Monetary policy must respond nimbly to second inflation round: IMF official

In a Q&A, the lead author of IMF's Asia and Pacific Outlook, dwells on the impact the Fed's move on the benchmark rate could impact India

Shanaka Jayanath (Jay) Peiris, the lead author of the International Monetary Fund’s (IMF) Asia and Pacific Outlook which came out last month, was in Delhi recently. He told Indivjal Dhasmana that while the Federal Reserve’s decision to raise key benchmark rate by 50 basis points was largely anticipated, any large movements in global equity markets from a sharper-than-expected tightening in the advanced economies would have implications for equity outflows from India. He talks on the monetary policy committee’s rate hike, India Inc’s debt, and exports prospects, among other things. Edited excerpts:

Q. The IMF’s Asia and Pacific Outlook says a rise in US interest rates will have significant spillovers for Asia. How do you see the impact of half a percentage point hike in the benchmark rate on Asia, particularly India?

The Federal Reserve is appropriately moving to a less accommodative stance of monetary policy, increasing the federal funds rate and running down the balance sheet. However, the faster pace of Fed interest rate hikes, especially if not fully anticipated by markets, increases the risks faced by other countries, especially emerging and developing economies.

Rising long-term rates in the US could also trigger market volatility in Asia through two channels. One, through tightening of financial conditions, higher funding costs and bigger capital outflows. Two, through negative impact on the pricing of risk assets. If US inflation is mostly driven by supply disruptions or Fed normalising faster than anticipated, then higher US interest rates would have a bigger impact on Asia compared to the case where inflation is driven by higher growth and higher demand in the US. This is because in the latter case, the impact of tightening is partially mitigated by high external demand from the US.

The impact of US monetary tightening may be amplified by the fact that Asian economies have become significantly more indebted over the past decade. In fact, Asia’s contribution to global debt has risen from 25 per cent in 2007 to 38 per cent in 2020, and is now the region contributing the largest share to global debt. Debt has risen in both public and private sectors. And our research shows that increases in US interest rates have a disproportionately negative impact on the investments of those firms with high debt levels.

Compared with the taper tantrum period in 2013, Asia is better prepared in terms of its external buffers, as most countries have higher foreign reserves and current account balances. But at the same time, as mentioned, Asian economies are also more indebted. So, Asia may be able to better weather the short-term impact on capital flows and external pressures due to Fed normalisation. But it will be surely affected by rising funding costs and be a drag on growth.

The recent increase of half a percentage point in the benchmark rate by the US Federal Reserve has largely been expected by the market. But the action needs to be viewed as part of the ongoing tightening cycle which would increase pressures on the interest rates and funding costs across the emerging markets, including India. Furthermore, any large movements in global equity markets from a sharper-than-expected tightening in the advanced economies would also have implications for equity outflows from India.

Q. How do you assess the monetary policy committee's move of raising the repo rate by 40 basis points, given that the IMF’s South Asia outlook had suggested such a measure? What is your take on future actions by MPC?

The Outlook noted the rising inflation pressures across the region partly due to the spike in commodity prices. Core inflation is also increasing in many countries and we projected a need to raise interest rates in many of the Asian economies over the next one or two years to anchor inflation expectations in the central bank target ranges.

As far as India is concerned, we welcome the RBI’s recent policy actions – the increases in policy rates and the cash reserve ratio – against the backdrop of elevated and broad-based inflation risks, including from higher global food and commodity prices. Looking ahead, monetary policy will need to respond nimbly, including through well-communicated expectations about the trajectory of inflation and the path of policy rate actions to address any second-round inflationary effects.

Q. The outlook also said that the region, which includes India, faces difficult policy trade-offs. After MPC’s rate hike, what kind of fiscal policy will you recommend for the government?

Asia, like much of the (rest of the) world, is facing difficult policy trade-offs with rising inflationary pressures and an incomplete recovery from the pandemic. The extent of these trade-offs varies across countries and therefore requires policy responses to be tailored to country-specific circumstances.

While interest rates are projected to increase, globally and in India, and fiscal space is reduced as a result of the necessary fiscal support provided since the pandemic, India still has fiscal space in the near-term.

A more accommodative fiscal stance, with additional support targeted towards vulnerable households, is warranted given weaker growth prospects. In that context, the budget’s conservative revenue projections provide some space for additional support. While there is fiscal space in the near-term, India will need to implement an ambitious fiscal consolidation strategy in the medium-term, to regain fiscal space. In that context, it is important for the government to provide more clarity on its medium-term fiscal consolidation strategy, which can also help improve the trade-off between near-term macroeconomic stabilisation and medium-term fiscal sustainability. In our view, such a strategy can be underpinned by both improved revenue mobilisation and expenditure efficiency.

Q. IMF has cut India’s economic growth projections by 80 basis points for 2022-23. However, its new projection of 8.2 per cent is much higher than that projected by RBI at 7.2 per cent. What has made the IMF so optimistic?

The 8.2 per cent growth projection in FY23 partly reflects a continued catch-up in domestic demand following three waves of the Covid pandemic in India and a sharp contraction in economic activities at the onset of the pandemic (-6.6 percent in FY21). In other words, the growth projection reflects a rebound from a low base. In addition, the 8.2 per cent growth projection reflects a strong statistical carryover from the growth momentum at the end of the last fiscal year.

While the recovery has become more broad-based, there remains some gaps in contact-intensive services (as in many other countries), and the employment outcomes for youth and women still lag behind.

Uncertainty around the economic outlook is elevated, with near-term risks tilted to the downside. The downside risks are driven in large part by the ramifications of the war in Ukraine and the sanctions on Russia, which can be amplified if other macroeconomic risks materialise—for example, future pandemic waves, or a widespread global risk-off event associated with faster-than-anticipated monetary policy normalisation in advanced economies. On the upside, a successful implementation of the announced wide-ranging structural reforms could increase India’s growth potential in the medium- and long-term.

Q. Your outlook on Asia says a spike in food and commodity prices will have an inflationary impact. In this concern, should India continue with its programme of free food supply for the vulnerable section and till what time?

Global food prices—as measured by the UN’s Food and Agriculture Organization (FAO) index—are at historical high. Other commodity prices, especially for oil and energy related commodities, have also spiked after the Russian invasion of Ukraine. Commodity and food price shocks can have swift and substantial impacts on inflation, in the absence of policy responses. Higher food prices, if prolonged, can also undermine food security. These developments are especially difficult for emerging and developing economies, and the poorer households within these countries, as food and energy tend to be a higher share of their consumption baskets. Fiscal policy has a crucial role to play to mitigate the impact of the recent rise in international energy and food prices on those who are most affected. Governments should prudently navigate a fine balance between ensuring access to food and energy for vulnerable households, on the one hand, and normalising fiscal policy after the Covid-19 pandemic and promoting green transformation and energy security, on the other. While policy advice will be country specific, in general, governments should aim at passing through higher international prices to domestic consumers while protecting vulnerable households. Price signals are crucial to facilitate adjustment of consumption while price controls are both fiscally costly (possibly crowding out other priority spending) and reduce prices for all consumers regardless of their ability to pay. In countries where targeted support to protect the vulnerable is not possible due to weak social safety nets, incomplete pass-through of international food and energy prices may be warranted, though these measures should be designed to be temporary.

India’s food security welfare scheme, Pradhan Mantri Garib Kalyan Yojana (PMGKAY), played a key role during the pandemic, providing a certain level of food security to vulnerable segments of the population. Against the backdrop of higher food and other commodity prices, additional targeted support to vulnerable households is warranted. Additional support can be provided through different schemes and extending the PMGKAY for a certain period of time, can help protect households from the direct effects of higher food prices. In this context, it should be noted that amid disruptions of global supply chains, India’s food security benefits from the fact that India has been a net grain exporter.

Q. Your presentation given in Delhi suggests that lower demand in Europe will weigh on the region’s growth. However, India’s exports have been rising. Why?

The growth forecasts for Europe have been downgraded significantly for 2022 but the weakness in external demand for Asian exports are only likely to show up in the data from Q2 2022 onwards as pent up demand for goods and easing of the Omicron wave in most of the World supported global trade in Q1 2022. Thus, weaknesses in exports will likely affect the region Q2 2022 onwards.

Indeed, India’s exports have been rising in recent months, driven by both higher prices and increasing demand in partner countries. Monthly exports reached an all-time high in March 2022, exceeding the $40 billion benchmark for the first time. According to the preliminary data for April, export growth was broad-based and led by petroleum products (reflecting mostly price effects), electronic goods, organic and non-organic chemicals, textiles and engineering goods, while rice, gems and jewelry exports moderated slightly. Moreover, we project robust export growth to continue going forward, which should add to economic growth in India. However, the spillovers from the war in Ukraine are projected to substantially reduce external demand growth in Europe, which is an important destination for India’s exports. Unfortunately, it means that the expansion of India’s exports will be less pronounced than it was projected before the war in Ukraine broke out.

Q. Do you see China slowing down, because your presentation did talk of risks from that?

In our baseline projections, growth for China in 2022 has been revised down to 4.4 percent from 4.8 percent. The downward revision is predominantly driven by: (i) a surge in local Covid-19 outbreaks prompting lockdowns and severe restrictions to mobility in several cities, including in key production hubs (Jilin province, Shenzhen) and financial center (Shanghai), and (ii) the Ukraine-Russia conflict, which poses headwind to China’s growth from higher commodity prices, lower external demand, and the latter’s spillovers to private investment.

Risks to China’s growth outlook are predominantly on the downside, including from more widespread COVID-19 outbreaks, a prolonged slump in the property market, and a further escalation of the Ukraine war. A longer-than-expected pandemic surge and/or broadening to encompass the rest of the country would result in further downward revisions to the 2022 growth forecast, on weaker consumption and supply disruptions. A deterioration in the Ukraine-Russia war could result in a much larger negative impact on global trading partner growth which, in turn, would warrant bigger downward revision for China’s growth. Finally, a longer-than-expected slump in the property market with deepening macro-financial and broader economic spillovers continues to pose a significant downside risk. On the upside, policymakers may increase macroeconomic policy support beyond what is currently assumed.

Q. How do you see corporate debt hampering economic growth in India?

The build-up of corporate leverage in Asia accelerated after the global financial crisis and increased further during the pandemic. Non-financial corporate debt levels in Asia are generally higher than in other regions, and now represent 42 per cent  of the global non-financial corporate debt.

High corporate leverage can add to scarring risks, as high debt firms tend to see larger and more persistent declines in investment following a recession, potentially due to financing constraints. Furthermore, high corporate debt can also raise vulnerabilities to US monetary policy tightening, as high debt firms tend to lower investment by more following US monetary policy shocks.

Pandemic-era support for heavily indebted corporates will need to be carefully unwound, including by allowing the exit of non-viable firms. In this respect, modernising corporate restructuring frameworks would help avoid firm zombification.

Similarly, in India, further efforts to make support measures even more targeted and facilitate the exit of non-viable firms may be warranted. For instance, the authorities could consider tightening the eligibility criteria for borrowers, increasing the residual exposure of lenders, and implementing additional reforms to reduce the costs and time of exit of non-viable firms. These changes would mitigate the risk of loan evergreening, which could worsen credit discipline and lead to resource misallocation if it materialises.