HSBC: RBI may skip tightening in November, but will ramp up rates again in December

Mixed Signals
India's industrial production declines in August
Industrial production growth for August disappointed markets, at 5.6% y-o-y, sharply lower than consensus and
our estimates of 9.5%. The wild card of capital goods production bares its teeth of unpredictability and lumpiness in
earnest this time round, contributing the bulk of the poor showing. The volatility of this measure supports our view
that the central bank will likely pause in November, as it awaits more economic data. However, the overall tightening
posture remains, with another 25bps hikes in December - as the ongoing inflation still calls for forceful measures.
Facts
Industrial production in August grew 5.6% y-o-y, versus an upwardly revised 15% y-o-y in July. On a seasonally adjusted
basis, industrial output declined 6.6% m-o-m in August after recording 7.4% m-o-m expansion in July. Manufacturing (index
weight 79%) grew 5.9% y-o-y in August vs. +16.7% in July. Growth was also weaker in the remaining electricity and mining
sectors. Under manufacturing, production of food, wood and metal products continued to grow whereas the big declines were
noted under 'machinery & equipment' (-30% m-o-m nsa). Transport equipment may not have grown sequentially but still,
current production levels are a good 20% over the previous year.
The use-based categorization will be more useful in understanding the headline number's disappointment. For one, 'Basic'
and 'Intermediate' goods which make up the bulk of the index did not show any increase in production over the previous
month. Though not the majority of the headline index by weight, the fact that the volatile 'Capital goods' category declined by
a hefty 40% m-o-m nsa was the chief culprit in the poor showing of the August industrial production growth. Nevertheless,
this has to be viewed with the fact that the same category registered a massive 50% m-o-m nsa increase in July in mind.
Meanwhile, consumer goods declined due to a fall in production of non-durable goods (-5% m-o-m nsa) offsetting gains shown
in production of consumer durables (+3% m-o-m nsa).
Implication
Much of the volatility in industrial production is mainly due to large swings in capital goods production. Even though capital
goods make up just 10% of the index, its excessive sequential swing, bouncing from +50% m-o-m to -40% the next month,
for instance, presents a large impact on headline growth. Overall, fiscal policy is still expansionary and the public sector
should continue to buy project goods in large quantities for spending on infrastructure projects this year. The other big buyer
of capital goods is likely to be corporate investing in business expansion this year due to current stretched capacities. Hence,
depending on the project and capital goods order pipeline, it appears that we might see further choppy readings in the industrial
production figures in the near term.
Volatility aside, we also advise against focusing on the IIP numbers too narrowly. As shown in Chart 2, at least from 2006,
the IIP may have significantly underestimated the economy's industrial output - as suggested by the gap between the industrial
figures from IIP and those from GDP component.
More importantly, it appears that we are not the only one who are aware of this discrepancy. It is telling that the IIP figure
is the first indicator that the government zooms in on when it ordered an audit on national statistics recently. Clearly,
policymakers, including the central bank are unwilling to take the IIP number - and the marked slowdown it is indicating, even

if we blindly disregard its inherent volatility - at face value. It is precisely for this reason that we think the Reserve Bank of
India will hold policy rates in November for more data before hiking policy rates in December.
Crucially, notwithstanding the (potentially unreliable) signal from the IIP deceleration, there are other indications such as the
strong pick-up in non-oil imports, together with the widening current account deficit, which point to the fact that domestic
demand continues to be very strong - and that the economy is still running above potential. On top of that, inflation continues
to remain too high for comfort and there is plenty of stimulus left in the economy to further stoke demand growth. Therefore,
monetary policy needs to be tightened further if inflation and inflation expectations are to be reigned in.
Bottom line: There is plenty of stimulus left in the economy to drive demand growth. A soft patch in industrial production
growth may not indicate slowing demand yet, especially if we account for its inherent volatility and its potential unreliability.
The central bank need to be vigilant and tighten policy further to control inflation that remains at uncomfortable levels. It may
skip tightening in November, but will ramp up rates again in December.