>WHEN YOU KNOW WHERE ECONOMY IS HEADING, YOU KNOW WHAT TO DO

■ EELII (Edelweiss ET Lead Indicator Index) keeps moving north
The Edelweiss ET-Now Lead Indicator Index (EELII), which is a composite weighted average index of a number of macro-variables exhibiting strong predictive ability of the core trends in the Indian economy, continues to strengthen. EELLII has been closely predicting the upturn in the economic cycle during the past few quarters. From a trough of ~73 in Q4FY09, EELII reached ~115 by Q4FY10. During FY10, thus, EELII records a growth of ~42 points – the highest in this current decade.

For April 2010, the value of EELII stands at ~121, up significantly from ~79 in April 2009. A value of ~100 for EELII suggests non-agriculture GDP growth of ~9% Y-o-Y.

■ Current uptick broad based, driven by multiple factors
Each of the lead variables constituting the index affects the real economy with different lead periods. For example, as per our model, the effect of change in policy interest rates (repo rate) is most pronounced on the economy with a lead of ~9-12 months, while the impact of change in commercial vehicle production is the highest with a lead of around three months. EELII has historically predicted non-agriculture GDP growth closely; the adjusted coefficient of determination (adjusted R-squared) for the multiple regression is over 0.80.

The uptick in EELII in the recent months was driven the most by strong production of commercial vehicles, cement dispatches, pick-up in non-oil imports, continuation of resource mobilisation in the domestic primary market and a reasonable interest rate scenario.

■ Third quarter macro developments map uptick in EELII
In the previous releases, EELII had indicated that non-agriculture (industry and services) growth would be over 9% in Q3FY10. The reported growth in non-agriculture GDP comes to ~8% for Q3. On the other hand, the projected growth in non-agri GDP had significantly surpassed the forecast of EELII in Q2. This has largely been due to the lumpiness in the government expenditure that had taken place during Q2FY10 (~13% Y-o-Y), courtesy the second tranche of the Sixth Pay Commission related disbursals, followed by a decline in Q3 (-2.2% Y-o-Y). While the actual non-agri GDP had been higher than projected in Q2 and lower in Q3, if one adjusts the lumpiness in the government spending, the trajectory of non-agri GDP mimics the trends in EELII.

In fact, even in Q3FY10, non-agri GDP (ex-government spending) records a growth of
~10% and is perfectly in line with the path projected by EELII.

Several other indicators coincident with GDP, viz. IIP growth, core sector growth, Purchase Manufacturer’s Index (PMI - India) firmly indicate towards quarterly strong non-agri GDP growth. During this period (October-December 2009), Y-o-Y growth in IIP averaged at ~13%. While some part of this is on account of a low base, substantial contribution to this growth is from pick-up in manufacturing and mining activities. Given the strong uptick in core growth trends in the economy, overall GDP growth for FY10
should ultimately be over 7%.

■ Government policies backing growth well
The government announced the Union Budget for FY11 amidst market speculation of a dilemma between need for focus on (a) growth, and (b) fiscal consolidation and stimulus rollback. Budget managed to do the tight rope walk of reining in the high deficit without hurting the ongoing growth recovery.

Finally, rollback of stimulus turned out to be selective and gradual – excise and customs duties were increased partially, while service tax rate was kept unchanged. Moreover, an effective reduction in income tax will put more money into the hands of consumers. Social sector programmes do not go out of the radar of the government with continuing support for rural employment and rural infrastructure. Overall, government did not resort to any severe fiscal policy contractions, keeping a steady eye on supporting broad-based growth recovery. While on one hand the gradual unwinding of the stimulus signifies that government is confident of growth, the budget also underscores the caution of policy-makers to ensure that the recovery momentum does not lose steam.

■ Monetary action to be slow but steady – “staying behind the curve” may be the preferred choice
Given the continued positive surprises on GDP and IIP fronts, inflation staying high, and current policy rates being far lower than their “steady state” levels, we expect the RBI to be cautious, start hiking policy rates at a slow pace from April 2010 onwards. However, such hikes will definitely be gradual - RBI will refrain from taking any hasty move based on point–to-point data releases. Such a tightening at the moment will not be a shocker as (a) a hike in policy rates will indicate RBI’s confidence in robustness of the economic recovery, and (b) even after the first few hikes, policy rates will still stay far below their “steady-state” levels (e.g., long-term average level of repo rate in India is ~6.0-6.5%). We think, both repo and reverse repo rate will witness a cumulative tightening of 100-125bps during FY11.

To read the full report: LEAD INDICATOR INDEX