Growth, inflation and financial stability -- tough choices

(Sanjay Sinha is the CEO of DBS Cholamandalam Asset Management Ltd. The views expressed in this column are his own)

By Sanjay Sinha

World over, the first set of noises are being made to herald the end of easy monetary policy.

The Reserve Bank of India (RBI), in its credit policy announced on Oct 27, has rolled back the 1 percentage point of leeway that it had extended in the statutory liquidity ratio (SLR) in Nov 2008 by bringing it back to 25 percent and has announced an enhancement of bank's provisioning norms to 70 percent in a graded manner over the next one year.

There is now a consensus view that we will see a hardening cycle begin from Jan 2010. The Finance Minister, the Commerce Minister and the Deputy Chairman of the Planning Commission were quick to jump in and assuage fears by announcing that it was too early to roll back the stimulus measures.

RBI is conscious of the fact that inflation will very quickly move up to 5-6 percent territory, largely driven by food prices while base effect will also play a villainous role. Despite political noises, RBI will need to act.

Globally too, things seem to be warming up with U.S. Treasury Secretary Tim Geithner announcing that the $800 bln stimulus buy back plan will be concluded and we need to brace ourselves for some rate hikes now. This was enough to send a shiver down the spine of financial markets.

The larger school of thought believes that we are not out of the woods as yet. The spectre of a double dip recession still haunts. How else will you explain that Citi Bank has opted to hoard $244 billion in cash reserves.

Economists of every hue also believe that 3.5 percent annualized GDP growth demonstrated by the U.S. in the last quarter is not proof enough, employment numbers will take some time before improving. Till the time this happens real consumption growth is not sustainable.

It is just that -- "a mountain of worries met a wall of liquidity". Therefore, nobody knows for sure how the world economy will react once central bankers begin to tighten and the liquidity starts vanishing.

It is in this background that we need to understand why the synchronous rally in all asset markets is seen with such skepticism. Investors believe that at the first sign of tightening, capital will fly to safety and emerging markets, which have received bountiful capital inflows, will be vulnerable to sharp corrections.

Brazil is apprehensive of the fickle nature of portfolio flows and has opted to impose a tax on such flows.

The International Monetary Fund has downplayed this action and does not expect this to be very restrictive or a prohibitively high disincentive. Bovespa has also not reacted too adversely having gone down by about 5 percent since the announcement.

In India, we need to make a tough choice between growth, managing inflation and financial stability. No doubt it is not practical to expect a 9 percent GDP growth in the 11th Five Year Plan and the midterm review will come up with a realistic target.

But growth is a pursuit which is central to any major economic policy of a government which is good- intentioned. This may not be so in the current circumstances. That India has been relatively untouched by the global economic calamity is largely attributable to a stable financial system.

Inflation has been fairly benign since the 2008 crisis but there is very little we owe to local policy for this.

World over, inflation has been very low due to collapse of commodity prices and since we had been importing this inflation through large scale imports, we have seen inflation fall from 11.49 percent in Oct 2008 to 1.51 percent in Oct 2009.

Going forward into 2010, inflation driven by reviving commodity prices (crude itself is up 64 percent since Apr 09 and a whopping 155 percent since the lows of Dec 08), will be a challenge to almost all economies and we will also have our share of the pain.

A truant monsoon in the early season and a torrent in the later part have added their share to the local spike in food grain prices. Hence, there is little that the RBI or the government can do to contain inflation.

The RBI expects inflation to average around 5 percent for FY10 and touch 6.5 percent by March 2010 (with an upward bias).

The practical view that is emerging is that Europe will see an L-shaped recovery, U.S. a U-shaped one and the emerging markets a V-shaped one. However, the world is seriously worried about the aftershocks of the financial tsunami, which thankfully has passed us by without causing the expected level of damage.

The lesson of 2008 will die hard. Financial stability was the cornerstone of our survival and growth can be re-instated if we are able to keep the house in order. Hence, financial stability will be central to any economic policy even if growth has to take a back seat.

Crises have a nasty habit of occurring when we least expect them to. Very rarely have typhoons -- climatic or financial -- struck when we have been amply prepared for them. This time also it may be no different.

A unipolar view seems to be developing about a double dip recession and central bankers and large institutions have braced themselves for it. It is quite likely that the global economy will test every one's patience and only when we let our guard down another crisis will be upon us.

The challenge before the policy makers in India: looking back did we compromise on growth in the interim period for a control on inflation and financial stability and were still unable to avoid a crisis in financial markets.

(You can e-mail Sanjay Sinha at: sanjaysinha@dbschola.murugappa.com)