The RBI has already hiked the repo rate by 375 basis points (bps) from the bottom, and it is loose fiscal policy that is the main culprit behind high inflationary pressures, says Macquarie

Over the past 22 months, headline inflation as measured by the wholesale price index (WPI) have remained well above the Reserve Bank of India’s (RBI) comfort zone of 5% to 5.5% and averaged 9.5% during this period. While worsening fiscal deficit is responsible for high inflation in India, it is the loose fiscal policy that is exerting high inflationary pressures, said Macquarie Research.

In a research note, the investment banking and diversified financial services group said, “While on monetary policy, the central bank has already hiked the repo rate by 375 basis points (bps) from the bottom, we believe it is the loose fiscal policy that is the main culprit behind high inflationary pressures."

According to a study paper prepared by the RBI, empirical estimates conducted over the sample period 1953-2009 suggest that one percentage point increase in the level of the fiscal deficit could cause about a quarter of a percentage point increase in the WPI.

“Post the credit crisis while growth in India bounced back quickly, the credit crisis-driven policy stance was not reversed at the same pace as policymakers were worried about sluggish global growth. Hence, the fiscal policy remained expansionary. The domestic demand side pressures in the context of binding supply constraints as capacity creation (investments) remaining weak is the main reason for the acceleration in inflation, in our view,” the research note added.

India has a history of high deficit levels. In fact, it was only before the credit crisis that India managed to achieve a consolidated deficit level of 4.8% of gross domestic product (GDP) in FY08, the lowest in the past two decades, Macquarie said.

India’s fiscal deficit has deteriorated sharply since the credit crisis. The government’s consolidated fiscal deficit (including off-budget items) increased significantly to 10% of GDP in FY09 from 4.8% of GDP in FY08 and remained high at 9% of GDP in FY11 (excluding telecom licence and BWA collection). Macquarie said, “For FY12, we expect India’s consolidated fiscal deficit (including off-budget items) to remain high at 8.6% of GDP in the wake of slowing revenue growth and lack of expenditure management by the government. Looking at the central government accounts, we estimate the deficit to remain high at 5.3% of GDP in FY12, with an additional off-budget expenditure of 1% of GDP compared to the government target of 4.6% of GDP.”

During the credit crisis, the government pursued an expansionary fiscal policy to meet pent-up domestic demand and hence cushioned growth. While government expenditure grew by 30% year-on-year (Y-o-Y) in FY09, gross tax collections grew by a modest 2%Y-o-Y during the same period. Consequently, the government’s consolidated fiscal deficit (including off-budget items) more than doubled to 10% of GDP in FY09 from 4.8% of GDP in FY08 and remained high at 9% of GDP in FY11, excluding collections from the telecom licence and broadband and wireless auction (BWA). Some of the measures announced in FY09 were populist as India had Parliamentary elections in May 2009 and these were announced even before the credit crisis to serve political objectives. These include wage hikes for central government employees, pre-election spending, farm-loan waivers and expansion of social-security schemes like rural employment.

The 10-year government securities (G-Sec) bond yields have already increased by about 30bps over the past two weeks to 8.8% currently on higher-than-expected government borrowing for the second half of FY12, inflationary concerns and concerns about further fiscal slippage.

“While we expect 10-year G-Sec yields to remain range-bound around the 8.7%-8.8% level in the near-term, considering that the RBI might conduct open market operations (OMO) to ease liquidity, the possibility of a pause in the rate-hike cycle might bring some temporary relief,” the research report added.