Turnaround in sentiment about India

There has been a rapid turnaround in the sentiment about the Indian economy in recent days. A few months ago, nothing could go wrong with the India story. Growth was high, inflation was low, foreign capital was flowing into India, the rupee was strong. Suddenly, everything has turned around. Industrial growth is down to single digits. Inflation is up to double digits. Interest rates are rising. Stock markets have seen a sharp fall. The rupee has weakened and foreign investors have turned away from India.

In terms of the domestic policy factors, it is the conduct of monetary policy that is the most important element in how macroeconomic policy was mismanged. In February the RBI engineered a rupee depreciation. In March came the inflation shock. Today, the inflation shock to the economy (the latest numbers show 11.4 percent yoy inflation) is one of the main factors responsible for the change in sentiment as well as for the slowdown through higher interest rates that it is now inducing as a policy response.

I think that the biggest policy mistake of the UPA was to run loose monetary policy for 4 years. The results of this policy have come to haunt it at a time when this government can least afford it. The RBI’s supposed attack on inflation through a hike in the repo rate is more posturing than good economic policy. In the last four years preventing rupee appreciation and risking high inflation was a policy choice made by the government and RBI. I think they failed to understand that the huge stock of liquidity in the system was as dangerous as it has proven to be. Read more

3 Responses to "Turnaround in sentiment about India"

  1. NFrazier   July 4, 2008 at 4:28 pm

    Globalization and relatively low Indian wages should cause some combination of inflation and rupee appreciation.The lack of political will for greater rupee appreciation has put downward pressure on interest rates. It has also allowed government deficit spending to continue apace.When strong external demand and a growing money supply meet the supply side bottlenecks caused by insufficient infrastructure and excessive regulation, inflation should result.Combined with the global commodity price inflation, there is the risk that corporate profit margins begin to pinch off due to rising costs at some point. Additionally, should the impending US economic downturn spread to India and her trading partners, corporate profit margins could be pinched from the revenue side as well.

  2. Guest   July 5, 2008 at 12:02 am

    India now has a problem of big current account deficit because of higher oil prices. India has to reduce its oil consumption. Oil usage per unit of manufactuinrg isamong the highest in world. There is euphoria among indians that they deserve to have superior complex. This will be brought to knees in coming recession.

  3. NFrazier   July 8, 2008 at 10:06 pm

    The IMF released a study last year on policy options for countries undergoing rapid globalization. In it, they mention the tendency of hot money to flow into economies like India’s causing inflation and rapid currency appreciation. This eventually leads to recessions, capital flight, currency devaluations, difficulties paying off debt denominated in foreign currencies, etc.So, many countries, in an attempt to control inflation, raise interest rates. Yet, due to the carry trade, this has the effect of making their currencies appreciate even faster. In an effort to maintain favorable terms of trade, countries may then devalue their currencies via a sterilized intervention. But this tends to lead to fiscal traps when governments are trying to payoff bondholders during the next inevitable downturn. If it doesn’t sterilize the intervention, on the other hand, then the expanded money supply tends to negate the effect of raising interest rates. The optimal solution, the IMF claims, is to tighten fiscal policy. This reduces internal demand, trade deficits, and inflation. Simultaneously, it reduces external demand for equities and keeps the currency from appreciating excessively. When the next downturn does occur, the accumulated fiscal surplus can then be used to stabilize the economy.But if a government doesn’t have the discipline to let its currency float freely, how can it be expected to engage in the requisite countercyclical fiscal policy?