India’s Rajan May Have to Head Off Modi

India’s Rajan May Have to Head Off Modi

ABHEEK BHATTACHARYA

June 3, 2014 8:24 a.m. ET

Unlike investors overjoyed with Narendra Modi’s election, Reserve Bank of India Gov. Raghuram Rajan is staying calm.

Mr. Rajan’s move to hold interest rates steady Tuesday is a reminder of the challenges India’s economy faces. Whatever new growth investors expect Mr. Modi to deliver, retail inflation was high at 8.6% in April.

Mr. Rajan did lower the statutory portion of deposits banks must park in government bonds by half a percentage point—cash the banks can now lend out instead.

Yet this seems more a sign of overhauling antiquated regulations than real easing. And there may be little immediate effect, since the banking system’s bondholdings actually exceeded the requirement by six percentage points.

Even as the central bank sounds pleased that it will hit its 8% inflation target by next January, there are plenty of reasons Mr. Rajan might find himself in rate-raising mode later this year.

First among them is the possibility of a Modi-sparked growth rebound. With inflation already so high, it is hard to see India’s economy expanding more quickly in the short term without more price pressures.

After years of delays in overhauls that could unlock supply-side bottlenecks, especially infrastructure, India’s potential growth rate was severely compromised to around 5% last year, according to J.P. Morgan. JPM +0.45%

Growing more rapidly than that, by this calculation, will trigger more inflation.

Mr. Modi could overhaul India’s growth potential, but such a process would take years. He may initially worsen inflation if he kick-starts new investment—by generating demand for capital goods before any reforms can increase local supply, says J.P. Morgan’s Jahangir Aziz. And if companies import capital goods, that will widen the trade deficit, weaken the rupee and again risk inflation by making oil imports dearer.

Another risk is food inflation which is likely to worsen this summer due to poor seasonal rains. Mr. Modi can help by releasing government food stocks and initiating changes that destroy food cartels. Mr. Rajan and investors are waiting for Mr. Modi’s budget next month to see if he takes these steps, and the politically tougher decisions to trim fuel subsidies and reduce the government’s deficit.

Then there is India’s external front. On the surface, all is quiet, with the current-account deficit down to a manageable 1.7% of GDP last fiscal year from 4.7% the year before.

Still, 65% of the current-account adjustment comes courtesy of government curbs on imports of gold and India’s importing fewer manufactured goods, neither of which may last. In addition, the deficit was almost entirely financed by fickle portfolio inflows in the March quarter.

If the Federal Reserve’s departure from easy-money policies again sends emerging markets into turmoil, Mr. Rajan may have to raise interest rates to defend the currency, as he did last year. That should be a reality check for investors who think Mr. Modi’s arrival alone ushers in a new Indian boom.