A historical analysis of inflation cycles in India suggests that average inflation tends to be higher in the last two years leading up to a Lok Sabha election.
Macroeconomic theory says that it is impossible for an economy to have all three of the following the same time:
- A fixed foreign exchange rate;
- Free capital movement; and
- Independent monetary policy.
China is an example of a country that has fixed the value of its currency and also has an independent monetary policy, but cannot allow capital to flow freely across its borders by consequence. Italy is an example of a country that has its exchange rate effectively fixed (thanks to the Euro) coupled with free flow of capital but its monetary policy cannot be independent (effectively the European Central Bank runs monetary policy for Italy and all the other Eurozone countries).
In India’s case, if the RBI wants to keep the INR at around the Rs65/US$ mark and if the country wants to continue to have free capital movement then the RBI has to reconcile itself to losing control of monetary policy. In the current context that means that were economic growth to stay weak, it is unlikely that the RBI can support a recovery through rate cuts given that India’s current account deficit is running at around 2 per cent of GDP. Hence, India needs capital inflows of around 2 per cent of GDP to keep the INR stable. Such capital inflows become less likely were the RBI to cut rates meaningfully at a time when the Western central banks are hiking their policy rates.
In fact, where things could get tricky for India – and where the trilemma could come to the fore – is if:
(a) Global commodity prices keep rising:
Crude petroleum, petroleum gas, and copper are two of India’s largest imports.
They account for around 37 per cent of India’s import of goods. While the price of oil has risen by 13 per cent per annum from $47.62 a barrel (as of 30 October 2015) to $60.94 a barrel (as of 31 October 2017), copper has risen 16 per cent per annum from $5112 per metric tonne (as of 30 October 2015) to $6839 per metric tonne (as of 31 October 2017) in the past two years. This has had a direct impact on the current account deficit, which has widened (see exhibit below). If this trend continues, India will have a problem on its hands as the RBI might have to tighten monetary policy even with a weak economic backdrop in India.
(b) Inflation rises:
Inflation in India usually picks up in the run-up to General Elections. In specific, a historical analysis of inflation cycles in India suggests that average inflation tends to be higher in the last two years leading up to a General Election (GE). For instance, average CPI inflation was higher by 80bps in the last two years leading up to a GE in the case of the last 5 election cycles (see exhibit below, for more please see our note dated 27 July 2016 titled “The potent political underpinnings of inflation in India”)
In the case of the last 5 election cycles, average CPI inflation was higher by 80bps in the two years leading up to a General Election
Such a rise in CPI inflation would not only forestall further rate cuts from the RBI, it would also push up bond yields and thus increase the cost of capital (against the backdrop of a sluggish economy). Since inflation erodes the value of the currency, rising inflation would also trigger capital outflows thus putting pressure on the INR.
(c) Global liquidity tightening:
The Fed has hiked rates three times since late 2016 and seems all set to hike once more before the end of 2017. On November 3 2017, the Bank of England raised rates for the first time in a decade by a quarter of a percentage point to 0.5 per cent. However, the ECB and the Bank of Japan have still not tightened monetary policy. Hence, liquidity continues to slosh around the global financial system.
Saurabh Mukherjea is the CEO of Ambit Capital Pvt. Ltd.
This analysis originally appears in ‘The Sceptical CEO’ section of the Ambit website. This post is an excerpt from the analysis ‘Is there a Modi put option?’