RBI'S DILEMMA
Inflation, Currency or Growth
Inflation in India is around 7.04%, which is above RBI’s comfort zone of 4% - with an outside limit of 6%. In the US, the inflation rate is 9.1%. In India, metal prices have cooled off. Food inflation, too, if we have a good monsoon, will cool off. Our primary issue is oil prices, as with prices over US $ 80, the Current Account Deficit is stretched. 85% of the oil requirements are imported. It is 1/5th of our total imports. Gold imports, too, have surged this year. This has prompted the Government to raise import duties on Gold up to 15%.
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Traditionally, inflation has been curbed by raising interest rates. Raising the cost of funds is supposed to reduce the demand for goods and services. However, the increased prices are more due to supply constraints rather than strong demand. With the expected global slowdown/recession, demand would anyway be curbed.
The rupee depreciates against the dollar, but it is appreciating against almost every other currency - Euro, Pound, Yen, etc. The dollar index touched a recent high of 109. Reasons for the Dollar Strength:
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The Federal Reserve ended its expansionary policy and started shrinking its Balance Sheet. As a result, it constrained the supply of dollars, which had the effect of increasing their value.
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Interest rates were raised. Hence, as investors moved to safety in the dollar, they got a higher rate of return on the same. With continued high inflation, further rate hikes are likely.
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The European Central Bank continued to lower interest rates, lowering the Euro. After 11 years, they have just raised interest rates by 50 bps in July. Political instability in Europe has not helped the Euro. The Dollar index automatically strengthens when the Euro weakens as it makes up over 50% of the index.
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The Bank of Japan formally decided on June 17 to continue its policy of aggressive monetary expansion even as many other central banks are raising interest rates.
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The rupee hit 80 against the dollar. Our reasons for the rupee weakening against the dollar were mainly due to our massive import bill for oil and gold. FIIs, too, have withdrawn over Rs 2lakh crores in 2022. Our current account reserves have fallen from US$ 642 billion to US$ 580 billion in the last few months. The significant measure that the RBI has taken is to allow Rupee settlement for international trade settlements. In a significant move, RBI has permitted banks temporarily to raise fresh Foreign Currency Non-Resident Bank i.e., FCNR(B) and Non-Resident External (NRE) deposits without reference to the current regulations on interest rates, with effect from July 7. This relaxation, too, will be available till October 31, 2022.
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RedHot US inflation figure of 9.1% has reset macro expectations. US 2-year treasury yield is sharply higher than the 10-year yield, which indicates recession fears. Inflation risks have come off on the margin because of commodity correction and global slowdown. Still, in an environment where the dollar will be stronger, it would put other currencies under pressure. Interest rates worldwide would have to increase to shore up confidence in their currency, including in India.
As the US is a net importer, the Dollar strength can result in cheaper imports. Cheaper goods make the Fed's aim to cool demand more difficult. The dollar’s strength hurts U.S. exports and currency-translated overseas profits of U.S. companies, threatening economic growth. On a year-over-year basis, every percentage point gain in the dollar results in about a half-point hit to earnings on the S&P 500. It is hoped that after the midterm elections in November, the Federal Reserve may cool off its aggressive rate hikes and tightening.
Rising interest rates and high inflation both hurt India's growth. Although the first quarter corporate earnings have been on expected lines, the initial impact of rising costs has been felt on the margins. RBI has to decide the priority - inflation, currency or growth - all three cannot be tackled simultaneously. As inflation cools off, RBI's attention will go back to growth.
India is, however, in a stronger position than many other countries:
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India's GDP grew 8.7% in FY 21-22 - the highest in 22 years. However, this figure was after a disastrous Covid-19 lockdown year.
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Manufacturing PMI continued stable at 54.6, and Services PMI was very strong at 58.9. IIP is also improving, indicating continued improvement in economic activity. The Nomura India business resumption index is above pre-pandemic levels.
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GST collections have been resilient since the economy has reopened and have been a significant source of revenue for the Government, which is working towards reducing the Fiscal deficit.
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Although the Forex reserves have fallen - India is in a better position than in the 2013 crisis, where it was at US $ 290 bn - about half our current level.
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India's exports jumped 30.7% in April – however, with the high cost of oil, the trade deficit widened to US 23 bn in May.
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India's labour market added 8.8 million jobs in April, the highest monthly increase since Covid-19.
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Capacity Utilisation is improving to nearly 75%, and simultaneously credit growth is picking up with Capex rising.
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Housing cycle is turning positive from multiyear lows:
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(a)
Sales for the top 10 developers show a surge.
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(b)
Residential inventories are dropping, which is positive for pricing.
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(c)
Affordability levels are amongst the best ever.
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Monsoons are likely to be normal, which is positive for rural incomes
According to the IMF, World Bank - India will remain the fastest growing economy in the world between 2021 - 2024.
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