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We now believe that India’s tightening cycle is in its conclusive stage. Both moderating
growth momentum and rising stress on the fiscal position are calling for a recalibration of
policy. Inflation admittedly remains elevated and may even spike up in the short term as
energy prices are adjusted higher but on balance, it is not an issue that can be addressed via
monetary policy. In any case, the RBI has already acknowledged the persistence of high
inflation in H1 FY12 (fiscal year ending March 2011).
At 7.8% yoy by industry of origin and 7.7% yoy by expenditure, Q4 FY11 GDP data was
weak and in a comprehensive manner The performance of both industry and manufacturing
deteriorated to the extent that in a rare occasion, non-farm GDP was the same as headline
GDP growth. Farm sector growth is not influenced by business cycle dynamics and suffers
from low productivity.
On the expenditure side, domestic demand continued to ease reflecting a peaking of
consumption cycle as well as further deceleration in the investment cycle. Investment growth
slumped to 0.4% yoy, the lowest in the post-Lehman phase. As we have said in previous
reports, investment demand is suffering from a combination of (1) slow approval of
infrastructure projects; (2) rising cost of capital and (3) uncertain external environment which
is limiting the ramp-up in information technology related exports. Figure 2 below traces the
evolution of the cost of capital by using a weighted average of the earnings yield and AAA
10yr corporate bond over the last few years.
More contemporaneous indicators are not signalling a meaningful turnaround either.
Consumption indicators including real currency held by the public, a good gauge of transactions
demand in cash based economy like India, auto sales and credit are all moderating. Production of
capital goods did pick up in March but weak investment intentions do not suggest that this will be
a durable upturn. These developments have also been captured in various surveys including the
industrial outlook survey of the RBI.
In a slight digression, we address the view that the current composition of manufacturing sector
basket is no longer reflecting the transformation of the economy particularly with regard to
consumer products. To this extent, the macro momentum may be understated. Indeed, this is
true. The current basket has become archaic in that in includes products like typewriters, sewing
machines and cassette recorders as opposed to mobile phones and consumer electronics.
Similarly, in the non-durables sector, goods such as processed foods and cosmetics continue to
have a low weighting. A revision of the manufacturing basket, as is scheduled by the end of this
month, could potentially give a one-time boost but what will matter are annual growth rates.
These should show a softening trend as suggested by broader coincident indicators.
Coming back to the main issue, the odds are now that in the absence of policy recalibration,
arresting this downswing will be difficult. Of course, until now, the RBI has been unambiguously
clear that inflation management will take precedence over supporting growth. The question we
raise is whether inflation is a monetary issue or not, at this stage. We think it is a commodity price
related issue and the influence of monetary policy will be negligible.
Indeed, we note that in the WPI basket, food, commodities and energy prices have been rising
the most aggressively. Manufactured product inflation, a crude measure of core inflation in the
Indian context has also moved up over the last two months, but again a decomposition of the
same shows that commodity heavy sectors have been the main culprits. Products that are more
intricately associated with domestic demand conditions have been more subdued.
Further validation of our view comes from the fact that monetary aggregates are also starting to
ease in line with growth. Non-food credit is tapering off and has contributed to an improvement in
the loan-deposit ratio. Similarly, the recourse of banks to the RBI’s liquidity adjustment facility has
come off sharply. Though part of this is explained by the resumption of government spending via
a draw-down of cash balances, slowing demand for credit has also contributed.
We are also aware that it will take some time for this divergence between inflation and growth to
close. Inflation persistence in India tends to be high and there is little certainty around commodity
prices. That said, the RBI has already assumed that inflation will remain sticky in H1FY12 at
around 9%. We believe this is a realistic estimate and considers some adjustment in fuel prices.
Slower growth can be ill-afforded by Indian policymakers particularly considering the difficult fiscal
position. As we have discussed in previous notes, meeting the FY12 fiscal deficit target of 4.6%
of GDP is contingent upon (1) a rise in tax buoyancy; (2) meeting a lofty disinvestment target of
INR400bn and (3) containing the subsidy bill. In this context, the government had included an oil
subsidy outlay for only three quarters of consumption and probably assumed oil prices to be at
USD85/barrel. A slippage is pretty much guaranteed but even so, limiting it will require that the
tax collection target which is growth dependent is met. The FY12 budget was based on real GDP
estimate of 9%.
Even in the unlikely absence of a fiscal slippage, we think that monetary policy will need to be
supportive to support the existing government borrowing programme. In this regard, though the
aggregate borrowing size is lower than in FY11,
So what should monetary policy look like? Our current forecast is for further cumulative tightening
of 50bps and in single steps of 25bps. We now think this is the outer limit and the RBI may well
stop after one more rate hike. Price action in the OIS curve, though exaggerated by fall in US
treasury yields is also indicating a reassessment of rate hike expectations.
Away from that, we think the RBI may step in to support the government borrowing programme
via open market operations, possibly in H2 FY12. In the absence of open market operations (as
was the case last year), overall system liquidity could tighten sharply again. In the pre-Lehman
period, such support was necessary as BoP surpluses were sizeable and the fiscal deficit was
low. Post-Lehman BoP surpluses have become much smaller and ensuring reserve money
growth has required an increase in RBI support to the government. Figure 7below shows the
changing composition of base money and the underlying BoP balance.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
We now believe that India’s tightening cycle is in its conclusive stage. Both moderating
growth momentum and rising stress on the fiscal position are calling for a recalibration of
policy. Inflation admittedly remains elevated and may even spike up in the short term as
energy prices are adjusted higher but on balance, it is not an issue that can be addressed via
monetary policy. In any case, the RBI has already acknowledged the persistence of high
inflation in H1 FY12 (fiscal year ending March 2011).
At 7.8% yoy by industry of origin and 7.7% yoy by expenditure, Q4 FY11 GDP data was
weak and in a comprehensive manner The performance of both industry and manufacturing
deteriorated to the extent that in a rare occasion, non-farm GDP was the same as headline
GDP growth. Farm sector growth is not influenced by business cycle dynamics and suffers
from low productivity.
On the expenditure side, domestic demand continued to ease reflecting a peaking of
consumption cycle as well as further deceleration in the investment cycle. Investment growth
slumped to 0.4% yoy, the lowest in the post-Lehman phase. As we have said in previous
reports, investment demand is suffering from a combination of (1) slow approval of
infrastructure projects; (2) rising cost of capital and (3) uncertain external environment which
is limiting the ramp-up in information technology related exports. Figure 2 below traces the
evolution of the cost of capital by using a weighted average of the earnings yield and AAA
10yr corporate bond over the last few years.
More contemporaneous indicators are not signalling a meaningful turnaround either.
Consumption indicators including real currency held by the public, a good gauge of transactions
demand in cash based economy like India, auto sales and credit are all moderating. Production of
capital goods did pick up in March but weak investment intentions do not suggest that this will be
a durable upturn. These developments have also been captured in various surveys including the
industrial outlook survey of the RBI.
In a slight digression, we address the view that the current composition of manufacturing sector
basket is no longer reflecting the transformation of the economy particularly with regard to
consumer products. To this extent, the macro momentum may be understated. Indeed, this is
true. The current basket has become archaic in that in includes products like typewriters, sewing
machines and cassette recorders as opposed to mobile phones and consumer electronics.
Similarly, in the non-durables sector, goods such as processed foods and cosmetics continue to
have a low weighting. A revision of the manufacturing basket, as is scheduled by the end of this
month, could potentially give a one-time boost but what will matter are annual growth rates.
These should show a softening trend as suggested by broader coincident indicators.
Coming back to the main issue, the odds are now that in the absence of policy recalibration,
arresting this downswing will be difficult. Of course, until now, the RBI has been unambiguously
clear that inflation management will take precedence over supporting growth. The question we
raise is whether inflation is a monetary issue or not, at this stage. We think it is a commodity price
related issue and the influence of monetary policy will be negligible.
Indeed, we note that in the WPI basket, food, commodities and energy prices have been rising
the most aggressively. Manufactured product inflation, a crude measure of core inflation in the
Indian context has also moved up over the last two months, but again a decomposition of the
same shows that commodity heavy sectors have been the main culprits. Products that are more
intricately associated with domestic demand conditions have been more subdued.
Further validation of our view comes from the fact that monetary aggregates are also starting to
ease in line with growth. Non-food credit is tapering off and has contributed to an improvement in
the loan-deposit ratio. Similarly, the recourse of banks to the RBI’s liquidity adjustment facility has
come off sharply. Though part of this is explained by the resumption of government spending via
a draw-down of cash balances, slowing demand for credit has also contributed.
We are also aware that it will take some time for this divergence between inflation and growth to
close. Inflation persistence in India tends to be high and there is little certainty around commodity
prices. That said, the RBI has already assumed that inflation will remain sticky in H1FY12 at
around 9%. We believe this is a realistic estimate and considers some adjustment in fuel prices.
Slower growth can be ill-afforded by Indian policymakers particularly considering the difficult fiscal
position. As we have discussed in previous notes, meeting the FY12 fiscal deficit target of 4.6%
of GDP is contingent upon (1) a rise in tax buoyancy; (2) meeting a lofty disinvestment target of
INR400bn and (3) containing the subsidy bill. In this context, the government had included an oil
subsidy outlay for only three quarters of consumption and probably assumed oil prices to be at
USD85/barrel. A slippage is pretty much guaranteed but even so, limiting it will require that the
tax collection target which is growth dependent is met. The FY12 budget was based on real GDP
estimate of 9%.
Even in the unlikely absence of a fiscal slippage, we think that monetary policy will need to be
supportive to support the existing government borrowing programme. In this regard, though the
aggregate borrowing size is lower than in FY11,
So what should monetary policy look like? Our current forecast is for further cumulative tightening
of 50bps and in single steps of 25bps. We now think this is the outer limit and the RBI may well
stop after one more rate hike. Price action in the OIS curve, though exaggerated by fall in US
treasury yields is also indicating a reassessment of rate hike expectations.
Away from that, we think the RBI may step in to support the government borrowing programme
via open market operations, possibly in H2 FY12. In the absence of open market operations (as
was the case last year), overall system liquidity could tighten sharply again. In the pre-Lehman
period, such support was necessary as BoP surpluses were sizeable and the fiscal deficit was
low. Post-Lehman BoP surpluses have become much smaller and ensuring reserve money
growth has required an increase in RBI support to the government. Figure 7below shows the
changing composition of base money and the underlying BoP balance.
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