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How to tackle inflation without harming growth will be Narendra Modi's biggest challenge if elected Prime Minister

Wednesday, 30 April 2014 - 12:15pm IST | Place: Mumbai | Agency: dna

Just a couple of weeks down the line a government in New Delhi will be staring at some big dilemmas.

El Nino or not, the all-pervasive demand recession has already gnawed into India Inc's hopes of a recovery post elections. The manufacturing sector is stagnant, and the outlook is weak as exports and imports are declining.

The new government may have reservations on the current thinking at the Reserve Bank of India (RBI), and may be forced to wage a different battle to bring the focus back on growth.

Piyush Goyal, national treasurer of the Bharatiya Janata Party (BJP), which is most likely to form the new government, and a Member of Parliament, told dna that hiking interest rates to tackle inflation is an outdated economic theory. "It should be revisited," he said.

According to him, RBI's primary job, among others, is to arrest inflation.

"RBI can't do it alone. It has to be a concerted effort, with the government."

On its part, RBI has continued to remain "focused on inflation". Some members of the RBI technical advisory committee, which met on March 26 and assessed the market situation, have expressed "concerns" on inflation.

They believe that there are clear upside risks -- such as suppressed pricing in electricity, LPG and diesel, and the impact of hailstorms on potato prices, if not on onion. According to them, inflation in housing, education and medical care is still elevated. As the economy picks up, there will be an increase in these components and inflation may surge again after October-November 2014.

This may force RBI to go against slashing interest rates anytime soon.

"During A B Vajpayee's rule, it was high interest rates and high inflation. We brought down both, coupled with high investment, rapid economic growth and employment generation," said Goyal.

RBI top officials believe that the country may see an improved investment climate after the elections. "Investment is likely to pick up as stalled projects take off after the election results. This could raise the output-capital ratio as well as potential output and savings," said a senior RBI official.

The worry at RBI is that if the revival in growth is driven by a pick-up in investment without matching revival in savings, it could lead to larger imbalances.

On rupee, BJP's Goyal is against allowing any huge volatility.

"Rupee is the pre-requisite to investor confidence, and to keep equilibrium in the economy and encourage larger investments. RBI needs to keep some decorum in the movement of rupee. Any rapid decline caused by the government ineptitude will make it difficult for RBI," he said.

A surge in foreign currency inflows can put the rupee under pressure. While exchange rate appreciation may help in lowering inflation, it may not be good for the economy in general as some categories of exports are highly sensitive to real appreciation. There is also an argument that an exchange rate below Rs 60 per $ could hurt manufacturing growth because of severe import competition.

"In the near term, external sector risks might have eased because of the increase in forex reserves over the last six months. In the medium term, however, the risk of capital outflows remains and may materialise if the US Fed raises interest rates earlier than is currently anticipated," believe some TAC members.

So should RBI intervene in the foreign exchange market?

Some top RBI officials believe that the central bank should actively intervene in the forex market to prevent excessive exchange rate appreciation. On the other hand, some others questioned the need for intervention when capital inflows are large. They were of the opinion that when inflows are good, firms should be allowed to adjust their balance-sheets rather than the RBI intervening in the market. Reserves should only be used to manage volatility and not the level of the exchange rate.

"We will respect the autonomy of regulators and uphold the constitutional authority," said Goyal.

According to a Mumbai-based banker, new finance minister should focus on balancing growth and inflation. "Today, there is a tilt towards inflation control. For the new government, an interest rate cut should be a starting point," said Amitabh Chaturvedi, managing director of Essel Finance.

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