India should prepare a plan to respond to volatility in global currency markets that may come as the U.S. Federal Reserve reduces monetary stimulus, the International Monetary Fund staff said in a report.
While India’s finances have improved since last year, a coordinated plan is needed in case capital account pressures re-emerge, the IMF said. Any plan should make rupee flexibility the key defense and include measures to raise the benchmark interest rate, impose cash curbs, open foreign-exchange swap windows and raise diesel prices, it said in an annual review of India’s economy.
“The principal risk facing India is the inward spillover from a tightening of global liquidity interacting with domestic vulnerabilities,” the IMF said in the statement. Pressures associated with India’s “still-significant external financing need” could lead to higher borrowing costs, fund outflows and “disorderly adjustments” in the exchange rate, it said.
India has reduced its current-account deficit, increased interest rates and built up foreign-exchange reserves after the rupee plunged last year on news the Fed would curtail its $85 billion in monthly bond purchases. The rupee has gained about 11 percent since hitting a record low last August, the best performance among major emerging-market currencies.
“The ministry of finance and the RBI have the tools to handle the volatility should it arise again,” Thomas Richardson, the IMF’s senior resident representative in India, told Bloomberg TV India today. Bringing inflation down can make the current-account deficit lower, providing a buffer for volatility in international markets, he said.
“We see India much more resilient than they were about the middle of last year to external shocks,” Paul Cashin, the fund’s mission chief to the country, said on a conference call. “But global financial market volatility is still a risk.”
The rupee, down 0.6 percent this year, rose 0.1 percent to 62.1500 per dollar at 10:38 in Mumbai today. The S&P BSE Sensex index gained 0.9 percent.
“It has been surprising how little the Fed tapering impact has been on India, largely because the current-account deficit has shrunk,” said Tushar Poddar, a Mumbai-based economist at Goldman Sachs Group Inc. Reduced imports due to curbs on gold purchases from overseas, efforts to build forex reserves and commitment to control inflation “have helped to take the sting away from the impact of the Fed tapering,” he said.
The U.S. central bank in January reduced purchases to $65 billion a month in the second consecutive $10 billion cut. Federal Reserve Chair Janet Yellen pledged Feb. 11 to maintain her predecessor’s policies by scaling back stimulus in “measured steps.”
Reserve Bank of India Governor Raghuram Rajan last month criticized the lack of a synchronized global monetary policy, saying in an interview that developed countries can’t “wash their hands off and say we’ll do what we need to and you do the adjustment.”
Indian officials “pointed to the need for greater clarity and communication by policy makers in advanced economies” regarding the pace of tapering, said the IMF report, which was prepared in January following consultations in November.
“If faced with a similar round of capital flow volatility, they indicated that the thrust of their response would likely be similar, using a combination of exchange rate flexibility, some monetary tightening, and, if needed, limited use of foreign exchange reserves.”
Rajan has raised the policy rate by a total of 75 basis points to 8 percent since taking over the RBI in September. A central bank panel last month proposed reducing CPI to 8 percent within one year and 6 percent by 2016, and that the RBI should then adopt a 4 percent target with a band of plus or minus two percentage points.
In the report, which was dated Jan. 9, IMF staff said it expects the current-account deficit to be $61 billion, or 3.3 percent of gross domestic product, in the year through March 2014, higher than Finance Minister Palaniappan Chidambaram’s estimate of $45 billion.
That difference has narrowed, with the fund now expecting a gap of about 2.5 percent of GDP as India moves to fight inflation, which could help reduce gold imports, Cashin said.
Retail inflation is expected to be near double digits, the IMF said. Consumer price gains slowed to 8.79 percent in January from 9.87 percent in December.
High inflation remains a “central macroeconomic challenge,” and reducing that “will require a tightening of the monetary stance, possibly over a protracted period, which inevitably will weigh on growth prospects,” the IMF said. Central bank authorities were “less persuaded of the need for a further, significant increase in policy rates” and preferred to see the effects of the previous rate increases, it said.
The IMF estimates Asia’s third-biggest economy will expand 4.6 percent in the year to March 2014 and 5.4 percent in the next year. The government forecasts growth of 4.9 percent this fiscal year, faster than the decade-low expansion of 4.5 percent in the previous period.