Parsing India’s inflation ::JPMorgan

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Parsing India’s inflation

India’s sluggish policy response to the ongoing 19 month long inflation scare largely reflects a misreading of the drivers of inflation. Rather than a consequence of unfortunate supply shocks, inflation was an unsurprising consequence of loose monetary and fiscal policies pushing the economy to grow beyond its capacity. The global economy is slowing and so is domestic demand in India. However it is unlikely that the moderation in global demand will be sufficient to slow activity in India and bring down inflation. And so the likely 25bps rate hike next Tuesday will not be the end of India’s monetary tightening cycle. The inflation scare in Asia now appears to be fading. Headline rates in most Asian economies are rolling over. Even in China, where the inflation reached a new cycle-high driven by food prices, the headline rate is expected to come off in the next few months. A slowdown in the global economy in the coming quarter and the policy-driven moderation in domestic demand in Asia appear to be driving the disinflation. The one exception to this general theme in EM Asia is India. Instead of showing any signs of abating, headline inflation in India has risen to 9.4% (in reality over 10%, given the now-customary 0.8 to 1% upward revision that comes two months later). The other major exception in the EM world is Brazil where inflation indexation and tight capacity and labor market conditions have kept inflation uncomfortably high despite several rounds of policy rate hikes. It isn’t that demand in India is not moderating. It is. IP, auto sales, PMI all point a slowdown. The recent surge in export and non-oil import growth (the latter indicating a much awaited upturn in private investment after languishing for more than two years) is also expected to slow as the global economy moderates. The problem is that slowdown may not be enough to bring down inflation in India given the tight capacity and the still relatively loose policy. Consider the following: back in January 2010, headline inflation was 8.7%, food inflation was a scary 19.8% and core inflation a benign 3.7%. Between then and now, there have been 10 rate hikes totaling 275 bps and two bumper harvests. All that has changed is that headline inflation is higher and core inflation has replaced food as its main driver. So how did India get here? There were two interrelated factors at play: a misreading of the underlying drivers of inflation and because of that a slow policy response that hardened inflationary expectations and has sparked off a generalized inflation. This happens in every economy and India did not turn out to be the exception policymakers hoped it would be. Misreading the drivers of inflation Ask any policymaker (government or the central bank), analyst, or India observer what is India’s “normal” inflation rate and the answer will be 4-5%. So why has inflation been persistently higher than that level for the last two years? The widely held view is that the weak monsoon of 2009 triggered the rise in food prices which combined with coincidental supply shocks (e.g., volatile global commodity prices) raised headline inflation. There are two problems with this argument. First the current cycle is the longest (19 months and counting) during which the headline rate has remained above the 5% level. This is well beyond the typical impact period of a bad monsoon. In fact in 2010 with the return of normal weather both the summer and winter crops were exceptionally strong. And second even before the market had any suspicion that the 2009 monsoon would be weak food inflation had already crossed into double digits. Food inflation last printed below 5% back in February 2008. Indeed except for four months, Nov 07-Feb 08, food inflation has been persistently above 5% since October 2005! A more convincing argument is that as growth moved to the 8-9% range from 2003 onwards and persisted, households began to believe that the income growth was permanent. With the rise in permanent income consumption growth followed. As initial incomes were low, the growth in consumption manifested strongly in rising food demand. Supply side factors such as decrepit distribution networks, falling agricultural productivity, the government’s reliance on farm transfers rather than increased agricultural investment all contributed, but these were at play well before 2008. The big change was the very sharp increase in demand whose impact was worsened by the weak monsoon of 2009. Improved supply is the solution, but given the persistence and size of the demand-supply gap this will need deep reforms, including in land rights, a new generation of technology, vastly improved distribution networks. These take time. Core inflation really matters So if it wasn’t food prices what kept headline inflation manageable? It was core inflation. And this was kept low by the surge in investment (from 24% of GDP in 2002-03 to 38% of GDP by 2007-08) that continually added to industrial capacity. One can see this in stark terms by comparing the experiences of China and India. Over the period Jan 2000 to Jun 2011, China’s headline inflation averaged 2.1% while that of India 5.8%. This large difference, however, is not because of food inflation. If one plots each economy’s distribution of food price shocks it is hard to pick one from the other. What has been the big difference is core inflation. India not only had a much higher average core inflation (5% compared to China’s 0.34%) the price shocks were much bigger (a fat right tail in the distribution). And this is because India, despite its strong investment growth, has remained a capacity constrained economy. On the other hand, industrial capacity in China, except for episodic power shortages, has typically been much easier because of its higher investment. But in the post-Lehman period private investment in India stuttered. Not because capital cost was high, in fact funding cost is still substantially lower than in the pre-Lehman period but because of Indian corporates’ concerns over the sustainability of global and domestic demand. Problems with governance and corruption may have played a role but it was a 4Q10 story. In the aftermath of the global crisis, the government stepped in with massive fiscal stimulus packages and the RBI cut rates 425 bps. This helped to lift overall investment briefly but non-infrastructure private investment languished. India’s SME’s were too shell shocked from the global crisis and credit constrained to restart their expansion plans and the larger corporates saw it in their interests to use this opportunity to diversify globally rather than in India. And with no discernible addition to industrial capacity, supply constraints began to bind as IP driven by a rapidly recovering export sector rebounded strongly in 2010 opening up a large output gap. An ironic aside Here too a comparison between China and India is interesting. In the period just before the global crisis of October 2008, India was a supply constrained economy with underinvestment being its most pressing problem. China was a demand constrained economy with curbing overinvestment the war cry of macroeconomic policy. Then Lehman occurred and in the face of a collapsing global economy both countries pushed out massive fiscal stimulus. And here is the ironic bit. If one looks at the distribution of the respective packages, each government loaded it heavily towards what they were most efficient in doing not towards the more pressing constraints. India’s stimulus package contained largely consumption boosting measures and China’s mostly investment measures. So the under investment in India and the under consumption in China, while alleviated by the crisis stimulus, are yet to be fully addressed. The sluggish policy response Back to India. However, instead of seeing the rising inflation as an aggregate demand problem, the authorities (both fiscal and monetary) convinced themselves that the inflation was a consequence of unfortunate and coincidental supply shocks. And so the government and the central bank spent much of 2010 assuring the public that the inflation was temporary and that it would go away soon enough as the supply shocks reversed. The central bank raised rates but with none of the urgency or aggression that was warranted, while the government went on pumping even more stimulus into the economy mostly in boosting consumption. With every passing month as the data unerringly surprised expectations on the upside and the authorities kept raising its inflation targets, the assurances increasingly unconvincing. By not seeing the driver of inflation for what it really was—an unsurprising consequence of loose monetary and fiscal policies pushing the economy to grow beyond its capacity—policy allowed food inflation to fester for 18 months. And the inevitable occurred. Inflationary expectations hardened and wage inflation picked up, sparking a generalized inflation. India stands today staring at a double-digit headline inflation that is threatening to rise even further. Is India now more tolerant of inflation? A niggling concern is that perhaps the sluggish policy response was not so much a misreading of the underlying drivers but a manifestation of the government’s increased tolerance for inflation. In other words in the perennial trade-off between growth and inflation, the government may have moved from their previously resolute abhorrence for inflation to a stronger liking for growth. But in democracy the government doesn’t really choose this trade-off. It reflects the preferences of its constituents. So has India become more tolerant of inflation? Prima facie evidence would suggest so. Food inflation has been continually above the 5% norm for the last 27 months and in between over 20% for the first half of 2010. And this in a country where acute poverty is still rampant. Yet there was no blood on the streets! Some would argue that the government’s rural unemployment scheme (NREGA) tempered the impact of rising food prices. While the NREGA has provided income support it is unlikely to have been quantitatively large enough to be the sole explanation. Leakages from the NREGA program in several states are allegedly very large and a significant portion of India’s poor live in urban areas who are not covered by fiscal transfers. A closer look at policy indicates that there hasn’t really been an increase in authorities’ inflation tolerance. Consider the RBI’s policy response. Once it was clear that even after the 2010 bumper winter harvest inflation rate wasn’t coming down and instead core inflation was picking up, the RBI in its May 2011 policy statement quickly acknowledged that demand was the main driver of inflation, inflation expectations were coming unhinged, and that that near-term growth would need to be sacrificed to curb inflation and safeguard medium-term growth. With the turnaround in its reading of inflation the RBI shrugged off its inertia of hiking rates in “baby steps” of 25bps and instead hiked policy rates 50bps. Those were the clearest signals yet that RBI was not afraid to turn on the heat when needed. The government too echoed this concern in highlighting that growth would be slower and in the FY13 budget programmed an ambitious fiscal adjustment, which even with a possible slippage of 0.5% of GDP due to increased oil subsidies, should deliver nearly 1% of GDP in fiscal consolidation. Where do we go from here? Back in March 2010 we had argued that inflation in India was driven by demand pressures more than supply shocks and that it was turning sticky (see “India: inflation turning sticky,” Special Report, JP Morgan, March 26 2010). We had forecasted that headline rate would end around 7.5% in Mar 11, higher than the official forecast of 5.5%. At that time it was an extreme view in the market with the global outlook pretty murky. But reality turned out to be worse than our fears. Mar 11 inflation ended at 9.7%! At the eve of another monetary policy review next Tuesday things look as murky. Headline inflation is in reality above 10%, core inflation is picking up, but the economy is slowing and global risks are decidedly on the downside (growth in US, Euro area, China have all been downgraded recently). In 2008 luck (the global financial crisis) more than anything else, brought an end to India’s runaway inflation. So will the moderation in global demand be sufficient to slow activity in India and bring down core inflation without further policy tightening? Right now it doesn’t look like it. The fact that core inflation is rising suggests that producers still have sufficient pricing power to pass on cost increases to consumers. This is a tell-tale sign that domestic demand remains strong. Investment is starting to turnaround but it will take time to add to capacity and release the pressure on prices. Many have been hand wringing over the rising cost of funding and how this is stifling investment and credit growth. Reality is somewhat different. The real 1Y AAA corporate rate which is reasonable proxy for the lending rates have just turned barely positive and it is significantly lower than what used to be the situation in 2006-07. Another way of assessing the stance of monetary policy is to look at the gap between real GDP and real rates. The gap acts as a proxy for profitability. Higher the gap, ceteris paribus, higher the profitability. Again profitability remains higher than the entire period 2005-09 measured against a variety of lending rate proxies. Investment isn’t happening as strongly as one would have hoped and because of that credit growth is slow. But high interest rate isn’t the reason. So India will need to slow growth further and rebalance the economy towards relying more in private investment rather than consumption if it intends to avoid a hard landing. In the last six months the Reserve Bank of India’s (RBI) survey of inflation expectations has moved relentlessly upwards despite the 10 rate hikes. Underscoring yet again that once the expectations genie is out of the bottle, it is very difficult to contain it without audacious policy changes. Will the RBI move audaciously next Tuesday and raise rates 50bps? This would truly shock market expectations. We don’t think so given the corporate pressure against any rate hike on fears of slowing activity further. Instead the RBI is likely to take the middle path and raise rates 25bps with continued hawkish language. But what looks reasonably certain is that the fat lady hasn’t sung just yet and the monetary tightening isn’t over.