RBI - Not done with tightening: HSBC

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Not done with tightening
Stubbornly high inflation in India requires further rate hikes
􀀗 While policy rates are up and the fiscal deficit is lower, more
is needed to tame inflation and sustain the expansion
􀀗 After last week’s hike, the RBI will likely pause until 1Q and
then resume tightening, raising rates by 125bp by end-2011
􀀗 Capital inflows are adding to the challenge, but there is no
need to push the capital control “panic button” yet





Too loose for comfort
India’s return from the depth of the crisis has been fast and furious with GDP growth
rising to 8.8% in the second quarter of this year from a low of 5¾% in the first quarter of
last year. The strong domestic demand base helped lessen the adverse spillovers in the
first place. Supportive macroeconomic policies and the quick normalization in global
trade then lifted business and consumer confidence, ringing up private domestic demand
as a key driver of growth during the recovery.

The cyclical recovery has now entered a more mature stage and the growth momentum
will be less strong as the economy now flirts with potential, essentially banging its head
against the ceiling. Still, GDP is projected to grow handsomely at 8.8% in 2010/11, up
from 7.4% in 2009/10, and only decelerate slightly to 8.3% in 2011/12.
With domestic demand expected to be vibrant over the forecast horizon, partly because
monetary policy remains highly accommodative, demand-pull inflation will become more
prevalent. This, in turn, calls for continued monetary policy tightening, especially since
the withdrawal of fiscal stimulus is limited this year and is not expected to be dramatic
next year either. So, the RBI is not done yet and the signalled pause last week is just that,
a pause. The tightening cycle will likely resume in early 2011 and deliver a total of 125bp
in hikes next year, bringing the policy rate to 7.5% by year-end.

Capital inflows to India have been significant, but they are of less concern because India
is not an export powerhouse and already has capital controls in place. But, even if inflows
should accelerate further there is no need to press the capital control “panic button” quite
yet. The flexible exchange rate provides a good buffer and can deter more speculative
inflows. Macro-prudential measures could also be a useful surgical tool and fiscal
tightening could come on-stream if there are concerns about broader demand pressures.