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Economy
December WPI: Inflation combating on in full swing. India’s headline WPI
accelerated to 8.43% in December 2010, in line with consensus expectation of 8.4%
and our expectations of 8.45% from 7.48% in November. The October inflation was
revised upward to 9.12% from the provisional estimate of 8.58%. The recent trends
have dashed all hopes of Indian policymakers of inflation coming within their comfort
zone this fiscal. The government has stepped up efforts to rein in food inflation, which
has been at the core of the recent spike in inflation. The RBI is also expected to play its
part in ensuring that inflation does not become more generalized in nature, and would
thus be on course of further policy tightening
Food inflation spikes up again, this time due to tomatoes, onions and other vegetables
Agro food inflation has been in double digits since June 2009, barring November 2010. Primary
food inflation spiked up to 13.5% in December from 9.4% in November, as prices of certain
vegetables (onions, tomatoes, etc.) underwent a sudden and sharp increase. The supply of these
vegetables has been severely affected as the unseasonal rains damaged their output, and hoarding
may have further aggravated the price situation. Vegetable prices are up 24.9% from a year ago,
after declining by 4.6% in November, with the index up 22.9% m/m. Additionally, inflation in
protein-rich food items such as milk, eggs, meat and fish was steady at 18.7%. However, food
grain prices have declined by 2.6% as the kharif output made its way into the market. We believe
that price pressures on the food side are unlikely to correct in any significant manner in the
coming months.
Non-food inflation stays strong
WPI ex-food ex-fuel edged up in December to 7.61% from 7.38% in November, while the index
rose by 0.7% over the month, indicating the presence of more generalized price pressures in the
economy. Much of the rise in the index in this month was due to a sharp increase in the primary
articles ex-food index (2.7% m/m) at 24.1% from 22.6% in November. Prices of fibers such as raw
cotton, raw jute and raw silk as well as prices of raw rubber, logs and timber are up 30-50% since
March 2010. Additionally, minerals such as iron ore, copper ore etc. have also risen sharply since
March. Non-food manufacturing inflation, which has been closely tracked by the RBI to gauge
demand-side price pressures, was steady at 5.3% from 5.4% in the previous month.
RBI to stay on course of monetary tightening as inflation remains above comfort zone
Headline WPI is likely to end higher than the RBI’s end-March target of 5.5%. In fact, the RBI had
indicated upside risks to its WPI projections in its December mid-quarter review and is likely to
push it to 6.0-6.5% range when it announces its monetary policy on January 25. Our own
expectations are for headline WPI to end the year in a range of 7.0-7.5% with continuing
pressures from the food side as also from firm global commodity prices and strong domestic
demand. Thus, inflation management would continue to be a priority for the RBI in the coming
months. However, the recent November IIP print (2.7%) has raised concerns of domestic growth
slowing. It would be a difficult task for the RBI to rein in inflation while also ensuring that growth
stays at reasonable levels. We thus think that the RBI will not be aggressive in raising policy rates
(as had been the expectation in the market for some time now) but would continue to increase
rates in small doses of 25 bps in each of its quarterly policy reviews, starting with the January 25,
2011 review. We expect the RBI to raise the repo and the reverse repo rate by a cumulative of 100
bps from current levels to 7.25% and 6.25%, respectively by end-CY2011E.
Food inflation shows no respite
Agro food inflation has emerged as the biggest challenge for Indian policymakers this year,
as price pressures have arisen from different fronts within food at different points in time.
While the earlier episode of food inflation was due to the drought in 2009-10, which
pushed up food-grain prices, the recent bout of pressure on food prices has come from
vegetables. Prices of certain vegetables such as onions, tomatoes etc. have seen a sudden
and sharp increase as the unseasonal rains in November damaged the crop, affecting the
supply. Moreover, there is evidence of hoarding activity, which has further aggravated the
price situation. As of the week ending January 1, vegetable prices are up 110.5% since endNovember (weekly figures), with tomatoes prices seeing the steepest rise (219%), followed
by onions (203%). In fact, the contribution of vegetables to the overall primary food
inflation has jumped from around 14 bps at the start of December to 830 bps as of January
1, 2011 (on the basis of weekly food inflation figures).
In this current episode, the ability of the government to bring down prices of these
commodities is limited as it does not hold public stocks of vegetables. The government
yesterday announced measures to tackle food-related inflation (summarized below).
However, these are likely to provide only limited respite. In our view, until the supplies of this
food items rise, prices could remain elevated. With cropping cycles for vegetables relatively
low, we could expect to see price pressures in these commodities coming off in
February/March, 2011.
Some of the short-term steps announced by the government on January 13, 2010 are as
follows:
` NAFED and NCCF shall undertake sale of onions at Rs35/kg from their retail outlets in
various locations. Arrival of onions from Pakistan will also help cool prices.
` Government will review import and export of all essential commodities on a regular basis
and impose controls on exports and ease restrictions on imports, including tariff reduction
where necessary, to improve domestic supplies.
` Public Sector Undertakings shall intensify purchases of essential commodities, particularly
edible oils and pulses, for distribution through their retail network and also through the
Public Distribution System operated by the state governments. The existing schemes for
subsidized distribution of edible oils and pulses will be continued. Exports of edible oils
and pulses, as well as non-basmati rice, will remain banned.
` Government will take stringent action against hoarders and black marketers manipulating
market prices. Cartelization by large traders will be strictly dealt with.
Importantly, the price pressure on the food side has also assumed a more structural shift.
Prices of protein-rich food items, such as milk, eggs, meat fish etc., have remained
stubbornly high. The demand for these food items has outpaced supply as higher disposable
incomes have shifted consumption towards these food items. While certainly the pace of
increase in inflation in protein-rich food items is sharply down from its peak of 35% in May,
it still remains stubbornly high at around 20%.
In our view, pressure on the food side is likely to persist, in the near to medium term.
` Recently, the government indexed the wages under MNREGA scheme to CPI-AL that is
expected to lead to an increase in wages by around 17-30%. This is likely to increase rural
incomes and hence, keep food demand elevated with supply not being able to keep pace.
` MSP prices have also increased steadily over the year, and would act as a natural floor.
This has also led to an upward surge in rural incomes.
` Globally, food prices have risen sharply in recent months and have rung alarm bells
amongst policymakers, especially in emerging markets where food is a higher component
of the overall CPI basket. In fact, UN’s Food and Agriculture Organization warned last
week that the world could see repetition of the 2008 food crisis if prices rose further.
Non-food inflation also firming
WPI ex-food ex-fuel edged up in December to 7.61% from 7.38% in November, while the
index rose by 0.7% over the month, indicating the presence of more generalized price
pressures in the economy. Much of the rise in the index in this month was due to a sharp
increase in the primary articles ex-food index (2.7% m/m) at 24.1% from 22.6% in
November. Prices of fibers such as raw cotton, raw jute and raw silk as well as prices of raw
rubber, logs and timber are up 30-50% since March 2010. Additionally, minerals such as
iron ore, copper ore etc. have also risen sharply since March. Non-food manufacturing
inflation, which has been closely tracked by the RBI to gauge demand-side price pressures,
was steady at 5.3% in December from 5.4% in November.
In our view, manufactured products ex-food inflation is likely to remain sticky or pick up in
the coming months, as the higher global commodity prices spill over to domestic
manufacturing. Further, there could be some degree of repressed inflation on the
manufacturing side, as higher input prices are yet to feed into higher output prices. For
instance, while logs and timber index is up 44.6% since March 2010, the ‘wood & wood
products’ index on the manufactured side is up only 3.4% since March. There is thus a
strong possibility that these higher input prices get passed on to the final product in the
coming months. Additionally, domestic demand is strong and with signs of capacity
constraints in certain sectors domestically, there is further upside risk to inflation from
manufactured ex-food products.
Moreover, with global energy prices currently hovering around the US$90-92 per barrel
mark, there is a likelihood of another round of fuel price hike in the near future. This would
further worsen the inflation outlook in the near to medium term. Petrol prices were hiked by
5.7% in December. However, unlike petrol prices, diesel prices are not deregulated and the
government has resisted such a step as the first order as well as the second order impact of
a diesel price hike is much greater (petrol has weight of 1.09%, diesel 4.67% in the
headline WPI basket), as it raises transportation costs. However, pressure could be building
up on the government to raise diesel prices too to provide some breathing space to the oil
marketing companies.
Inflation to remain above RBI’s comfort zone in FY2012E
Given the recent trends in headline inflation, there is a very low probability of headline WPI
ending the fiscal year around 5.5-6.0%. We think that with food price pressures likely to
remain elevated in the next few months, and pressure emerging from global commodity
prices, headline inflation could be in the 7.0-7.5% zone by March 2011 end. In the next
fiscal, we expect headline WPI inflation to remain sticky at around 6.75-7.25% between
April and November 2011. There could be some softening thereafter assuming no disruption
in crop production. Consequently, we would expect headline WPI inflation to end in March
2012 at around 5.75-6.00%. Importantly, these levels are far higher than the stated comfort
zone of RBI of around 4%.
RBI to stay on course of policy tightening
Following the tepid November industrial production growth (2.7%), there is a concern that
growth could be slowing and this could prevent the RBI from raising rates too aggressively.
Further, it is also generally argued that while inflation is a problem, monetary policy would
be ineffective as it is largely a supply-related phenomenon. While this is true and the central
bank also agrees to it, we believe that there are other factors at play which would keep the
central bank on a tightening path
` There are risks of a wage-price spiral emerging in India. Wages in India are indexed to the
CPI, and food forms a very high component of all the CPI indices. The stubbornly high
food inflation, even if due to supply-side factors, would result in headline CPI inflation
remain firm. This in turn would cause wages to rise and in turn keep food demand high
and so on, resulting in a vicious cycle.
` There is also a structural element to food, emanating from protein-rich food inflation,
which is also a cause of worry for the central bank. Dr. Gokarn, in a speech last October,
had remarked, “Persistent price increases in commodities for which there are no effective
substitutes (i.e. milk, eggs, meat, fish) will, other things remaining equal, raise the
potential rate of inflation over a period of time. This means that either actual inflation or
interest rates will be higher than they would be in the absence of such increases”.
` Inflationary expectations, as measured by the RBI’s household survey, have been on a
sharp upward trend since June 2009. Currently, the one year hence inflation expectations
are running at 12.7%.
` Firm global commodity prices as also strong domestic demand would prevent any
softening of manufactured product inflation.
` Real interest rates are still in the negative zone and have kept deposit growth muted. As a
result of this, banking system liquidity has come under pressure. There is thus a need to
raise policy rates to a level so that real rates are in the positive zone.
` We thus expect the RBI to tighten both the repo rate and the reverse repo rate by 100
bps from current levels in the coming year, taking them to 7.25% and 6.25%,
respectively. We expect the central bank to hike policy rates in doses of 25 bps in each of
its quarterly monetary policy reviews starting with the January 25, 2011 review.
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