Tighter monetary policy and fiscal support
In May, retail prices rose by 7% year-on-year (y/y). This rate was above the RBI's target of 4% ± 2 percentage points (pp) for the fourth consecutive month. As a result, the Central Bank brought its accommodating monetary policy to an end; it increased its policy rates by 90 basis points (bps) in May and June, bringing the repo rate to 4.9%. Furthermore, it raised the banks’ reserve requirements ratio by 50 bps to 4.5% in order to reduce excess liquidity in the banking sector. Further rate rises are expected following the next monetary policy committee meeting in August. The RBI expects inflation to remain above 7% from July to September, slowing down from October to sit at an average of 6.7% over the current fiscal year.
Although this tighter monetary policy will weigh on domestic demand, it will not be enough to curb inflationary pressures that are generated by supply constraints. However, the rise in interest rates should help to shore up the rupee, and thus contain imported inflation.
In these circumstances, and in addition to the ban on wheat exports, the government adopted several budgetary measures during May in order to contain the rise in domestic prices. However, these adjustments will delay the ongoing consolidation of public finances (in FY 2021/2022, the fiscal base rose by 1.4 pp to 11.4% of GDP compared with the pre-pandemic level) as the measures introduced will weigh on both spending (up 0.7% of GDP) and revenue (down 0.7% of GDP).
To contain the rise in energy prices, the government reduced excise duty on imports of gas oil and diesel by Rs8 and Rs6 per litre respectively, largely offsetting the rise in prices of Rs10 per litre in March and April. All customs duties on coal imports were also lifted. Finally, the government increased subsidies for 90 million of the most vulnerable households to help them cope with rising gas prices (particularly gas used for household cooking).
In addition, the government doubled the amount of subsidies on fertilisers (up 0.4% of GDP) in order to limit cost increases for future harvests. The grain distribution programme for households covered by the National Food Security Act was extended until September 2022, increasing the cost of food subsidies by almost 40% compared to the initial budget (up 0.3% of GDP).
Therefore, the government’s forecast of a reduction in the budget deficit from 6.7% of GDP in FY 2021/2022 to 6.4% of GDP for the current fiscal year appears optimistic, even though the increase in inflationary pressures will generate a greater increase than expected in nominal GDP. The general government debt-to-GDP ratio is expected to continue to fall gradually, while remaining above 82%.
The structure of government spending will become less favourable. The share of rigid spending (made up in particular of subsidies and interest payments on debt) is set to increase to 38%, and the government could be forced to limit infrastructure spending to rein in budgetary slippage. The rise in yields of the government’s 10-year bonds (up 100 bps over the last 12 months to reach 7.4% at the end of June) will increase the interest debt burden. Interest payments stood at 36.5% of government revenue in FY 2021/2022 despite inflationary pressures (deflated by the core CPI, the yields of the government’s 10-year bonds in real terms remain below their pre-crisis level but are now above the levels recorded in 2020 and 2021).
