Evidence that India is well along the road to recovery emerged this week with the news that its economy expanded at a rate of 7.9 per cent in the third quarter, much higher than even the most optimistic forecasts. The report has strengthened calls for swift action from the Reserve Bank of India (RBI) to prevent the economic gains from being eaten up by inflation. "That the central bank will tighten monetary policy is a certainty. The only uncertainty is the form it will take and when it will happen," said Prof Bibek Debroy of the Centre for Policy Research in Delhi.
Inflation is rising sharply. The increase in the cost of living is now expected to be more than double the RBI target of 3 per cent by the end of March next year. The Organisation for Economic Co-operation and Development (OECD) called last month for tighter Indian monetary policy. "Given that activity is expected to strengthen relatively quickly and that the recovery is likely to have begun with only a modest level of slack in the economy, delayed fiscal consolidation will also contribute to higher inflationary pressures," the OECD said. Many international economists support a 25-basis point rate increase, with both Morgan Stanley and Macquarie Group calling for a rate increase next month. However, many Indian economists are warning of an overreaction. They say much of the price pressure in the economy is restricted to the agricultural sector, which is suffering the effects of a weak monsoon season. They also say that real rates are quite high, even though nominal rates look low.
"It's not really inflation, it's food inflation, which is not best addressed by monetary policy mechanisms but which is a political concern," Prof Debroy said. He did not expect higher rates until next April, although he did expect the RBI to mop up excess liquidity before then. The greater concern is the effect on investment, said Kanhaiya Singh, the senior fellow at the National Council of Applied Economic Research.
Although rates look low, investment yields are equally low. This means that interest rates are actually quite high in real terms and a further increase could choke off already weak investment. "Many people are actually not very clear what they are talking about in terms of inflation," Mr Singh said. He believes that high real rates pose the greatest immediate risk to the Indian economy: investment is weak, and in a couple of years this could cause supply constraints, leading not just to weaker growth but to higher prices as well. This is why Mr Singh believes that instead of containing inflation in the present, higher rates now could actually cause inflation in the future.
"Prices may actually go up because of supply constraints, because investment has slowed," Mr Singh said. The RBI has already started to roll back fiscal stimulus, requiring banks to hold a greater proportion of deposits in government bonds, and it has also warned of higher interest rates at some point. Headline inflation is not the only problem it confronts. With global interest rates at record lows, traders seeking yield in a low-rate world this year started piling on to the new "carry trade", or money borrowed at low interest rates elsewhere and then reinvested in higher-yielding economies and currencies.
Funds flow rapidly into international stock and property markets, boosting asset inflation, which often goes unreported in national inflation indicators. It was this type of trade that triggered the 1997 Asian financial crisis. While India is reporting headline inflation of about 6.5 per cent, Mumbai's Sensitive Index, or Sensex, is up by 75 per cent on the year. While that is not as impressive as in Brazil, where the benchmark stock index has more than doubled, it is still above the benchmark Morgan Stanley Emerging Market Index, which was up 62 per cent to the end of October.
Foreign portfolio cash, called "hot money" in reference to its volatility, is flooding into the Mumbai stock market and could overtake India's 2007 record portfolio inflow of US$17.7 billion (Dh65.02bn). The turnaround occurred in the second quarter this year with inflows of $6.4bn, followed by $7.4bn in the third quarter and $2.4bn to the end of October. It is the same story with foreign direct investment (FDI).
Even though FDI inflows are declining worldwide, in India they continue to rise, increasing last year to $35bn despite the global crisis. After some weakness early this year, inflows rebounded in June and then increased 55 per cent on the year to $3.5bn in July despite a global FDI decline of 30 per cent. This massive capital influx has prompted some discussion of capital controls, something Brazil implemented a couple of months ago. While Delhi has so far shown little inclination to follow Brazil's example, Pranab Mukherjee, the Indian finance minister, has told regulators to keep a close eye on foreign inflows and has also pledged to roll back fiscal stimulus programmes sharply once growth takes hold.
With growth well on its way to attaining the government's target of 9 per cent, the question now is whether the critical point has been reached. @Email:firstname.lastname@example.org