Hawkish RBI warns of 'twin deficit' risk to stability, growth

In a hawkish policy statement unveiled on 31 July, the Reserve Bank of India (RBI) clearly pointed to major threats to macroeconomic stability and growth unless the ’twin deficits’ the economy faces are narrowed.

The central bank said the twin deficits of a current account deficit (CAD) and a ballooning fiscal deficit has serious impact and failure to narrow these with appropriate policy actions will threaten both macro stability and the sustainability of growth.

Says RBI in its statement: “At current levels of the CAD and the fiscal deficit, the Indian economy faces the “twin deficit” risk. Financing the latter from domestic saving crowds out private investment, thus lowering growth prospects. This, in turn, deters capital inflows, making it more difficult to finance the former.”

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[caption id=“attachment_398434” align=“alignleft” width=“380”]  RBI did not make any changes to its key rates at its 31 July policy review, choosing instead to make a signal one percentage point cut in the statutory liquidity ratio (SLR) from 24 percent to 23 percent. Reuters[/caption]

RBI did not make any changes to its key rates at its 31 July policy review, choosing instead to make a signal one percentage point cut in the statutory liquidity ratio (SLR) from 24 percent to 23 percent, suggesting it was focused on inflation management for now, given the mounting risks on the inflation front.

Underscoring that it saw inflation management as its top priority at this point, the RBI pointed to several other risks to the economy in its policy statement. It said the outlook for food and commodity prices, in particular crude oil, has turned uncertain, reflecting the setback to the global recovery and also weather-related adversities in several parts of the world. These developments, it said, also have adverse implications for domestic growth and inflation.

The deficient and uneven monsoon has also posed additional risks over and above the inflation in protein items owing to structural demand-supply imbalances. This again has the potential of aggravating inflation and inflation expectation, the central bank warns.

On the mounting external risks too, the central bank presents a gloomy picture. Pointing out that it saw external risks to the outlook for the Indian economy “intensifying”, it said ‘adverse feedback loops’ between sovereign and financial market stress in the euro area were resulting in increased risk aversion, volatility in the financial markets and perverse movements in capital flows.

“With the deteriorating macroeconomic situation in the euro area interacting with a loss of growth momentum in the US and in EDEs, the risks of potentially large negative spillovers have increased. India’s growth prospects too will be hurt by this,” the statement goes on to add.

The central bank said the conduct of monetary policy will “continue to condition and contain perception of inflation in the range of 4-4.5 percent.”

Although inflation has remained persistently high over the past two years, it averaged around 5.5 percent during the 2000s, both in terms of WPI and CPI, down from its earlier trend rate of about 7.5 percent, it said. This is in line with the medium-term objective of 3.0 percent inflation consistent with India’s broader integration into the global economy, the central bank pointed out.

Importantly, RBI has raised its FY13 forecast for inflation to 7 percent from the earlier 6.5 percent in view of the perceived risks, and lowered its growth forecast for the year to 6.5 percent from the earlier 7.3 percent, signal enough of how it expects the global and domestic conditions to pan out and impact India.