RBI Governor Speak: How India won in uncertain times

29 Nov 2023 , 09:22 AM

Why monetary policy was significant in last 18 months

The theme of the article is “Winning in Uncertain Times: The Indian Experience.” This was part of the speech delivered by RBI governor, Shaktikanta Das at the recent FIBAC conference in Mumbai. The background to the topic “Winning in Uncertain Times” is the aftermath of the COVID pandemic, which had resulted in runaway inflation as supply just failed to keep pace with demand. As global economies infused liquidity, the bounce in demand was instantaneous, but supply chain bottlenecks were largely created by the persistent shutdowns in China. The result was runaway inflation and it called for a unique response mechanism by the RBI to tackle this rather persistent inflation.

In retrospect, Indian monetary policy has been able to manage the fine balance between controlling inflation and not damaging the growth engine. Inflation has come down from well above 8% to below the 5% level on a sustainable basis. Of course, the inflation is still higher than the RBI median inflation target of 4%, but it is surely better than the outer tolerance limit of 7%. But the real victory for the RBI is that the inflation control was achieved without pushing the Indian economy into a hard landing. Even after 250 bps in repo rate hikes, GDP growth in India continues to average around 7% and that is likely to help India retain the distinction of being the fastest growing large economy in the world, for the second year in a row. We are only talking about economies with GDP over $1 trillion.

Retrospective of monetary policy in last 18 months

The RBI response mechanism actually began around May 2022, when it started hiking the repo rates to curtail inflation. Between May 2022 and February 2023, RBI had hiked rates by a full 250 basis points taking the repo rates to 6.50%. However, the delicate balance was between interest costs, growth, inflation, and liquidity. Here is how it was done.

• In the last 18 months, the thrust of the RBI monetary policy has been on prioritising inflation control over growth, narrowing the Liquidity Adjustment Facility (LAF) corridor to regulate liquidity and simultaneously increasing repo rates by 250 bps, while draining excess liquidity. The consumer inflation of 4.9% that we get to see in October 2023 is a sum total of all these initiatives by the RBI.

   

• If you look at the experience of the US markets in the early part of 2023, many of the small and medium sized banks came under stress due to a combination of liquidity tightening and depreciation of investment portfolio amidst rising interest rates. Fortunately, India had managed to skirt such a crisis by maintaining the balance between price stability and growth triggers. This can also be attributed largely to the regulatory requirements prescribed by the RBI, under which banks are expected to strictly manage their interest rate risk. These requirements acted as safeguards against any hint of stress when the rates actually started rising. 

   

• In many of these cases, the standard challenge was, exchange rate stability. The reasons were not far to seek. Higher rates in the US meant that the dollar was strengthening, which was evident from the dollar index moving all the way up to 107 levels. That is a level, the dollar index (DXY) has breached only thrice in the last 40 years. However, regular RBI intervention in the forex market ensured a stable move in the rupee, despite substantial volatility in global currencies.

To recap, RBI has managed the interest rate risk effectively in the testing 18 months. Let us now turn to how growth was handled in this period.

Growth Drivers and Opportunities

If interest rate risk, exchange rate stability and inflation are one side of the story, the bigger challenge always was to handle growth. It was a delicate balance. The RBI not only had to contain inflation, but also regulate inflation expectations. Low inflation could not be ignored since it had two salutary effects on growth. Firstly, it enhanced the real rate of growth, even if nominal growth was flat to uncertain. Secondly, it ensured that the cost of funds for Indian corporates remained under check and supported valuations of Indian equities. Here are some key points to know about how the RBI has handled the growth story, amidst such challenging macroeconomic conditions.

• After a rather nerve-racking GDP contraction of -5.8% in FY21, the growth bounced back to 9.1% in FY22 and to 7.2% in FY23. For FY24, the early estimates are that GDP would grow in the range of 6.5% to 6.8%, depending on the performance in the last two quarters. This still ranks India as the fastest growing large economy in the world. How did the Indian economy remain resilient and continued to grow? The demand destruction was largely in terms of export demand and domestic demand was intact. Most of the growth in India came from domestic demand, which remained robust. Structural reforms in banking, taxation, inflation management and manufacturing sector (like the PLI scheme); also went a long way in sustaining the growth impulses.

   

• Interesting, many global investors call the current situation in India the Goldilocks economy effect, where inflation is lower than expected and growth is better than expected. In short, India moved from an era of twin deficit and twin balance sheet stress to the current period of twin balance sheet advantage. What exactly is that? The balance sheets of banks saw significant improvement in asset quality, net interest income (NII) growth and the level of net interest margins (NIMs). The latest RBI industrial outlook survey indicates that business outlook further improved with manufacturing firms being optimistic about demand condition in Q3-FY24. Above all, the capacity utilisation manufacturing sector is on a steady uptrend. Not to forget, the government has been on a massive capex drive and the trickle down effects are already visible.

   

• Let us spend a moment on agriculture, which appears to have benefited substantially in the last few yeas from the more liberal MSPs (minimum selling price) offered to farmers. That has led to agricultural momentum with annual growth consistently in the range of 3.5% to 4% on a median basis. This year, despite the uneven south-west monsoon and lower kharif production, overall foodgrain output and horticulture output are at record levels. In recent years, any shortfall in Kharif is being more than made up by Rabi output. 

   

• Even as manufacturing is contributing about 17% to 20% of GDP, it has potential to grow its share further with the PLI and import substitution schemes. But the real action is in the services sector. Currently, the services sector contributes the largest share in India’s GDP and remains the anchor of overall growth. Indian services sector is adopting new technologies like AI, ML, IOT, cloud computing and data analytics to improve service delivery. Even as merchandise trade deficit continues to pose a problem, the surplus from services exports is making up for it. One question is how are services growing amidst tepid growth in IT services exports. The thrust is coming from new areas like accounting services, audit services, consultancy services, global competency centres (GCC) etc. it is services exports that has given a leg-up to India’s external position.

What are the key takeaways from the RBI governor speech?

It is never a great feeling to live in uncertain times in an interconnected world. Bad news travels apace and nowhere are they more evident than in the global financial markets. Transmission of shocks are instant and magnified in many cases, so central banks like the RBI have had to be extra careful. In addition, new sources of risk are also coming up. In the last 18 months, the RBI has successfully steered the Indian economy through the global vicissitudes but more shocks and uncertainties may be in store. 

For instance, global geopolitics is still fluid and oil prices still have a huge impact on India’s external vulnerability. In such a scenario, building up further on resilience would be the best insurance against shocks and uncertainties. This has to happen at a government level, bank level, corporate level and even at a household level. As the RBI governor rightly pointed out, there has to be greater focus on investment in capacity building, skilling of human resources and adoption of newer technologies. That lies at the core of sustainable growth for India in uncertain times.