit inflation, followed by a fairly aggressive tightening from the Central Bank.  

However, Gaurav Kapur, Senior Economist at ABN AMRO was not surprised with inflation numbers coming in at over 11%. His estimate was close to about 10.6%. He said that we are faced with inflationary pressures in a number of other commodities other than just fuel and this just points to the fact that the whole trigger from the supply side is now broadening to the other areas of the economy. Wherever there is still some excess demand, one is still witnessing price pressures.

He further said “In such a scenario, a monetary tightening is imperative. A 25 bps repo rate hike and perhaps even a CRR hike is pretty much on the cards. It will definitely have some negative impact on growth after the first repo rate hike of 25 bps. My sense was that that we could see GDP growth slipping to about close to 7.8%.”

However, Kapur still thinks that we will be able to achieve growth of around 7.5% to 8%. He is not that pessimistic at this point in time. The Fiscal policy this year and the budget this year has been extremely accommodating - so to say a counter cyclical in a very big way, he said.

Kapur added “If one looks like the direct tax numbers from April to May and the other such leading indicators including our PMI, it does not show at this point in time that the activity levels have or the pace of growth has declined very sharply. Pressures have built up and they are likely to show up over the coming quarters and higher interest rates would definitely add to the trouble or the burden of the consumer.”

Indranil Sengupta, Chief Economist,  DSP ML said that he expected a number above 10%, but clearly not 11%. Whether inflation cools off from here on immediately or not will just depend on the rains and that’s the hard incontrovertible fact that we all have to face, he said. What happens especially to districts that produce oil seeds, pulses and rice will be the key to inflation coming off in the immediate term, he added.

Sengupta said, "We knew that the petrol price hike would lead to 100 basis points of additional inflation. But I never understood how the 50 basis point calculation ever came to be made. A lot of the inflation is still of a supply side character and some of it depends on the rains, so I am not entirely sure that massive rate hikes are actually going to do much to inflation. That doesn’t mean that an inflation that has got in to double digits and can come down without any monetary action. The RBI can raise the CRR, the RBI can raise rates but the banks have to be able to raise the prime lending rates."

Q: Now if you are guessing a half percent hike in CRR and repo, what does it mean then,? Does it mean a sub-7 at all and can growth be impacted so much?

Kapur: I would still think that we will be able to achieve growth somewhere around 7.5% to 8%. I am not that pessimistic at this point in time. The fiscal policy this year - the budget this year has been extremely accommodating and so to say a counter cyclical in a very big way and if you go by the direct tax numbers which are available from April to May and the other such leading indicators including our PMI (Purchasing Managers Index) - it doesn’t really show at this point in time that the activity levels have or the pace of growth has declined very sharply. That said, pressures have built up and they are likely to show up over the coming quarters and higher interest rates would definitely add to the trouble or the burden of the consumer.

Q: You have seen that 1995 period, 1997 period of 17% PLRs and 15% PLRs and half built steel plants and unfinished or barely started oil refineries. Is the situation likely to be as bleak as that or we will still get by, you are only going to see the economy skid off one or maybe two years and the long-term 8-9% is intact?

Drabu: I think here the situation is different from what we saw in 1995-1996 in a number of ways quite apart from the structure of the economy, the levels of financial intermediations etc. Definitely this is to my mind- I have been looking at this for sometime now perhaps the most difficult phase of policymaking after 1991. It’s not so much in terms of what we have seen so far but what we are getting into. Because we are getting into in some way unchartered areas of experimentation and that’s a huge cause for concern. We started off with this whole thing about moderation growth rates slowed down, now we are looking at a very high inflation with serious slowdown in growth and are we staring at a phase of stagflation in some way or the other.       

Let's not fool ourselves and say that this is 11% on the back of fuel. This is not yet seen what the actually fuel impact is. So in some way, I think we need to go back to basics at this point of time and see where does the problem lie? To my mind, the problem is that we are looking for monetary solutions to a fiscal problem. The fiscal issue has been delayed so much that we have now to pay the price for it. No matter what the Reserve Bank of India does whether it does it to be seen to be doing something or in a fact is forced to do something, or it does it out of genuine policy muscle it is not going to have an impact, the kind of impact that you would wanted to have.

At best you would actually be now getting into an area where you have distinctly slowdown growth. Any rate hikes now are going to have where there is a serious trade off that would now start working on because till now having seen everything you haven’t seen a slowdown investment in manufacturing companies and in investment plans of the companies. From now on, any action would actually have a serious trade off in terms of growth. Every point now becomes very critical as to where we are going.

As I said the worry for me is that we have got into areas, which we haven’t really got into earlier. Like this whole, the way you finance the oil bond thing and you have done off-market deals, you have done private placements; imagine what would have happened to bond yields had that money come to the debt market. Let’s say you have done a bond issue with SLR (statutory liquidity ratio) status or something like that or it has gone to the foreign exchange market.

In some ways, you may have done something that is creative but it’s not correct in the long-term interest of macroeconomic policymaking because you have done off-market deals; you have suppressed issues that otherwise would have come in. You have virtually monetized deficits, you have virtually doubling fiscal deficits through oil bond thing. What you are doing now is actually constraining ourselves in the days to come and to my mind the days to come are going to be much more difficult than what we are seeing right now.   

Q: If you are looking at some fairly serious action from the RBI in terms of half a percent or even more than that in terms of rate hike within a quarter. What are the growth projections? Are you ready to scale it up to 7 and below or at least scale it down seriously?

Prasanna: Probably for the first two-three quarters it’s not going to affect too much. So at this point of time I am sticking with 11.5% and it probably have to wait for what exactly RBI is going to do before revising it.

Q: There will be definitely more fiscal problems for the government; the manner in which probably the government will have to bail out even on the oil front. Will not that expanded fiscal borrowing itself cast an impact on interest rate. The repo can wait but the markets are not going to wait for the repo hike already 8.6% and the five-year Overnight Index Swaps (OIS) is 9.1% or something. That is the market that is unencumbered by any Statutory Liquidity Ratio (SLR) demand. If that is the rate it is pointing out the interest rate in economy will any way move up with or without Reserve Bank of India. So surely you can come to some conclusion about how much corporate earnings could be impacted and how much Gross Domestic Product (GDP) could be impacted?

Prasanna: That’s right but what I am trying to point out is although these changes in interest rate act with a lag we shouldn’t forget that. Markets can discount things quickly but in the real economy obviously the changes percolating through the economy will happen with a lag. So that’s why I am saying I am comfortable with 7.5%; I think there are downside risk I am not denying that but at this point of time it’s a bit panicky to say 8-7% below and all that. That’s what I am trying to point out.

Q: How do you think global investors will take all of this the way our macros have been moving culminating in this inflation figure today at 11.05%?

Sanyal: As you mentioned inflation is not an India-specific problem but what is important to recognize which has been brought out by some of the other speakers is that it’s not just about oil. India has a genuine inflation problem over and above the oil problem and it seems that that is an issue that needs to be tackled. I do expect fairly aggressive Central Bank action and not just on interest rates but CRR and so. The exchange rate for e.g. will be at the very least held where it is, and not allowed to depreciate further. So, all and all, you do have an environment that will affect growth by the last quarter of this calendar year and certainly by the beginning of 2009.    

Q: So far the talk is all hovered or hinged around as to what is going to happen to the growth and the interest rates in the current year, if there is more action from the RBI, as Prasanna was pointing out, do you fear that maybe the slowdown could extend in to 2009 and we might not get out of this sticky situation in the next 2-3 quarters?

Drabu: Yes that’s what I am saying. But before I come to that, let me also just point out that quite apart from that, while we keep always talking about what government hasn’t done in terms of the fiscal policy, we also need to look at what is happening in the banking sector itself. I am a bit surprised, that after what the RBI did 10 days ago and after what we have been seeing and hearing about the macro economic situation, no bank in the country raised its PLR - now what are you trying to do? In some way, you are hoping against hope that something will happen, and something will emerge and I don’t see any good news emerging in the horizon for the next three quarters certainly.

So instead of kind of getting prepared for it, we are postponing the problem and by postponing it, compounding it because with every single day the policy options get squeezed and reduced. So what is this banking sector doing without raising PLR’s and perhaps we are the only bank in the country which actually raised the PLR by one percent last week after the RBI raised the repo rates and it’s very obvious that this needs to be done now and otherwise we are headed for trouble and having said that, in some ways the government has not done on its own or perhaps was not allowing others to do which is causing the problem. It surely is now looking that this is not going to be a three quarter phenomenon. The fall, from 11% to levels that we think is desirable and tolerable rates of inflation between 3%-4% or 4% and 5%, it will take some more time and with every action of the RBI now, the impact will not be immediate; so it would have to be very gradual and second is that there are now distinct trade-offs, and for every 1% hike you will actually see a corresponding drop in terms of growth rate trajectory.

So, it will certainly extend into the next year. It is also that it’s not that we have comparative status. It’s a dynamic situation where today will feed into tomorrow and tomorrow will feed into day after so there gets when you are in a growth trend the virtual-cycle operates, and now it’s a reverse of that so you will feel the sentiment depressed and you will feel the global investors very concerned. The whole flows will change now and we begin to compound the problem.

So I am looking now at a situation where in FY09 is again not going to be something that we had expected earlier – we had thought it as a short-term adjustment problem but it’s gone beyond that and as it is becoming evident – it’s not just an oil-related issue and there are other things as well. We have had demand-push factors in the system, as well as supply induced factors - we have given tax breaks, we have given pay commissions, debt relief, and expansive fiscal policy. Where was the need to do all this at one point in one package? All this adds to their disposable incomes and puts demand pressure across the board and not just on specific commodities and add to that the supply side; so it is becoming a fairly serious situation which will definitely extend into the next year.

Q: What year end do you see the tenure G-sec at 9% and what kind of corporate bond yields are you looking at for 2008?

Kapur: The way inflation is going, 9% on the ten year is just a matter of a few more weeks. The way the OIS has moved and because of  the SLR related demand, it curbs the tendency and the upward pressure. With inflation with 11%, the average inflation for this year is close to 8.5% even if you were to take  revisions. So we are already looking at a real negative or almost a 0% yield. So, a 9% or a 9.5% over the next 3 months is pretty much on the cards and I would expect the tenure to settle in 9% or 9.25% for the rest of this year.

Q: Where do you see the growth trajectory? You said you will be comfortable with 7.5% just now and will want to look at the number only after looking at a monetary policy action. But would you say that for the moment we have to forget that 9% growth trajectory that we build up over the last four years and settle for perhaps something like 6-7 for the next two-three years? Is it looking as bad as that?

Prasanna: At more than 9%, the economy is growing faster than what it can support, when you take into account the potential growth and the output gap. So three years of sub par growth is what is required. The key is what the policymakers are looking at. If RBI is convinced of the key into rein in inflation expectations, they will have to target a growth of below 7%. The question is whether they are willing to do it and willing to do it in a credible and a public manner.  

Q: What do you feel about the slightly longer term, if I had to get one last guess form you as to what will be the likely growth trajectory over the next two years? Would you say it would be around that 7% rather than 8%, what’s your guess?

Drabu: My guess is that it will move between 7.5% and 8%.

Q: What’s your guess; you think that even if we pass through 7.5% this year, the next one is going to be tougher?

Prasanna: Yes next year will be tougher because we are probably looking at 7% or even lower than 7% to my best guess.

Q: What about the banking space, what’s the call on that segment purely in terms of interest rates and how do you expects the move to be here on?

Sengupta:  We have been talking of a 50 basis point hike in the CRR and a 25 basis point hike in the repo rate. The far more important thing is whether banks, especially PSU banks, get to raise lending rates. Unless they raise their lending rates, you are not going to be able to transmit the RBI action into a fight against inflation. So we expect banks especially PSU banks to raise the lending rates by 25 to 50 basis points from here on. We expect the RBI to try and stem the rupee depreciation because this is hardly the time you can afford a weaker rupee. So I see monetary tightening from various quarters.

Q: Do you expect the RBI to move soon in the next meeting and if yes, with what repo or CRR you think?

Sengupta: We expect a 50 basis point CRR hike. The main worry today is that the money supply is growing at 22%. If money supply continues to grow at this level, then you will be in a situation like the mid-90s where excess liquidity began to drive inflation. So that to me is the main national risk we face today and that is why we expect a 50 basis point of a CRR Hike. There could be a repo rate hike of 25 bps to control inflation expectations, but I think that controlling money supply at this stage is really the most important thing the RBI needs to do.