After the year-on year (y-o-y) Index of Industrial Production (IIP) growth figure for April came in at 17.6 per cent and the Wholesale Price Index (WPI) inflation for May at 10.16 per cent, the Reserve Bank of India (RBI) would, under normal circumstances, have acted post-haste to clamp down on inflation. However, two factors caused it to stay its hand in June, when an inter-meeting rate hike was widely expected: a liquidity deficit in the domestic banking sector and the flaring up of the European credit crisis. Ultimately, responding to inflationary pressures, RBI raised the repo rate (the rate at which it lends short-term funds to banks) by 25 basis points (bps) from 5.25 per cent to 5.50 per cent on July 1. It also raised the reverse repo rate (the rate at which it absorbs liquidity from the system) from 3.75 per cent to 4 per cent.
First, let us look at the factors that are exerting upward pressure on interest rates.
Inflation-sticky and widespread
The WPI inflation figure for May (10.16 per cent year-on-year) exceeded consensus estimates that were pegged at around 9.5 per cent. What is cause for worry is that when the revised estimates for May come in, they could be even higher: the revised estimate for March has already been raised from the original 9.9 per cent to 11 per cent.
The May figure brought home the fact that it is not food shortage (a supply-side factor) that is now driving inflation. What we are now dealing with is core inflation caused by rise in prices of manufactured articles (excluding food and fuel). This type of inflation is driven by demand-pull factors, tends to be sticky, and can be difficult to dislodge once embedded in the system. According to Samiran Chakraborty, head of research at Standard Chartered, “Inflation has turned uglier in India. Food prices are not falling fast enough while the prices of manufactured goods are rising rapidly.”
Food inflation held firm at 11.8 per cent. However, it has been declining since December 2009 when it was as high as 21.6 per cent y-o-y. When you examine food inflation at the disaggregated level, you get mixed signals. While prices of rice, wheat and sugar are declining month-on-month, those of pulses continue to rise. Vegetable prices, which had been falling, rose again in May.
Meanwhile, core inflation (in manufactured goods) has now shot up from 1.6 per cent in December 2009 to 8.1 per cent in May this year. In May seven of the 11 subgroups within manufactured goods registered price increases of more than 1 per cent month-on-month (m-o-m), underlining the widespread nature of manufacturing-sector inflation. Iron and steel, minerals, cotton textiles, man-made textiles, chemicals and wood products all showed strong inflationary pressures during May. Several factors are causing the upswing in core inflation: one, rising domestic demand is enabling companies to charge higher prices; and two, in some sectors capacity constraints are pushing prices higher.
After the high WPI number for May, economists have revised their estimates for average WPI inflation in FY11: these estimates now range from 7.5 to 8.5 per cent.
The following variables will determine whether inflation moderates in future:
Base effect. The base effect will remain unfavourable till August 2010. According to a note from Standard Chartered, the favourable base inflation could pull WPI inflation as low as 5.5 per cent by the end of FY11.
Monsoon. A favourable monsoon could ease food inflation. However, despite a good harvest, structural factors, such as high MSP (minimum support price), will not allow prices of many food products to fall beyond a point.
Slower global recovery. Global growth is likely to slow down in the second half of 2010. This is expected to cause prices of some commodities to soften marginally before they begin to rise again in 2011. For instance, steel prices rose rapidly from January to early June, but are expected to increase only moderately in the second half of FY11.
Growth well embedded
IIP rose by 17.6 per cent y-o-y in April compared to the revised 13.9 per cent in March. This was again higher than the consensus estimates of 13.5 per cent by Reuters and 14.3 per cent by Bloomberg. Sequentially IIP rose 3.4 per cent m-o-m.
The biggest contributor to the sharp rise in IIP was the capital goods index, which rose a whopping 72.8 per cent y-o-y and 31.4 per cent m-o-m. Another large contributor was the consumer durables index which rose 14.5 per cent y-o-y and 0.5 per cent m-o-m. Fifteen of the 17 industry groups showed positive growth, the highest growth coming from sub-sectors such as machinery, equipment and transport goods.
Based on April data, HDFC chief economist Abheek Barua has revised his industrial growth projection for FY10 from 8.5 per cent to 9 per cent now. Says Barua: “We had expected IIP growth to slip into single digit by June, but this has not happened due to higher than expected traction in capital goods and consumer durables. Industrial growth has also become quite diversified.”
Liquidity tight
In the normal course, with growth well entrenched and inflation in double digits, RBI would have hastened to revise interest rates upward. However, it did not do so throughout June due to the tight liquidity situation within the banking system. This tightening has occurred because the telecom players who have won the auctions for 3G spectrum have to pay Rs 67,700 crore to the government. A large part of this money has been borrowed from banks. Another Rs 38,500 crore has gone towards broadband wireless payments.
Advance tax payments by corporates have also drained the system to the tune of Rs 30,000-35,000 crore. Altogether about Rs 1,40,000 crore will exit the banking system in June on account of these three payments. All these outflows have pushed the overnight interbank call money rate past the repo rate. From a liquidity surplus situation it today finds itself in the midst of a liquidity deficit.
Barua estimates that credit growth is likely to rise to 19 per cent by September end while deposit growth is unlikely to match this pace. Therefore, even though surplus liquidity will be available, it is likely to be of the magnitude of Rs 20,000-25,000 crore. Says Barua: “The implication of this lower liquidity surplus is that it removes the need for monetary tightening through further increases in the cash reserve ratio (CRR).” He further suggests: “The only way the government can restore liquidity is by enhancing its expenditure. It could either launch new schemes or disburse money faster to existing schemes. Another way it could ease the liquidity situation is by delaying its borrowing programme.”
Bleak external situation
Another factor that caused RBI to delay its rate hikes is the weak external situation. The flaring up of the sovereign debt crisis in Europe has increased risk aversion among global investors and led to outflow of foreign funds from Indian stockmarkets.
Responding to inflationary pressures, RBI hiked rates on July 1. Rates are likely to remain on the upward trajectory during FY11. However, do not get unduly worried: most economists believe that the quantum of hikes will not exceed 100-150 basis points during the rest of FY11.
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