India: IP plunges but it’s not as bad as it looks ::JPMorgan

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India: IP plunges but it’s not as bad as it looks; RBI still likely to hike

July IP plunges to 3.3 % oya from 8.8% in June but the headline overstates the weakness because the fall is driven primarily by a sharp decline in the volatile capital goods sub-component Instead, ex-capital goods, July IP prints at 6.7% -- the highest growth in 4 months Three-month-moving-averages show that IP growth is slowing from the beginning of 2011 but not collapsing India’s sizzling export growth finally moderates in August, in line with global cues and falling new orders Import growth also moderates but continues to be strong resulting in a sharp widening of the monthly trade deficit A widening trade deficit, elevated global stress and idiosyncratic local factors have caused the INR to significantly under-perform the ADXY in recent weeks With the August inflation print (out on Wednesday) likely to remain elevated and show a re-acceleration over July, the RBI is expected to see through today’s IP print, and raise policy rates by another 25 bps on September 16   IP plunge driven primarily by volatile capital goods   July IP plunged to 3.3 % oya (-1.9 % m/m, sa) from 8.8 % in June and significantly below market expectations (JP Morgan 4.7%, Consensus 6.2 %). However, the print is not as bad as it looks because it was driven primarily by a plunge in capital goods production (-15.2 % oya, -18% m/m, sa). Recall, capital goods have been notoriously volatile over the last year resulting in sharp swings across months. Much of this is because private corporate investment continues to be anemic, and capital goods production is being driven by infrastructure projects which are typically lumpy and volatile themselves. As such, while capital goods constitute less than 9% of the IP basket, large monthly swings have unduly influenced the headline rate. Last month, for example, capital goods surged 14.2 % m/m, sa boosting the headline rate to 8.8% oya. In contrast this month, capital goods gave all of their gains pulling the headline rate down with it. What today’s numbers also revealed was that the expectation that the private capex cycle was picking up (supported by two surges of capital goods production within the IIP in the last four months and rising non-oil imports) was belied by today’s data.   In light of the capital goods production volatility, a better measure to gauge the trend of industrial activity is to look at a three month moving average (3mma) as well as the IP index without capital goods. Both these measures reveal an economy where industrial activity may be slowing but not collapsing. Specifically, on a three-month-moving average (3mma) basis, IP growth slowed to 6% oya from 6.7% the month before and down from 7.4 % oya in January.   Ex-capital goods, IP growth rose to 6.7% oya in July, the highest in 4 months. On a 3mma basis, July growth also increased to 5.7% compared to 5.1 % in June and was only marginally below the 6% in January 2011. In sum, today’s headline print of 3.3% overstates the industrial sector’s weakness.     Basic goods and consumer durables demonstrate renewed resilience   In contrast to capital goods, consumer durables showed renewed resilience, growing 8.4 % m/m, sa (8.6 % oya) after declining sequentially for three of the last four months. Consumer durables have certainly slowed in response to the rate hikes (the 3mma has fallen to 5.1 % oya from 9.3 % oya in January), but today’s number suggests that they have not completely collapsed like two of the last three data points seemed to suggest. However, consumer non-durables did not demonstrate the same resilience, declining 2.3 % m/m, sa from the previous month.   In addition, basic goods (which comprise almost half the IP basket) had a particularly strong month (3.4 % m/m, sa, 10 % oya) and growth for this sub-component, in contrast to the other sub-components, has actually accelerated mildly over the last year.         Trade deficit widens as exports began to moderate ….finally   After sustained strength over the last two quarters, India’s merchandise export growth finally began to moderate in August, consistent with weakening global cues and falling new export orders within the manufacturing PMI. Specifically, provisional August data suggests that exports declined 11.1 % m/m, sa but this comes on the back of strong sequential increases over much of the last year. A weak base from last August meant that the year-on-year growth rate was still healthy at 44.2 %.   Imports, too, declined sequentially but less so than exports (-7.8 % m/m, sa) and continue to stay at a relatively elevated level consistent with the fact that growth is moderating slowly and sustained elevated inflation levels at home are inducing firms to increase imports in lieu of domestic production.   As a consequence, the monthly trade deficit rose sharply to $14.1 billion from $11.1 billion the month before and $7.7 billion in June and thereby contributed to pressurizing the rupee INR (see below)     INR underperforms as trade deficit widens and global stress rises   Despite demonstrating remarkable resilience over much of the last year, the INR has significantly underperformed the ADXY over the last six weeks. The underlying factors are both external and domestic.   The INR typically underperforms the region during periods of global stress on negative sentiment given India’s need to finance its current account deficit, in contrast to the current account surpluses of its Asian neighbors. Heightened global uncertainty in the US and Europe and corresponding FII outflows from India over the last six weeks has seen this phenomenon play out again.   Compounding this phenomenon are domestic issues. A rising trade deficit in August likely put further pressure on the INR and this same phenomenon is likely at play in the first half of September. If all this was not enough, local idiosyncratic factors added to the pressure, with oil-payments of $5 billion finally being paid out to Iran in August after the political impasse was resolved.   The INR weakness could persist in the short-run because (i) global uncertainty is likely to remain elevated in the near-term as concerns over peripheral Europe and Greece rise, and (ii) the trade deficit could stay at elevated levels until growth slows further to quell import demand and inflation moderates so that the desire to import-substitute is reduced.   August inflation expected to accelerate over July, likely inducing an RBI hike   The August inflation print, which is out Wednesday, is expected to show a re-acceleration of the headline WPI print from the 9.2 % levels observed in July (August consensus: 9.7 % oya). Furthermore, input prices seem to have re-accelerated in August (both within non-food primary articles of the WPI index and the manufacturing PMI) suggesting that inflationary pressures in the system remain firm, and could further pressure output prices and core inflation in the weeks to come, unless demand is slowed to the point that pricing power evaporates.   It is undoubtedly the case that activity is slowing but, unlike what today’s IP headline print suggests, it is not collapsing. It is also the case that, in line with leading indicators, the slowdown is likely to get more pronounced in the months to come.   All that said, headline and core inflation is significantly above policy-makers’ comfort zone and the tolerance for inflation among policymakers is still low. As such, until there is clear and sustained evidence that activity is slowing to the point that pricing power has evaporated across most sectors, we expect the monetary tightening to continue. We haven’t reached that point just as yet, and therefore expect the RBI to hike policy rates by another 25 bps at its mid-quarter review on Friday.