Column : Let’s not get ahead of ourselves

Indian financial markets have been barely able to contain their excitement in recent weeks. Episodic reform efforts by the government have certainly contributed to that euphoria. But underpinning all this is the expectation that RBI will, finally, be able to start on a significant monetary easing cycle. As a result, short-end swap markets are pricing in 75-100 bps of front-loaded cuts in 2013, bond yields have rallied 30 bps over the last six weeks, and equity markets have rallied nearly 10% since October—likely pricing in the growth stimulus that such an easing cycle could generate. And why not? Don't the current growth-inflation dynamics justify aggressive monetary easing?

To be fair, there is merit to this argument. The current growth momentum (annualised sequential growth) fell to 4% in 3Q12 and is below the most sobering estimates of potential growth. Output gaps have finally closed and, in fact, turned modestly negative in India. It's no wonder that producer-pricing power is finally being impinged, as manifested by the monthly momentum of core wholesale prices remaining very muted for three successive months. Core inflation is, therefore, at a near three-year low. All this is true and, by itself, perhaps warrants 25-50 bps of cuts in the first quarter.

But not more. And here's why. Think about why output gaps have closed and pricing power has abated. This has not happened because investment has picked up, capacities have come on-line and pricing power has been competed away. Not by a long shot. It's happened primarily because demand has fallen off sharply, part design and part accident. Rural demand has been come off both because the monetary policy tightening of the last two years has slowed growth and because the monsoon and kharif crop were less than stellar last year. In addition, slowing global growth—the second and third quarters of 2012 witnessed among the slowest global growth since the expansion began in 2009—has caused India's exports to fall off a cliff. And government spending has ground to a halt in the last four months as authorities tried to avoid runaway slippage this year. So, slowing demand has been the reason that output gaps have turned negative and inflation pressures have abated.

Now, let's project forward. High-frequency indicators suggest growth has bottomed and a modest re-acceleration is on the cards. New export orders suggest a meaningful export pick-up in the coming months. A strong rabi crop should boost rural demand and, in a year peppered with eight state elections leading to a general election, it's hard to imagine public finances being austere. All this suggests that a consumption and demand-led recovery could characterise 2013. It will likely be a modest recovery, but even a modest one will likely re-open positive output gaps at a time when there are no signs of an investment pick-up. If this scenario, which is increasingly likely, plays out, inflation may re-accelerate in the coming months.

But all this is very much in the future, right? What prevents aggressive easing now? Quite apart from the fact that monetary policy has to be forward-looking, there are other considerations that the central bank will not be able to ignore. CPI inflation is in double digits, deposit growth is at a nine-year low, and gold imports continue to surge such that the FY13 current account deficit (year ending March 2013) may even beat last year's record and print close to 4.5% of GDP—almost twice as mush as is deemed sustainable in the Indian context.

And these are not unrelated facts. Stubbornly high retail inflation has meant that depositors continue to experience excessively low or negative real rates of return on financial assets in India. As a consequence, deposit growth continues to suffer (although, admittedly, it is also being impacted by the low growth of base money creation over the last year) as households are making a perfectly rational portfolio allocation by demanding ever larger quantities of gold. True, the demand for gold also has speculative origins, but there is undoubtedly a powerful inflation-hedging motive as well.

Some might quibble that all-India CPI inflation rising above 10% in December was largely on account of an unfavourable base effect. That is true, but it's not just about December. Retail inflation—as measured either by the all-India CPI or Industrial Workers CPI—has been close to double digits through all of 2012. To be sure, the momentum has tapered in recent months, but is still uncomfortably high. And the divergence between WPI and CPI inflation is understandable given the cost-push nature of inflation over the last two years.

Finally, what's also important to realise is that the current account deficit (CAD) continues to deteriorate even as non-oil and non-gold imports are on course to contracting this year as demand has slowed. If RBI were to slash rates to jump-start growth, the current account would suffer from a double-whammy—rising gold imports from lower deposit rates and rising non-oil and non-gold imports as consumption and demand re-accelerate. This is likely to offset any gains from exports and keep the CAD near 4% of GDP.

Can India continually finance such a deficit? Only in a perfect world, where global liquidity is awash, tail risks around the globe are minimised, and policy at home remains continually constructive. But if any one of these factors gives, we could be back to August 2011 or May 2012—where the combination of a sudden stop in capital flows and a bloated CAD puts the rupee under enormous pressure, and helps spark another bout of inflation.

The bottom line is that the current moderation in inflation pressures is unlikely to sustain unless the true underlying causes are addressed—a structural deterioration in investment and the fiscal deficit since the Lehman crisis. Only aggressive de-bottlenecking of supply-side constraints can boost the economy's potential and keep core inflation contained in the medium term—as we experienced in the mid-2000s. And only when the fisc corrects will the current account follow and the pressure on the currency abate. To be fair, the government has demonstrated intent in addressing these issues in recent months. But unless policy measures are taken to their logical conclusion, 2013 could look very much like 2012: some easing at the start but a central bank left with very little room to manoeuvre thereafter.

The author is India economist, JP Morgan

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