Modi and Rajan face uphill battle with India’s growth and inflation
Given the potential conflict between Narendra Modi’s focus on growth and the Reserve Bank of India President Raghuram Rajan’s goal to curb inflation, both will need to work together to ensure a stable India.
In the run up to Narendra Modi’s smashing victory in the Indian elections, rumors spread that the governor of the Reserve Bank of India (RBI), Raghuram Rajan, might be forced out of office. Some members of Modi’s party, the Bharatiya Janata Party (BJP), had come out against Rajan’s move to raise interest rates in an effort to curb inflation.
With slumping domestic growth, Modi and the BJP won a resounding victory by promising economic growth modeled on the expansion seen in Modi’s home province of Gujarat. This puts them somewhat at odds with Rajan’s hawkish inflation policy, which typically would slow growth.
It appears that Modi, now in office, has no intention of sacking Rajan. The new finance minister in the administration, Arun Jaitley, met with Rajan the day he took office and reportedly agreed to work on reducing inflation. Modi and Rajan will need to cooperate on this. Otherwise Rajan’s focus on taming inflation might come into conflict with an administration seeking to deliver on promises of new growth.
Hawkish Moves from the RBI
Since becoming governor of the Reserve Bank last September, Rajan has moved aggressively and raised RBI’s benchmark repo rate three times, bringing it up 75 basis points to 8.0 percent. While inflation has evened out since Rajan started, food prices pushed April’s consumer inflation to an elevated 8.6 percent, well above the 8 percent goal the RBI wants to achieve by the start of 2015. However, in his recent policy statement, Rajan indicated that the RBI will hold rates steady for now.
This move highlights the tightrope walk between reducing inflation and spurring growth. While Rajan certainly wants to see higher growth, he does not want it at the expense of higher inflation and a weaker rupee. If Modi quickly drives up growth without reform measures to raise India’s growth potential, output could increase too much in the short term, driving up prices.
On the other hand, Modi soundly defeated his opposition precisely because he promised a return to the higher growth India once expected. Rajan, however, recognizes the need for balance between the two objectives of raising growth and lowering inflation. In an interview with the Japanese newspaper Nikkei, he noted that “Our fight against inflation is measured, rather than abrupt… we are keeping an eye on growth.”
On a positive note, India’s current account deficit has decreased substantially. According to the policy statement from the RBI, the deficit shrank to 1.7 percent of GDP, down from 4.7 percent in 2012-2013. The balance in the current account basically sums up a nation’s position as either a debtor or a creditor on the world stage. A high current account deficit means a sharp reversal in financing (lending) could constrain future economic activity, which cannot be funded from lower savings. Stronger capital accounts would help India fund new growth without sparking inflation. In addition, a stable current account would bolster India against any volatility from the U.S. Federal Reserve’s winding down of its Quantitative Easing policy.
Piloting India to stable growth
If inflation continues its downward glide over the course of the year, Rajan and the RBI may see room for future easing, which could complement Modi’s growth initiatives once implemented. The policy statement included this: “If disinflation, adjusting for base effects, is faster than currently anticipated, it will provide headroom for an easing of the policy stance.” For now, investors should look for cooperation between Modi’s administration and Rajan on bringing down inflation towards 8 percent.
With prices under control, the RBI could then consider measures in support of Modi’s agenda. In the interview with Nikkei, Rajan said it might take a few years to get back to India’s old level of 7-8 percent growth. While the magnitude of Modi’s win might push newly elected BJP members to push for a front loaded strategy, Rajan seems to favor a more stable medium term approach to raising growth.
India does not want to shake international investor confidence with a fractious relationship between its newly minted government and its central bank. Given Modi’s reputation as a skilled manager and the market’s confidence in Rajan, cooperation between the two could greatly burnish India’s attractiveness for investment. Cracks that emerge between the two, however, could spell trouble.