Pacific Money

India’s Economic Challenge

The Reserve Bank of India has eased rates for the second time this year. Will strong growth return?

India has again moved to try and shore up economic growth despite persistent inflation. After this latest shift, however, there is less room for additional measures, and investors know it.

Several factors continue to complicate government policy. To these one must now add renewed political posturing that is threatening to undermine the reforms India’s economy requires, adding further uncertainty into New Delhi’s already precarious situation.

On Tuesday the Reserve Bank of India (RBI) acted for the second time this year and cut its key repo interest rate by 25 basis points to 7.5%. As Pacific Money has previously noted, India has struggled with falling growth and stubbornly high inflation.

Consumer Inflation is still high at 10.9% for the month of February, with wholesale inflation also remaining above target at 6.84%.  These figures have been causing further distortions in the banking system. Depositors, worried as inflation erodes the value of their savings, have been shifting from banks to other assets, including gold and real estate.  Gold, in particular, comprises a significant portion of India’s troublesome current account deficit.

Perhaps equally significantly, the banks’ ability to lend is being constrained because of the hit they’re taking on their liabilities sides as depositors withdraw their money.  This dynamic could reduce the effectiveness of monetary easing, at least until inflation is brought under control.  Inflation is thus not only limiting the scope of the RBI’s monetary policy easing, it is also reducing the effectiveness of the easing policies that are being adopted.

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The last thing that the government needs at this moment is political drama, but that was exactly what occurred on the same day as the RBI’s repo rate cut. The Dravida Munnetra Kazhagam (DMK), a key partner of the UPA-led ruling coalition, said it was withdrawing support for the government, potentially leaving Prime Minister Singh’s administration without the votes it will need in order to pass key economic reforms. Many economists consider these reforms— which include liberalizing foreign investment in India—to be crucial to reviving growth in the country.  

Furthermore, Finance Minister Palaniappan Chidambaram’s continuing efforts to avoid the possible downgrading of India’s sovereign rating to “junk” status add yet another angle to this already complex situation. His targets for limiting the budget deficit continue to constrain the “fiscal stimulus” options India can undertake to spur growth.  

With all four routes to reviving growth (monetary, fiscal, export-led and reform-led) now facing insurmountable obstacles, potentially, it is not an easy time to be responsible for economic policy in the world’s biggest democracy.