RBI may shift focus to growth as inflation eases; no magic wand for rupee: SocGen’s Kundu

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The Reserve Bank of India may not increase interest rates as sharply as the street expects and may even slowly turn its focus back to growth because the coronavirus pandemic-hit economy has seen significant scarring over the past couple of years, the India economist at Societe Generale said.

“While the economy may currently grow at the pace that is faster than the potential growth rate, the fact is even a 7 percent real GDP growth is still quite below what the economy needs to create the number of jobs that would be demanded by the young population,” Kunal Kumar Kundu told Moneycontrol in an interview.

He said the pandemic destroyed jobs and demand. Slowing down a weak economy will have long-term growth consequences. In a country with a large number of discouraged workers, another slowdown could lead to a further fall in labour force participation and possibly more discouraged workers, he said.

“So there has to be a trade-off the central bank has to look at and hence re-focus on growth once inflation provides some semblance of control,” Kundu said.

While the RBI will need to be more aggressive on rate increases in the next few meetings as it seeks to curb inflation that has stayed over its tolerance ceiling for several months, the benchmark policy repo rate could finally settle at 5.75 percent at the end of this tightening cycle, Kundu said, against market expectations of a terminal repo rate of over 6 percent.

“We believe that the inflation expectation for next year is a bit overblown. We are already seeing commodity prices falling because there is an engineered global growth slowdown,” the economist said. “As a global slowdown takes shape, I see a gradual easing of supply-side challenges.”

The RBI’s rate-setting panel increased the policy repo rate by 90 basis points to 4.9 percent since early May and is widely expected to increase the rate again when it meets next month.

The central bank is unlikely to target a zero or positive real policy rate as an easing inflation trajectory will give it the space to buffer the hit to growth, the economist said.

While Kundu expects the situation to improve from the middle of 2023, he assesses India’s potential growth rate might have dropped to 5.5-6 percent.

No magic wand

The rupee, which has fallen to fresh lows session after session amid a global risk-off sentiment and investors fleeing emerging market assets, is likely to see further support from the authorities that are focusing on containing volatility.

The rupee fell below 80 to the dollar on July 19 as crude oil prices surged. Investors have been selling Indian equities for months and elevated inflation and a widening trade deficit are adding to the currency’s woes.

The RBI and New Delhi have announced a raft of measures in recent weeks to aid the currency.

“One measure that is likely… is bilateral currency swap agreements to ward off pressure on the currency. That is one weapon in the RBI’s arsenal that has not been utilised. We can see some NRI bonds come in,” Kundu said. “Possibly a little more can be done but we do not think there is a magic wand here. The only thing the RBI will possibly need to do is to try and ensure that the currency does not weaken too much and too fast because that will have its own consequences.”

India faces a twin deficit challenge—widening fiscal and current account deficits as well as a rising misery index, which is the sum total of inflation and the unemployment rate, pointing to the short-to medium-term challenges faced by the economy.

Ensuring overall macroeconomic stability is important in the present context, the economist said.

“Measures taken during the crisis period are unlikely to act as a magic wand that can suddenly change the situation. These can only ease the pain a bit. Given the steps taken thus far, the depreciation pressure on the currency may ease a bit but we do believe that the RBI needs to be aggressive on the policy rate front to be more effective,” he added.

Meanwhile, foreign investors are not likely to look at India at this point if the risk-off sentiment persists. However, the situation will likely change in the second half of 2023 by when the inflation challenge could be relatively better settled and as growth slowly comes back on track, Kundu said.

“I am hopeful of things being relatively better in the second half of next year. But the remaining half of this year will definitely be a pain and there will be some persistence of that even in the first half of next year,” he said.

Demand-investment conundrum

India’s growth prospects have taken a hit due to the consistent stress faced by the so-called micro, small and medium enterprises and the weak recovery in domestic demand, Kundu said.

“When you look at data on corporate performance, you actually see a classic case of a ‘K’-shaped recovery where the bigger companies have been able to continuously increase their market share, while the MSMEs are consistently losing market share,” he said.

Companies won’t be keen to invest if overall domestic demand remains weak, keeping their total capacity utilisation below the long-term average.

“Infrastructure investments have generally been doing well. Government spending on infrastructure has also been pretty robust. This remains the brightest spot in the post-pandemic period,” Kundu said.

“But business spending is not strong enough. Unless both these parts of investments start firing, recovery cannot be robust. So when demand is yet to gain adequate traction and only one part of investment is firing, growth will remain subdued.”

Jobs challenge

The number of discouraged workers in India has increased dramatically after the pandemic, with the labour force participation rate among the lowest globally, the economist said.

“The biggest challenge is the total job creation in the economy. Even now, two years after the pandemic, the employment level is lower than what it was before the pandemic started. So on a net basis, we are still negative,” he said. “Some job creation has, of course, happened but given the kind of stress we have seen in the informal sector, total employment level is down, the labour force participation rate is extremely low, unemployment is still high.”

Moreover, the quality of job creation is questionable and workers are shifting to low-paid jobs in the informal sector. There is also a huge amount of disguised unemployment.

“On an aggregate basis, we have been pretty worried about how domestic demand would shape up,” Kundu said.