In early April, when the Monetary Policy Committee (MPC) met, after reviewing the current and evolving macroeconomic situation, it decided to keep benchmark interest rates unchanged. It also assured that it would remain accommodative as long as inflation remained within its target. Then, barely a month later, in early May, the MPC announced an increase in key interest rates, for the first time since August 2018. And, it was the sharpest increase in 11 years! In April, the RBI recognized the escalation in geopolitical conflict and accompanying sanctions were causing steep and substantial rises commodity prices, across the board, amidst heightened volatility. Commodity trade was being impacted quite adversely and crude oil prices spiked to a 14-year high in early March; despite some correction, they remain volatile at elevated levels. Further, there were renewed supply chain pressures, which were expected to ease once the pandemic abated, and financial markets were exhibiting increased volatility.
In a nutshell, the global financial environment was precarious. Effectively, in April itself, the global environment prescribed a domestic rate hike. But still the RBI was willing to wait and watch. While that sounds incongruous, it was largely because the domestic recovery seemed strong and the RBI may not have wanted to stifle nascent growth impulses. India’s real GDP had grown at 8.9% to cross pre-pandemic (2019-20) levels by 1.8% and high frequency indicators, such as urban demand, travel, passenger vehicle sales, imports of capital goods and merchandise goods exhibited signs of recovery. The manufacturing and services PMIs remained in expansion zone in March and even agriculture supported the turnaround with food grain production touching a new record in 2021-22, as both kharif and rabi output crossed the final estimates for 2020-21 as well as the targets set for 2021-22. The third wave of Covid19 was ebbing fast.
In fact, the Indian economy seemed to be returning to robust health. The main concern was inflation. In both January and February 2022, headline CPI had breached the upper tolerance threshold, particularly on account of food inflation. Domestic food prices were increasing in sympathy with international prices, despite the record food grains production and buffer stock levels and elevated global price pressures in key food items due to global supply shortages were imparting high uncertainty to the food price outlook.
Further, international crude oil prices also remained volatile and elevated due to the uncertainty in global supplies. All these factors warranted continuous monitoring and pro-active supply management.
At the same time interest rates, which are the flipside of the inflation, were rising globally. During the pandemic, to cope with the economic and health crisis, central banks across the world followed expansionary policies. A reversal of this easing was definite; the only questions were ‘when and in what gradient’.
Now, central banks in several countries are tightening borrowing costs in an effort to cushion businesses and consumers from inflation, especially at a time when economies are recovering from the pandemic and the Russia-Ukraine conflict is disrupting supply chains. Even the US Federal reserve raised its policy rate by 25bp for the first time in March 2022 after a gap of more than three years and followed by another 50bp rate increase in early May— its highest increase in more than 20 years.
Naturally, concerns about rising global inflation and interest rates prompted the RBI to raise its rates too. But what could rising inflation and interest rates mean for India’s growth and its financial markets.
Typically, such a situation at the global level could hamper economic growth and even push economies into recession. For India, monetary tightening by the US Fed translated into an outflow of portfolio investment. Until 16th May 2022, foreign portfolio investors had pulled out a whopping USD 21.2 billion from India. Alongside the higher import bill, on account or rising commodity and crude prices, this outflow put immense pressure on the Indian rupee and forex reserves.
While evaporating domestic liquidity was the first round impacted of the rate hikes, the impact on business growth and infrastructure development will be visible in the second round. The question of ‘how much’ the impact will be, will depend on ‘how long’ the geo-political uncertainty continues to disrupt supply chains.
If the conflict get resolved before the real economy, i.e. large and small businesses, face adversities in their fund flows, the financial markets could recover within a quarter or two, at most. However, if international supply constraints persist and fund flows remain volatile, it could lead to a longer term tightening in India’s financial conditions, reflected in further rising of interest rates, bank lending rates, weak capital flows and a depreciating rupee.
As the RBI governor explained, several storms have hit together and India’s monetary policy response should be seen as an important step to steady the ship. On the bright side, the Indian economy has been fortunate to have sterling captains who have, in the past, brought this ship to safety in the midst of raging storms. While there is never a perfect playbook for any financial or geopolitical incident, it’s comforting to know that the RBI is as vigilant as always; it actually raised domestic interest rates a few hours before the mighty US Fed called in its second rate hike. It’s safe to say that it will follow a conservative but not necessarily reactionary approach to protect domestic financial markets from international backlash in FY23.
