Prudent fiscal policy combined with structural reform is the way forward and the Indian economy simply cannot afford the Food Security Bill, says Nomura

The sharp downturn that the rupee’s trajectory has taken recently has sparked off concerns about an interest rate hike as a possible policy response. The rationale for that would be to raise interest rates to contain aggregate demand to address the current account deficit and attract more capital inflows in order to help the balance of payment.
 

According to Nomura however, conventional theory may not be applicable to India's present macro-economic situation for three reasons. For one, Nomura says that the problem that needs to be addressed is not one of a high aggregate demand, but of a lack of supply. Next, it remains debatable as to whether capital flows into India are growth or interest sensitive. Finally, domestic demand has already collapsed, with non-oil/non-gold imports declining, suggesting the presence of weak private demand. Nomura says that the cost of hiking interest rates could do more harm than good, given rising domestic leverage on corporate balance sheets and their inter-linkage with banks.
 

Nomura invokes the theory of the impossible trinity, according to which a country can only have two out of the three from among an open capital account, a fixed exchange rate and an independent monetary policy. Given a low risk of capital controls, Nomura holds that the Reserve Bank of India (RBI) will have to decide between letting the currency adjust on its own or losing control over its monetary policy. Nomura’s recommendation is that the RBI should let currency adjust gradually, given limited forex reserves and a dismal domestic growth outlook.
 

Nomura says that while the competitive gains of the rupee depreciation are limited by supply-side considerations, the negative implications of higher imported inflation, delayed rate cuts, high asset price volatility, the increased cost of foreign currency debt, etc are many.
 

Nomura's report suggests that India's issues stem from a lack of fiscal and structural reform, with the rupee depreciation being a by-product of that. The brokerage recommends that the ideal response would be to implement a prudent fiscal policy, along with structural reforms that would put a check on consumption demand, ease inflationary pressures and eventually allow the RBI to re-focus on growth. The report explicitly says that government spending is budgeting to rise 16.4% this year, and with the Food Security Bill also being prepared, the Indian economy simply cannot afford this at the moment.