RBI’s wake-up call — tough time ahead

The Reserve Bank of India (RBI) has presented a tough picture as to the immediate prospect for the economy. It has projected inflation for the financial year ending in March to be around 7%, moving up from the previous projection of 5.5%.

It has also said that the current account deficit — the difference between exports earnings and import payments — to be 3.5% of the GDP and said that this was much too high for the health of the economy.

Its own response to tackle rising inflation was to make money dearer by raising the repo rate — the interest rate which the banks have to pay for their borrowings from the RBI — from 6.25% to 6.50%, and reverse repo — the interest rate at which RBI would borrow from the banks — from 5.25 to 5.50%. Experts have voiced concern that this was not an aggressive enough move to contain inflation.

The RBI has expressed the view that prices of commodities are going to be on the rise, especially international oil prices — which is the main reason for increase in inflation — and that this will add to overall inflation.

The RBI has suggested the need for a policy of increasing export earnings through diversification and of being prudent about imports. It is good advice which is not easy to implement if the growth trajectory is to be maintained.

This is indeed the classic dilemma between growth and low inflation. If growth is robust, then the economy can weather inflation up to a point. With the global economy yet to come out of the recession woods, it is going to be a difficult proposition for India to improve its growth rate dramatically.

The RBI however has not changed the annual growth rate for 2010-2011 at 8.5%. But this may not be enough to make an inflation rate of 7% bearable .

The central bank has also cautioned against the short-term capital inflows and said that if the situation in developed economies were to improve, there could be a reversal in the flows. It has therefore suggested that preference should be given to long-term foreign direct investment (FDI).

What this goes to show is that 2011 could prove to be tough for the country. Inflation will remain a major worry, especially in food prices. One of the ways of dealing with it is to improve the supply side, which the government can handle through some intelligent management. It is a wake-up call, a gentle one as yet.