An aggressive tightening of monetary policy may be a drastic prescription for India's beleaguered economy, but some economists are advocating the measure as a way to ease sky-high inflation and put a floor under the rupee.
According to Lombard Street Research, the Reserve Bank of India's (RBI) new chief may be compelled to take on radical measures that hark back to the time when Paul Volcker was chairman of the U.S. Federal Reserve some 30 years ago.
"The country may soon be forced into an abrupt and aggressive monetary tightening cycle," Shweta Singh, an economist at Lombard Street Research, said in a note.
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"With the limited window of opportunity getting even narrower, the newly appointed central bank governor, Raghuram Rajan, may be forced to tighten aggressively, not the least to avoid a more disruptive tightening by market forces," she said in the report titled "India: will Rajan be forced to do a Volcker?"
Paul Volcker, as Federal Reserve Chairman from 1979 to 1987, was forced to raise rates to 20 percent in June 1981 when inflation peaked at 13.5 percent. Volcker's series of rate hikes eventually brought U.S. inflation down to 3.2 percent by 1983.
India's inflation rate climbed to 5.79 percent in July, its fastest pace in five months and above the 5 percent economists had expected, as the food inflation rate rose to an annualized 9.5 percent in the month. The country's benchmark interest rate stands at 7.25 percent.
The RBI has faced an ongoing dilemma of trying to rein in runaway prices without compromising economic growth, which fell to an annualized 4.8 percent in the January-March quarter, the lowest in 15 quarters.
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Its struggle is reflected in the central bank's recent policy flip-flops to prop up the plummeting rupee, which touched a record low of 65.56 against the dollar on Thursday. On Tuesday, the RBI announced plans to inject 80 billion rupees ($1.3 billion) into the country's banking system by buying long-term government bonds among other steps, which industry watchers say contradict its recent tightening moves, including the imposition of capital controls last week.
Tapping overseas capital
Citigroup also believes India should keep liquidity tight, but wants the country to seek more external funding sources.
The South Asian nation needs steady inflows of capital from abroad to support its large and growing current account deficit, which stood at 4.6 percent of gross domestic product, or $88 billion, in the fiscal year ending in March, up $10 billion from a year earlier. The country has suffered an exodus of capital in recent months amid fears over the winding down of U.S. monetary stimulus and deteriorating economic conditions in the country.
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"With very low sovereign external debt (zero India global bonds), we think non-resident Indian (NRI)-targeted and/or global bond from the sovereign is the more effective (though not costless) way to mobilize more capital inflows," Citigroup said in a report.
Barclays agrees with Citigroup on the need to seek external funding, advising further opening up access to the sovereign debt market, pushing policies to encourage foreign direct investment and issuing debt to NRIs. But it parts company with Citigroup and Lombard on the tightening measures, calling the latest RBI moves "a step in the right direction."
"Over-tightening liquidity conditions always risked being counterproductive rather than a support for the rupee. It weighed on an already weak growth outlook, thereby hurting foreign investor sentiment," Barclays said in a note.
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But most economists appear to agree on one prescription: the need for structural reforms.
"The government needs to release a credible and sustainable fiscal consolation plan," Sonal Varma, an economist at Nomura, said in a note. "India needs clarity on land acquisition and mining policies, power sector reforms, a renewed focus on the manufacturing sector, and the removal of distortions in the agriculture sector to tackle the double-digit food inflation problem, among others," she said.
"This is not the time for quick fixes. Real reforms may take time to play out," she added.