The Curious Case Of Indian Inflation

BMI View: Despite sluggish economic activity and tighter monetary conditions, headline inflation remains a key concern in India. Acute food price pressures lie at the heart of the problem, which we believe is, to a large extent, a function of expansionary government policy. Absent a major reduction in subsidies and minimum support prices for agricultural goods, both of which are unlikely with general elections nearing, there is a risk that the Reserve Bank of India (RBI) may be forced to keep interest rates tight for longer in 2014, which would in turn stifle economic recovery prospects in the coming 12 months.

In most cases, sluggish economic activity, tighter monetary policy and a multi-year credit cycle downturn would be sufficient to place a lid on headline inflationary pressures. This is far from the case in India, however. On the one hand, the domestic economy continues to stumble, with real GDP still growing at a rather lacklustre sub-5% clip. What's more, the Reserve Bank of India (RBI) remains very much in tightening mode, having hiked the benchmark interest rate by 50 basis points (bps) since August to 7.75%. On the other hand, headline inflation continues to pose a huge headache for policymakers. India's wholesale price index (WPI), the benchmark inflation rate, climbed to an eight-month high of 7.0% year-on -year (y-o-y) in October. At a retail level, the problem is more acute, with the country's consumer price index (CPI) increasing by 10.1% y-o-y in October, the first double-digit rate on record since March.

The breakdown of WPI provides some insight into India's curious inflation problem. It would be inaccurate to suggest that the disinflationary macroeconomic forces outlined above have not had an impact. Manufactured WPI, which is regarded as a proxy for core inflation, has actually been quite well behaved, rising by just 2.5% y-o-y in October (and a monthly average of 2.8% y-o-y since the start of FY2013/14 [April-March]). Instead, the main driver of headline inflation has been surging food prices. Food WPI increased by 14.7% y-o-y in October, the fastest pace in 30 months. Food CPI, meanwhile, came in at a similarly acute 12.3% y-o-y. Many of the key staples of the Indian consumer are experiencing runaway inflation, such as onions (up 278.2% y-o-y), tomatoes (121.9%), and ginger (108.8%).

Food The Main Driver
India - Components Of Wholesale Price Index, % chg y-o-y

BMI View: Despite sluggish economic activity and tighter monetary conditions, headline inflation remains a key concern in India. Acute food price pressures lie at the heart of the problem, which we believe is, to a large extent, a function of expansionary government policy. Absent a major reduction in subsidies and minimum support prices for agricultural goods, both of which are unlikely with general elections nearing, there is a risk that the Reserve Bank of India (RBI) may be forced to keep interest rates tight for longer in 2014, which would in turn stifle economic recovery prospects in the coming 12 months.

In most cases, sluggish economic activity, tighter monetary policy and a multi-year credit cycle downturn would be sufficient to place a lid on headline inflationary pressures. This is far from the case in India, however. On the one hand, the domestic economy continues to stumble, with real GDP still growing at a rather lacklustre sub-5% clip. What's more, the Reserve Bank of India (RBI) remains very much in tightening mode, having hiked the benchmark interest rate by 50 basis points (bps) since August to 7.75%. On the other hand, headline inflation continues to pose a huge headache for policymakers. India's wholesale price index (WPI), the benchmark inflation rate, climbed to an eight-month high of 7.0% year-on -year (y-o-y) in October. At a retail level, the problem is more acute, with the country's consumer price index (CPI) increasing by 10.1% y-o-y in October, the first double-digit rate on record since March.

Food The Main Driver
India - Components Of Wholesale Price Index, % chg y-o-y

The breakdown of WPI provides some insight into India's curious inflation problem. It would be inaccurate to suggest that the disinflationary macroeconomic forces outlined above have not had an impact. Manufactured WPI, which is regarded as a proxy for core inflation, has actually been quite well behaved, rising by just 2.5% y-o-y in October (and a monthly average of 2.8% y-o-y since the start of FY2013/14 [April-March]). Instead, the main driver of headline inflation has been surging food prices. Food WPI increased by 14.7% y-o-y in October, the fastest pace in 30 months. Food CPI, meanwhile, came in at a similarly acute 12.3% y-o-y. Many of the key staples of the Indian consumer are experiencing runaway inflation, such as onions (up 278.2% y-o-y), tomatoes (121.9%), and ginger (108.8%).

Favourable Monsoon Does Not Necessarily Mean Favourable Prices
India - Monsoon Rainfall Versus Agricultural Output (LHS) & Food WPI (RHS)

That food inflation is rising rapidly despite relatively subdued global commodity prices and a favourable monsoon is particularly alarming. On the former point, we note that the S&P Goldman Sachs Agricultural Index is actually down 24.1% y-o-y at the time of writing. Meanwhile, according to the Indian Meteorological Department (IND), the 2013 monsoon season, which runs from June to September, delivered 6% higher rainfall than the long-term average. All else being equal, this should be positive for Indian crop production. Indeed, the chart above shows a reasonably strong linear correlation between monsoon rainfall and agricultural output, using data going back to 1980. However, it is striking that favourable rainfall does not necessarily translate into falling food inflation, with both these factors showing no correlation whatsoever ( see chart).

India - Minimum Support Prices For Key Commodities, INR/tonne
2009/10 2010/11 2011/12 2012/13 2013/14 2014/15
Wheat 10,800 11,000 11,200 12,850 13,500 14,000
Barley 6,800 7,500 7,800 9,800 9,800 11,000
Chick Pea 17,600 21,000 28,000 30,000 31,000
Lentils 18,700 22,500 28,000 29,000 29,500
Rapeseed & Mustard 18,300 18,500 25,000 29,500 30,000
Soybean 13,700 14,200 16,500 22,000 25,146
Rice (common paddy) 10,000 10,000 10,800 12,500 13,100
Corn 8,400 8,800 9,800 11,750 13,101
Source: BMI, Food Corporation of India

We believe that the pervasiveness of food price pressures is, to a large extent, a function of expansionary government policies. Given that weaker global prices and strong crop output should ordinarily be price-negative, other factors appear to be in play. Firstly, food subsidies have played a major role in keeping prices high and leading to poor distribution of agricultural produce. Food subsidies currently account for more than one-third of the total subsidies, and are on course to exceed the already-generous budget targets. As the accompanying chart shows, the government ploughed its way through INR689.6bn (or 75.7%) of its full-FY2013/14 food subsidy budget of INR910.9bn in just six months of the year. Meanwhile, minimum support prices afforded to farmers across a number of key commodities are being raised aggressively ( see table). Both these policies are inherently inflationary in nature, as they keep the fiscal deficit high, distort supply-side dynamics, and provoke major wastage of production.

Subsidy Overspend
India - Central Government Food Subsidies Versus Budget Target

With elections around the corner, it appears unlikely that the government will reverse course on such measures anytime soon. The United Progressive Alliance (UPA) is facing a major challenge to its decade-long leadership at the ballot box in 2014, and policies such as agricultural price guarantees and food subsidies typically strike a chord with India's rural communities, which remain the bedrock of the coalition's support base. With this in mind, a reversal of such measures is unlikely. In fact, the UPA's plan to implement the National Food Security Bill, a legal food entitlement for 67% of the population at a cost of INR400bn, will ensure that the subsidy bill continues to rise materially (and that the supply picture will continue to be distorted by unwieldy procurement processes).

Rate Cuts To Face Delays

Food price pressures typically fall outside the purview of traditional monetary policy, meaning that there is solid case to be made for the RBI to keep rates on hold even as headline inflation bites. However, since his appointment in September, RBI Chairman Raghuram Rajan has established extremely hawkish credentials, meaning that there remains a risk of one more 25 basis point rate hike in December. One of the central bank's key concerns is that rising food price pressures lead to a contagionary impact on core inflation, keep downside pressure on the currency, and undermine medium-term price expectations. Indeecd, according to the RBI, inflation expectations are rising sharply, with the latest survey showing that households expect a 13.5% mean CPI rate in 12 months time. With this in mind, we are pushing back our rate cut expectations. We now expect the central bank to remain on hold at 7.75% for the rest of FY2013/14 (albeit with the possibility of one more hike in December), before delivering monetary easing worth 50bps in the following fiscal year. The prospects for a prolonged period of tight monetary policy could therefore undermine India's economic growth recovery prospects over the coming 12 months.

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This article is tagged to:
Sector: Country Risk, Agribusiness
Geography: India
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