Monetary policy allows breathing space

An accommodative monetary policy in the last fiscal year, 2011-12, had allowed banks additional space to rebuild profitability, but inflation and exchange risks are on the rise, suggesting the need to tighten, according to the International Monetary Fund (IMF).

Weak credit demand and the overhang of banks’ excess reserves at the central bank however suggest that, while money growth was excessive, upward pressure on prices from monetary policy was moderate, it said in its report. "Rather, the bulk of inflation stemmed from factors like administered prices, higher import prices through exchange rate depreciation, and the effect of wage and salary increases.

However, prices have continued to climb since the end of the fiscal year, with headline inflation reaching just under 12 per cent, year-on-year, in August — the ninth consecutive year-on-year increase.

Real interest rates have been negative for over a year, and the wedge between domestic and India’s one month interbank rate has widened to almost 900 basis points on a sustained basis — suggesting a powerful financial incentive for capital flight, and a risk to the exchange rate peg.

According to the report, the central bank shifted policy in July 2012, signalling its intent to bring broad money growth to 15 per cent in the current fiscal year, consistent with a targeted average inflation rate of 7.5 per cent. However, it is also not possible due to rising informal economy.

The exchange rate peg has served as a pillar of stability and although quantitative estimates suggest some overvaluation, the rupee does not appear fundamentally misaligned, it added.

The peg continues to provide a widely visible nominal anchor and support macroeconomic stability. Adjusting the peg may curb imports, but depending on accompanying monetary and fiscal policy adjustments could also stoke inflation, it said, adding that more meaningful adjustment is likely through structural reforms to address a weak business climate — particularly infrastructure and labour relations.

However, the peg also complicates macroeconomic management in times of external shocks, by limiting room for adjustment. In this context, consideration should be given to exit options should external shocks bring unsustainable pressures on the external accounts, the report added.