A Report on Roadmap for Sustaining India’s Growth

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imagesIt can be argued that the fundamentals of the Indian economy over the medium term continue to be sound. This claim may currently sound misleading; but, since monsoons have been adequate this year, demand will pick up and spur growth. The major impediments to higher growth over the next 12 months stem more from how soundly India finances its current account deficit and reduces its fiscal deficit.

Given India’s growth rate to be 5 percent in the year 2014, it would have to gear up in increasing its forex reserves, creating more investor friendly environment and improvising on the manufacturing sector along with prudent subsidies scheme.Fuel, fertiliser and food subsidies are among the big-ticket subsidies provided by the Indian central and state governments.

Some food subsidies are warranted. By contrast, fertiliser subsidies are even less justified than fuel subsidies, though politically difficult to reduce in the near term. Consequently, inflationary pressures will persist and so will the causal factors of confidentiality and convenience, which drive incremental cash investments in gold.

In terms of net foreign exchange outflows from India’s debt and equity markets, an important concern is the extent to which US growth recovers and the Federal Reserve’s purchases of longer-term Treasuries and mortgage securities start “tapering” down. The UK economy and the eurozone has started to do better and the unemployment rate is decreasing. To sum up, there is little that India can immediately do to reduce oil or gold imports, or to directly address risks arising from the G7 economies that are continuing to recover.

BRICS countries is moving to BIITS as China and Russia are replaced by Indonesia and Turkey and India has to now also tackle with funds from international banks and institutions. It has been reported that India will invest about $4.5 billion in International Bank for Reconstruction and Development bonds to be able to borrow exactly the same amount from the IBRD, since we have reached the country risk limit for borrowings from that institution. (as per BRICS report 2000)

IBRD bonds are issued at yields of about six-month dollar Libor, or London interbank offered rate, minus 20 basis points; and IBRD loans carry interest rates of around six-month dollar Libor plus 80 basis points. If the information that India will invest in IBRD bonds is correct, it is surprising that we are prepared to bear an additional interest cost of one per cent to borrow an equivalent amount from IBRD along with delays related to project clearances.

On September 4, 2013, the Reserve Bank of India (RBI) enhanced the prospects for capital inflows from non-resident Indians by announcing an exchange rate guarantee for foreign exchange deposits with maturities of three or more years. This move has improved sentiment about the rupee’s exchange rate. However, the exchange rate risk of converting fresh foreign exchange deposits to rupees and back to the corresponding foreign currencies at maturity does not disappear. This risk will show up on the RBI’s balance sheet as a contingent liability, and hence such deposits should be limited.

Future outflows from the debt market by foreign institutional investors (FIIs) would be limited since residual foreign investment in government debt stands at about $20 billion. FII equity outflows too should have an upper bound. If there are net equity outflows of, say, $15 billion, this would cause market levels and the rupee to plunge and it would be counterproductive for FIIs to sell more. However, if India’s credit rating is downgraded, as per FII investment norms, they would have to reduce exposure to India. Another source of risk is that the last four years of extremely low interest rates in the larger G7 economies have created several asset bubbles. As US interest rates inevitably rise, bond market bubbles would be among the first to be pricked. Further, although real interest rates are low in India, investment decisions are based on nominal rates.

It follows that the RBI has to reduce interest rates to push investment and growth. Lowering interest rates would put pressure on the rupee exchange rate and this is another reason to bolster foreign exchange reserves in anticipation. Prudent risk management, the need to encourage fresh investment and India’s limited options on what can be done immediately suggest that the country needs to augment its foreign exchange reserves and rupee resources through a VDS.

This VDS could be open for three months, offering, say, three per cent less than current market interest rates on deposits of maturities of three years and more. The growing international scrutiny of tax havens should be worrying for tax evaders. Consequently, a VDS offer could attract as much as $50 billion (approximately Rs 3 lakh crore).

This is unlikely, since three months is not enough time for significant amounts of fresh round-tripping. On balance, the positives would outweigh the negatives if the funds that come back to the formal banking system, from within India or abroad, are used to boost growth and employment.

Before going into the details about how repo rate affects inflation and vice versa, it is important to understand what repo rate is? Repo rate is the rate at which the Reserve Bank of India (RBI) lends money to commercial banks. Repo rate is also an instrument of monetary policy. When commercial banks run out of funds, they turn to RBI for help. So, when the repo rate is low, banks get funds from the RBI at a cheaper rate. Recently, the governor of RBI, RaghuramRajan, unexpectedly raised the repo rate by 0.25 percent, from 7.25 percent to 7.5 percent. In simple terms, the cost of borrowing has increased for commercial banks. The impact of repo rate on inflation and the rest of the economy are known as the transmission mechanism. The public expects RBI to do what is necessary to reduce the rate of inflation. Currently, India is experiencing a high inflation rate.

So, with an increase in the repo rate, the market interest rates will rise too. This will lead to a decrease in consumption and investments, and ultimately a reduction in the demand. This will eventually lead to a decrease in the rate of inflation. This is exactly whatRaghuramRajan is aiming at. Repo rate also has an impact on the exchange rate. When repo rate is increased, like what has happened in India, the market interest rates also increase and lead to a stronger exchange rate. This leads to an increase in imports and decrease in exports. With lower import prices, inflation rate is once again lowered. RecentlyWorld Bank reduced growth forecast of India.

As of August 2013, India’s inflation rate was recorded at 6.1 percent, the highest in the last 6 months. The rate of inflation has been increasing uncontrollably in the last few months, which is why RBI has been forced to take extreme measures to bring the Indian economy back on its feet.

On the other hand, critics of RaghuramRajan have expressed disappointment at RBI’s decision to increase the repo rate. These critics claim that repo rate will not affect inflation, but in turn affect exports and bring down the Indian economy. It is true that the hike in repo rate will reduce India’s export value; however, India cannot achieve all the goals through one policy alone. The pressing issue that India is facing at the moment is inflation, which is why all the monetary policies are aimed at addressing inflation. India’s manufacturing sector is hurt by the increasing repo rate saga, and manufacturing companies claim that inflation is rising because of inefficiencies in the supply chain. Supply chains ought to be good in a country like India as wastage scope should be less. High interest rates and high inflation rate add to manufacturing costs and make the industry less competitive.

In every step and decision, there is a trade-off. In the recent step undertaken by the RBI, there is a trade-off between inflation and export value. So, if inflation reduces, exports suffer and vice versa.

Repo rate does help keep inflation in check even though some critics may think otherwise. RBI has always been changing the repo rate to keep inflation in check. In fact, former governor of RBI DuvvuriSubbarao increased the repo rate 13 times between March 2010 and October 2011. Repo rate is an instrument and financial tool that financial ministers and governors of central banks all over the world use to tackle inflation.

RBI has to maintain a trade-off between inflation and interest rate in order to create a good investment environment and stir the growth.

(References:BBC,Reuters,McKinsey)

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Mufaddal Dahodwala

The author is ex-employee of Accenture and he is currently pursuing MMS finance from JBIMS,mumbai. He has won several prizes from top MNCs for his contribution towards articles as well as idea generation and business plans having a social impact to the society.