The RBI should change the stance to neutral, with inflation broadening out in India: Nomura’s Sonal Varma

From the nature of this inflation shock, it is going to impact the low-income consumers the hardest because the inflation is essentially hitting the bulk of your fuel-food baskets, said Nomura's Sonal Varma. (Illustration by Suneesh Kalarickal)

With the economy absorbing shocks from various corners and bracing for more, inflation has emerged as a challenge. All eyes are on the RBI, with its MPC Meet this week, wondering if the Central Bank will finally change its accommodative stand and take out some of the liquidity. The trouble comes largely from the supply side–with the Russia-Ukraine war, the sanctions on Russia and commodity price rise–and will require a fiscal intervention. But, according to Sonal Varma, Managing Director and Chief Economist for India and Asia (excluding Japan) with Nomura, the Central Bank needs to consider the broadening out of inflation. In an interview with Moneycontrol, she discussed some of the challenging questions facing the Finance Ministry and the Central Bank. 

What would you say are the biggest uncertainties the Indian economy is dealing with today?

Quite a few of them, actually. There’s the war in Ukraine, in terms of how long it's going to last, and how long the sanctions imposed in Russia are going to last. Then what that means for the outlook for commodity prices. Are elevated levels of oil prices going to sustain? Or is this more of a transitory problem? There’s a lot of uncertainty on that.

The related question is what kind of economic impact will this have. In general, the expectation is that it will lead to lower growth and high inflation. But, the extent of the economic damage from these… there's still uncertainty about that across different countries. Outside of this, there are also the risks from the faster than expected normalisation from the US both in terms of the pace of rate increases, as well as the quantitative tightening that lies ahead. You know, whether that leads to more volatility in capital flows. Then there is the pandemic. Most countries are learning to live with the virus, but there is, of course, the risk that the virus can still mutate. There are quite a few uncertainties but these would be the key ones.

Also read: Chasing growth in the time of high inflation

Would you say India’s fiscal deficit numbers are particularly worrying? A recent Nomura report had said that India was  particularly vulnerable to external shocks because of it.

The report was basically looking at the impact of higher commodity prices across Asia. Most in the region are net oil importers, but there are also countries that export coal, palm oil and LNG, such as Indonesia and Malaysia, so they benefit from the price rise. But for most other countries in the region, including India, the rising commodity prices is a negative trade shock. It (the observation about India’s vulnerability) was a relative assessment.  

A negative trade shock can result in low growth, high inflation and the twin deficits. Of these various effects, I would say, the impact on the current account deficit is quite large. But our cushion on FX reserves is also much larger today than it was back in 2013. So the ability to handle the shock on the external sector is better. 

But on the fiscal side, with the aggregate government debt as well as deficits, (India’s vulnerability) is much higher than it was back in 2013. While we don't have the petroleum subsidy burden today, and its prices are market determined, there’s still under recovery. Then, there is going to be fiscal pressure on account of the extension of the free food grains scheme as well as the fertiliser subsidy side. So, we are starting at a slightly worse point (than in 2013) which leaves lesser cushioning on the fiscal side to accommodate this shock. Typically, when you have this kind of supply-side inflation shock, it is really fiscal policy that should be the first line of defence, by cutting taxes or giving direct cash transfers to specific low income households. That cushion is basically less.

Considering the higher fiscal deficit, does FinMin have the leeway to drive growth?

It won’t be an easy decision. Clearly the level of taxes today, even after the reduction we saw in November, are still much higher than they were pre-pandemic. So, consumers are clearly bearing a higher burden and there is room to cut taxes. But from the government’s standpoint, there are constraints as well. 

Firstly, how long will prices be here (elevated)? Once you reduce taxes, it is much more difficult to bring them back if need be. Also, since there is already the fertiliser and food bill, which will (now) be higher, the fiscal hit from a reduction in excise duty will be much more. The question now will be if we should compromise on CapEx or allow a slippage on the fiscal front. These are complicated questions. 

If prices stay elevated for long, then perhaps there is a case to reduce the burden for the consumer at the margin. Otherwise, the extent of price rise that will be passed on to the consumers would be quite substantial.

Is the country really tackling a twin-deficit problem?

It’s obviously much milder on the current account. Of course, the current account surplus we had for the last couple of years was more cyclical, reflecting both the demand drop and the commodity price drop. So, now that the economy is normalising and you have higher commodity prices, the current account has swung back into a deficit. Our forecast 2022 calendar year, we will have between 3.5% to 4% of GDP on the current account deficit. In our view, this means that the balance of payments will likely be in a deficit… because the net FDI flows should be closer to 1.5% of GDP, then you have other sources of capital flow, of which some are harder to predict. But it isn’t the 2013 (scenario).

As I mentioned earlier, on the FX reserve side, we still have about 10 to 11 months of import cover, which is down from where we were a couple of quarters back. But, if you compare this back to 2013, reserve cover was down to six months. At the margin, of course, the current account is worsening. I think it's manageable still.

The ability to use the foreign exchange reserves to smoothen out any exchange-rate adjustment is there.

On the fiscal side, the ability of the economy to absorb the shock and protect, let's say the consumer, is much lesser. On the fiscal side, the worry is from two perspectives–one from the growth perspective and two from the size of the government borrowing. In terms of growth, can the government cushion the consumer with a tax cut? Then, will it cut down on capex, which of course we still need, because direct investments haven't fully picked up? About the government borrowing, it is already quite large and the ability of the markets to actually absorb the combined supply from Central and states is limited. 

What do you expect from the MPC meet? Will it continue with the accommodative stance?

Clearly, the assumptions and the projections given back in February need to be revised. Both shocks–of higher oil and other commodity prices, and of potentially weaker global demand–need to be incorporated in the February projections. This implies a downward revision on growth and an upward revision on inflation. The RBI had given a growth projection of 7.8% but they may revise that to 7% to 7.5%. On inflation, the central bank had given a projection of 4.5% for FY23. It's hard to predict what oil prices they're going to assume. But, our sense is that there will be at least a percentage point upward revision in the inflation projections.

Now, then the question is whether this calls for a change in the monetary policy strategy. From the comments we've heard from the RBI so far, over the last two to three weeks, its stand seems to be that this is a supply-side shock and the fiscal should basically deal with it. That using monetary policy to respond won’t be right.

Our own view is that the RBI should change the stance to neutral from accommodative. And, I am using the word ‘should’ here, because as a central bank, it has to be alert about the risk of second-round effects (such as wage revisions, which means higher cost to companies and higher cost to consumers if the companies pass them on). And, what we've seen is basically more and more evidence that inflation is broadening out in India, expectations have been moving higher in the last two years now, and now you have this additional supply side (shock), which is happening at a time when the output gap is negative but also narrowing. 

Also read: CPI inflation for farm, rural workers at 5.59%, 5.94% in February

When people’s inflation expectations are going up, they are likely to spend less. Will this have a spin off effect on the spending by companies?

I would say more than the companies, we should be more worried about the pandemic’s disproportionate impact on lower income households. They typically have less household-savings buffers. From the nature of this inflation shock, it is going to impact the low-income consumers the hardest because the inflation is essentially hitting the bulk of your fuel-food baskets. So the risk comes from not seeing similar increase in incomes, particularly if we look at rural wages… so, this becomes a cost of living issue for many consumers, particularly in lower income households.

So that's where the bigger worry is I would say. But yes, even for companies (there are concerns)... we have seen some pass through since last year. We continue to see pass-through even now across different consumer durable and non-durable companies. But even that pass-through will be partial so companies will experience a margin squeeze. That is a negative from a profitability standpoint. But beyond that, the broader uncertainty will make it hard for firms to take a clear decision on what to do. So there is a risk that investment decisions could get postponed because of this uncertainty.

You have written that the RBI is already controlling money supply through a stealth mode, using variable reverse repo rate (VRRR) auctions. Do you think this is a more efficient way of doing it than doing a rate hike, since they can control the supply in a calibrated manner?

It’s efficient from their perspective. But from a macro perspective, we don't think it's a substitute for the policy normalisation. Because ultimately, the RBI brought the effective rate closer to something below 4%, from the lower end of the interest-rate corridor at 3.35%... So, effectively, you've tried to do that bit of normalisation through VRRR. It is a decent starting point. But it’s not a substitute. 

Our forecast for inflation for CY22 is around 6.2% and we expect inflation to breach on a consistent basis. So, with the VRRR bringing the rate closer to a little less than 4%, the real policy rate will be a negative 2% going forward. So, VRRR cannot be a substitute for policy normalisation.