>India: risk of aggressive tightening (DBS)

Summary
Despite the recent surge in manufacturing sector growth, our assessment of India’s growth prospects remain largely unchanged. We continue to expect GDP growth of 5.7% in FY09 (ending Mar10) and 7.5% in FY10. Yet we believe price data, including food price data, betray a buildup in underlying inflationary pressure that is non-transient. We also believe the Reserve Bank of India (RBI) will not regard such pressures as transitory food price or supply-side blips. As a result, we continue to expect the first rate hike in Jan10, well ahead of consensus’ expectations. Moreover, we see rising upside risks to our forecast for 200bps of rate hikes in 2010.

At the quarterly policy meeting next Tuesday, we expect the prevailing hawkish tone to be raised another notch and expect clearer signals that rate hikes are imminent. To be sure, the central bank’s indicative inflation projection for Mar10 would have to be raised from the current 5% YoY rate to be credible (we expect inflation to cross 6% by Mar10). The forecast change itself would be a signal that rate action is imminent implying, as it would, inflation in excess of the RBI’s comfort level of 5%. Furthermore, the statutory liquidity ratio (SLR, the minimum share of bank deposits to be held in government bonds, cash, gold etc.) could be hiked as early as next week. We do not rule out a 1 percentage point hike in the SLR rate to 25% reversing the 1 point cut implemented in Nov08 (the rate had been held at 25% for 11 years before last year’s cut). Such a move could also point to imminent rate action.

Recent growth momentum - picking up, but, in part temporary
Industrial production recorded a double-digit rise in year-on-year terms in Aug09 (10.4%), drawing attention to the economy’s surprisingly strong growth momentum. To be sure, manufacturing sector growth is stronger than what was anticipated at the start of the year but this is already factored into our current GDP forecasts. Also, our reading of the current growth spurt is that it is in part temporary and a result of pent-up demand (steep rate hikes followed by the global financial crisis dragged down consumption), and that growth should moderate soon. This is also evident in the graph of industrial production levels (graph, previous page). Manufacturing sector GDP grew by 22% (QoQ, saar) in 2Q09 and we estimate 3Q09 manufacturing growth at 12%. We expect manufacturing growth to slow to around 7% in the quarters ahead. The expected slowdown is already evident in the monthly data for consumer durable goods (graph, previous page).

This correction should keep GDP growth in line with our 5.7% forecast for FY09 and 7.5% FY10 (the non-agriculture GDP growth forecast underlying this GDP forecast is about 7.2% and 7.9% respectively). Even though we do not foresee growth quickly returning to the 9% rate that prevailed in recent years, for purposes of monetary policy and inflation forecasting, it should be noted that the slower pick up in growth is in part due to supply constraints, especially in infrastructure and hence cannot be deemed as materially below-potential. Indeed, the RBI acknowledges that the economy is supply-constrained.

Rising inflation - is it supply-side?
Wholesale price (WPI) inflation has begun climbing rapidly in year-on-year terms in recent weeks and is also leading to worries about earlier rate hikes. In fact, prices have been rising rapidly since March. The month-on-month seasonally adjusted and annualized growth rate (MoM, saar) has been running at an average rate of 7.5% since Mar09 and it is now reflected in higher on-year rates. The latter has begun to climb since August and has printed 0.9% (YoY) as on Oct 3, from a low of -1.5%, hit on Aug 8. According to our calculations, WPI inflation should cross RBI tolerance level of 5% (YoY) by Dec09 and cross 6% by Mar10 (graphs, below). While on-year inflation might decline after Mar10, it should remain elevated at about 5%, with risks to the upside. At the same time, consumer price (CPI) inflation, which has been elevated since 2008, accelerated in recent months. In Aug09, CPI inflation recorded double-digit gains in both on-year and sequential annualized terms. In fact, CPI has exhibited a rising trend each year since 2006, driven especially by rising food prices.

As always, the question is whether inflation is supply-side and/or temporary in nature or whether it reflects persistent excess demand pressures. On the surface, there are reasons to believe that inflation is not demand-led. After all, growth is not at the scorching 8-9% rate now and food prices are one of the key drivers of inflation, at present. However, our reading of the price situation is that underlying inflationary pressures are building up and warrant early rate action. We believe that the underlying rate or core rate of inflation is around 5% already and risks rising further, especially in 2H 2010, as growth picks up further. In fact, there is a rising risk that 150bps of rate hikes in 1H09 is insufficient to cap inflation and further rate increases are needed in 2H10, beyond the 50bps we have pencilled in for 2H10. It is, therefore, important for interest rates to keep pace with growth and rising inflation risks, and hence vital that the RBI starts normalizing rates from Jan 2010.

Proxies of underlying or core inflation
Two simple proxies of the underlying or core rate of inflation are WPI exprimary articles and fuel (i.e.: manufacturing WPI) and CPI ex-food and fuel. CPI inflation has generally been viewed as the less preferred measure of the two by the government and the central bank. This partly owes to the lack of a single national measure of consumer prices and the narrower basket of goods in the latter. Both WPI and CPI measures of core inflation point to material underlying inflationary pressure. Core WPI has averaged 6% (MoM, saar) in Mar-Sep09 while core CPI (for industrial workers) has averaged 5.5% (MoM, saar) in Mar-Jun09 (latest available data). In year-on-year terms, core CPI is rising beyond 6% while core WPI is still depressed due to basis effects (graphs, below). The interpretations from these data though are only as good as the data themselves. CPI excluding food and fuel has the disadvantage of excluding nearly half of the consumption basket. WPI manufacturing, on the other hand, is influenced by commodity prices. For this reason, the government does not announce any official measure of core inflation, and the central bank considers WPI manufacturing as merely a proxy of core (and doesn’t discuss core CPI).

To see the full report: RISK OF AGGRESSIVE TIGHTENING