By Prasanna Balachander
Much has changed in the global and national context since the August meeting of the MPC. The US Fed is about to start cutting back on monthly purchases. Inflation in Germany has reached levels not seen since the days of Helmut Kohl. The prices of energy, gas in particular, have experienced an unprecedented increase. Constraints on the supply side have intensified.
Domestically, inflation surprised positively, driven by food inflation. Tax collections continue to beat even the most positive estimates, limiting the size of second half borrowing with divestment products, especially from Air India, increasingly appearing as a distinct possibility. The economic recovery is at two paces. On the one hand, the formal sector is doing well, driven by exports and there is a recovery in services due to the increase in the number of vaccinations as well as an observed recovery in real estate and related sectors. On the other hand, the informal sector continues to suffer, with job losses and income declines.
In this context, what should the MPC do? The answer lies in how quickly the economy hits its pre-pandemic trajectory and how transient supply shocks are. Most importantly, the MPC should be reassured by the steady increase in vaccination in India. When the MPC met in August, India had delivered 50 crore doses of the vaccine. In less than two months, that number rose to over 91 crore. At the current rate, India is expected to vaccinate most of its eligible population in the coming months. The increase in vaccinations is expected to lead to the opening of the contact-intensive service sector, which has been hit hard by the virus. For example, the GVA of commerce, hotels and transport is 30% lower than it was two years ago. Even the education sector should experience a gradual opening up in the coming months.
ICICI Bank’s UFI (Ultra High Frequency Indicators) index hits an all-time high of 109.3, well above pre-Covid levels. At the height of containment, that figure had fallen to 38.6. Exports are booming, led by engineering products and software services. Non-oil and non-gold imports, a barometer of domestic demand, saw a sharp increase in September ahead of festival season. In April-September 2021, imports of gold and non-oil, non-gold increased by $ 8 billion and $ 10 billion compared to the same period in 2019.
While the informal sector has borne the brunt of the pandemic, India’s startup ecosystem has never been better. India now has 65 unicorns, 29 of which were created in 2021 alone. Nasscom believes there will be 76 by the end of 2021. Unicorns have been able to generate jobs for 3 lakhs.
Indian businesses are also increasingly confident in the recovery, as evidenced by corporate tax collections that will easily exceed government estimates earlier this year. Government policy is favorable, whether in the form of tax compliance (end of retrospective taxation) or production-linked incentive programs (PLI). Investments are expected to pick up in the digital economy, 5G and ESG sectors. The Centre’s monetization pipeline and divestment will also support private sector investment. This promotes a sustainable recovery of the economy.
How transient are supply shocks? Manufacturing PMIs released earlier this month suggest that supply constraints have worsened. Factory activity in China, according to the official PMI, unexpectedly declined due to reduced electricity consumption in September. Energy shortages are visible in most of Europe and the UK, with demand still not being met. The shortage of crisps is likely to hurt Indian car production just before the holiday season. Global coal prices have increased 121% this year. Oil prices are also on the rise (+ 95%). This is also the case for gas prices (+ 81%).
As vaccinations progress well, the underlying demand will only increase. The offer will take time to catch up. At the very least, inflationary pressures emanating from the shortage of energy supplies before the winter season in China and Europe will reverberate around the world.
India is in a much better position, with a normal monsoon and large food surpluses. Food inflation has been subdued this year and has surprised positively. A high base also supports lower inflation through November 2021. However, domestic energy prices continue to experience upward momentum, driven by high international prices and domestic taxes. Indian companies will also have to gradually pass on higher commodity prices to consumers.
With positively surprising inflation, the RBI might consider lowering its estimate of inflation from 5.7% in FY22 to 5.5%. A demand-led rebound and cost pass-through means that inflation is expected to reach or exceed 5% in FY23.
The growth-inflation dynamics above suggest that this may be the most optimal time for the RBI to let yields rise a bit. How can he report it? First, it can absorb much more liquidity through longer-term variable term repo auctions rather than fixed rate auctions. This can be achieved by tricking banks with a higher yield than the overnight rate. Second, the absolute GSAP auction amount, even if converted to a liquidity neutral “Operation Twist”, may be gradually reduced over the next four months and we may have our own equivalent of the “Indian Taper”. This will set the stage for RBI to narrow the political corridor in December 2021 and February 2022, respectively. This will also give the MPC time to consider the evolution of the growth scenario and any risks emerging from a third wave. MPC members will have time to assess how transient the supply constraints facing the global economy are.
Last but not least, this will put the RBI ahead of the US Fed’s reversal of global monetary policy. While the Fed’s withdrawal is unlikely to have an impact on India given India’s rock-solid external account (unlike what we saw in 2013), it will give the RBI options on how it wishes to pace the liquidity and interest rate cycle in the months to come.
The author is Group Leader, Global Markets, Sales Trading & Research, ICICI Bank
Views are personal