Wednesday, December 14, 2011

India's central bank - between a rock and a hard place

The Reserve Bank of India (RBI) is in a tough spot. With the headline wholesale inflation coming in at 9.1% and the core at 7.8%, the standard approach would be to keep tightening. But how much tighter can the monetary policy get before choking off growth?
MarketWatch: In late October, India’s central bank delivered its 13th hike in interest rates since March 2010, raising its key lending rate to 8.5% and its borrowing rate to 7.5%. But it signaled that a pause was likely at its next meeting.
And now RBI faces another problem: the rapid sell-off in the rupee, driven by capital outflows.

Chart shows stronger USD vs. INR (Bloomberg)
The weaker currency is going to exacerbate the inflationary pressures driven by more expensive imports. India imports crude oil, machinery, fertilizer, and chemicals – which may drive fuel and food prices higher. Another product that India imports is gold. So when people scratch their heads as to why gold is down over 5% in a single day, the answer should be simple – risks around a slowdown in Asia.

In addition to inflationary issues, as foreign capital flows out, there is some concern that certain banks or corporations may run into a liquidity problem. RBI is expected to address these quickly, but investors don’t want to take chances.
MarketWatch: There has also been mounting concerns that India’s regulated banking system, along with many Indian firms, might be facing borrowing and liquidity issues, given high interest rates domestically, shrinking global investments, and the sliding rupee.
Given the importance of India as a major global economy, this development is of significant concern for global growth.
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