India EcoView: If Capital Inflows Spike Up, What Will Be The Policy Response?: Morgan Stanley

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India EcoView: If Capital Inflows Spike Up,What Will Be The Policy Response?



Likelihood of policy rates in G3 remaining low for
long and potential increase in quantitative easing in
US and Japan has increased the risk of rise in
capital inflows into emerging markets and India. We
recently released a detailed report on policy implications
in this environment for Asia Ex-Japan region (Impossible
Trinity Strikes Again, October 13). In this week’s
EcoView, we have zoomed in on analyzing the potential
policy responses in India in the context of inflation risks
and continued rise in asset prices. We believe that in the
current macro environment, policymakers could find it
increasingly challenging to manage aggregate demand
and inflation risks with aggressive monetary tightening.
We believe a more effective policy response will be
fiscal tightening.
Elsewhere in this week’s EcoView, we summarize the
following macro developments:
Macro funding remains strong: Bank credit, domestic
debt, equity issuances and external commercial
borrowings continue to rise. Based on this funding trend,
we believe that capex recovery remains on track.
Banking sector credit deposit ratio remains high:
Bank credit has accelerated to 20.1%YoY compared
with deposit growth of 15%, keeping credit-deposit ratio
at high levels of 72.4% as of the fortnight ending 8
October, 2010.
RBI responds to tight interbank liquidity: Interbank
liquidity remains in deficit for last few weeks. To address
this, RBI announced a decision to buy back G-sec bonds
of Rs285.5 billion.
Rural and agricultural labourer’s CPI moderates
further: CPI-AL and CPI-RL decelerated to 9.1% YoY
and 9.3% YoY, respectively, in September from 9.6%
YoY and 9.7% YoY in August and the peak of 17.6%
YoY and 17.4% YoY in January 2010.


Key Points
• India has had no major challenge in managing
capital inflows so far: High current account deficit has
been absorbing most of the capital inflows. We estimate
that over the last 12 months, the current account deficit
has been about US$51 billion compared with capital
inflows of about US$68 billion.
• Major rise in capital inflows may increase inflation
and asset price risks: If capital inflows rise sharply over
the next few weeks, we believe the first step by policy
makers will be to intervene in the FX markets, and the
second step will be to discourage debt-related inflows.
Considering that currency has already appreciated a lot
on a real effective exchange rate (REER) basis, we
believe there is less scope to allow appreciation in tradeweighted
nominal exchange rate.
• So far, the burden of managing inflation risks has
been on monetary policy: RBI has gradually lifted
policy rates by 125 basis points from the trough and
short-term market interest rates have risen by 240 basis
points over the last 5 months. Although the debt-related
capital inflows have been manageable so far, there is an
increased risk that these inflows may start rising if RBI
tightens monetary policy aggressively.
• Going forward fiscal tightening may be more
effective to manage inflation risks: We believe that in
an environment where G3 interest rates are likely to
remain low for long, a more effective policy to manage
aggregate demand and inflation risks will be fiscal policy.
The government needs to work on a plan to pursue a
faster reversal in fiscal stimulus as private sector
spending is rising quickly.