India Signals Tougher Inflation Resolve to Avert ‘Hard Landing’ of Economy

By Kartik Goyal - Jul 27, 2011

The Reserve Bank of India signaled it’s prepared to accept a slower expansion to pull down an inflation rate that risks causing a crash in the pace of growth in Asia’s third-largest economy if left unchecked.

The RBI yesterday surprised all 22 economists surveyed by Bloomberg News with a half-point boost in the repurchase rate to 8 percent. The bank said in a statement that stronger action was needed in the absence of government steps to damp demand or efforts to address the nation’s supply bottlenecks.

Governor Duvvuri Subbarao was forced to escalate what was already the steepest increase in borrowing costs among major Asian economies, after household expectations for inflation exceeded 12 percent, above the 9.44 percent current pace. The bank will add another half point to the benchmark rate by the end of 2011, the median of 11 estimates in a Bloomberg survey yesterday showed.

“Policy makers now have accepted that demand is the underlying driver of inflation and needs to be brought down to cool inflation and avoid a hard landing,” said Jahangir Aziz, an economist at JPMorgan Chase & Co., who previously worked at India’s finance ministry and the International Monetary Fund. “Capacity constraints are much tighter and demand pressures much higher than they had thought.”
Stocks, Bonds

The benchmark Bombay Stock Exchange Sensitive Index slid 1.9 percent in Mumbai yesterday, the day’s worst performance in Asia and the biggest drop in five weeks. It was unchanged as of 10:36 a.m. local time. The rupee advanced 0.6 percent to 43.92 per dollar and the yield on the 7.8 percent government bonds due April 2021 rose 3 basis points, or 0.03 percentage point, to 8.47 percent. It reached 8.48 percent earlier, the highest since September 2008.

While keeping its growth forecast for the fiscal year through March at 8 percent, the RBI said that “in the absence of appropriate actions for addressing supply bottlenecks, especially in food and infrastructure, questions about the ability of the economy to sustain the current growth rate without significant inflationary pressures come to the fore.”

Subbarao, 61, acted as the central bank elevated its inflation forecast for the year through March by 1 percentage point, to 7 percent.

After what could be Subbarao’s final rate decision, the central bank blamed the government for contributing to inflation, with its “large fiscal deficit” stoking price pressures. The RBI July 25 also cited a high share of production capacity in use, risk of a “wage-price spiral” and “stickiness” in food costs fanning price gains.
Subbarao’s Term

The Bank of Thailand, which also raised interest rates this month, said rising food and fuel prices remain the “key risk” to economic growth, according to the minutes of its July 13 meeting released today.

Subbarao’s term concludes before the next scheduled rate announcement on Sept. 16. A former top bureaucrat in the Ministry of Finance, Subbarao took office in September 2008. Prime Minister Manmohan Singh’s government hasn’t publicly indicated whether it intends to reappoint him.

While growth has shown signs of moderation, “there is no evidence of a sharp or broad-based slowdown as yet,” the central bank said in its policy statement yesterday.
Industry Concern

An increase in borrowing costs alone may not help in containing inflation because it is driven by higher global commodity prices, B. Muthuraman, president of the Confederation of Indian Industry, said in a statement dated yesterday. The emphasis should be on easing bottlenecks, speeding up reforms and increasing investments in the economy, he said.

“The 50 basis-point hike in policy rates will seriously slow down the growth rate of industry, which is already suffering from an increase in the cost of funds,” said Muthuraman, who is also vice chairman of Tata Steel Ltd., India’s biggest producer of the alloy. “While it is important to control the threat caused by persistently high inflation, we cannot risk a collapse in growth which will affect employment creation.”

Maruti Suzuki India Ltd. (MSIL), maker of almost half the cars sold in India, yesterday reported first-quarter profit increase of 18 percent that beat analyst estimates because of higher sales and a jump in unspecified other income.

“The challenge for the government and the RBI is to ensure demand is constrained in the short term,” Subbarao said at a press conference yesterday. He said “fiscal consolidation” is critical to managing inflation.
Tax Cuts

Singh’s government last month cut the customs duty and excise levy on fuels to curb prices, undermining efforts to narrow the budget shortfall. It was forced to raise diesel costs for the first time in a year to reduce losses at state-owned refiners such as Indian Oil Corp. The tax cuts will cost the government 490 billion rupees ($11 billion), Oil Minister S. Jaipal Reddy estimated.

Finance Minister Pranab Mukherjee aims to trim the budget gap to a four-year low of 4.6 percent of gross domestic product in the year ending March 31.

Prices are also climbing as a lack of investment by companies curb capacities. Corporate investment in the second half of the fiscal year ended March 31 dropped 43 percent compared with the first six months of the year, the RBI said in a report on July 25.
Investment Prospects

“There are no signs of improvement in investment during 2011-12 as yet,” according to the report.

Manufactured-products inflation quickened to 7.43 percent in June, according to calculations by Bloomberg News based on data from the commerce ministry.

Retailers such as Bentonville, Arkansas-based Wal-Mart Stores Inc., Paris-based Carrefour SA and Cheshunt, England- based Tesco Plc have been lobbying for a chance to sell food products to India’s 1.2 billion people, arguing they will lower prices and provide the scale that can improve local food networks.

Food inflation has averaged 12.6 percent in the past year as about 40 percent of India’s fruit and vegetables rot before they can be sold because of a lack of cold-storage facilities and poor transport infrastructure.

A panel of Indian bureaucrats this month recommended allowing foreign companies to own up to 51 percent in multi- brand retail stores, according to a finance ministry official with direct knowledge of the matter.

“The economy’s ability to grow rapidly for any length of time without provoking inflation is dependent on implementing policies, with corresponding resource allocations, which will allow the supply of various products and services to keep pace with demand,” the central bank said yesterday.

To contact the reporter on this story: Kartik Goyal in New Delhi at kgoyal@bloomberg.net

To contact the editor responsible for this story: Stephanie Phang at sphang@bloomberg.net
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