India Monthly_March 2011
- 1. 14 November 201614 November 2016 ROBUST GROWTH DESPITE HIGH INFLATION INSIGHT: INDIAS INFLATION Indias March inflation forecasts for headline WPI have been revised to a bracket of 7.7% 7.2% and to remain stable closer to 7% for the remainder of 2011. The cause of the higher forecast for inflation, and the December 2010 increase in WPI inflation to 8.43% y/y from 7.48% y/y the previous month is the persistent structural bottleneck in the agricultural and food industries, which have been unable to keep pace with growing demand. The WPI for food had increased by 18.32% y/y at 25 December 2010 though it had moderated slightly to 11.49% y/y on 12 February 2011, due to government intervention and the reduction of the prices of key fruits and vegetables through state marketing agencies. The government is also considering requests for price ceilings to be enforced on the open market. MACROECONOMIC DEVELOPMENTS The economic growth outlook remains consistent with a forecast of 8.5% in 2010/11, though we are concerned about the long-term effects of a strong rupee on industrial growth and employment The current account deficit continued to widen to 3.7% of GDP in the first half of 2010/11 with no intervention from the RBI. We expect the RBI to enact a policy of currency control if the exchange rate drops below USD/INR44 The RBI increased the repo rate by 0.25% from 6.25% to 6.5% on 25 January 2011. We expect further hikes totalling 0.75% in 2011 The Union Budget for 2011/12 targets a fiscal deficit of 4.6%. The Budget has been bullish for bonds as the borrowing programme has only grown 2.3% The threshold for foreign institutional investor (FII) investment in corporate infrastructure bonds has been raised from US$5bn to US$25bn
- 2. April 2010, appeared to be succeeding when headline inflation hit 7.48% y/y in November 2010. Based on this downward inflation trend, led by lower food and non-food primary articles inflation, we expected Marchs inflation to reach 6% y/y. We concede now that this is unlikely and we expect it to come down to within a bracket of 7.7% 7.2% and remain stable closer to 7% for the remainder of 2011. The upward revision for inflation, and the cause of the December 2010 jump in WPI inflation to 8.43% y/y from 7.48% y/y the previous month is the result of the persistent structural bottleneck in the agricultural and food industries, which have been unable to keep pace with growing demand. The WPI for food had peaked at 18.32% y/y at 25 December 2010 though it had subsequently moderated slightly to 11.49% y/y on 12 February 2011, due to government intervention and the reduction of the prices of key fruits and vegetables through state marketing agencies. The government is also considering requests for price ceilings to be enforced on the open market, though no such policy was announced in the 2011/12 Indian Budget delivered on 28 February 2011. GLOBAL COMMODITY SURGE The top ten contributors to Januarys year-on-year inflation are shown in Table 1: Table 1: Top ten contributors to year-on-year inflation (January 2010) Source: Office of the Economic Adviser Data as at March 2011 These contributors to inflation can be grouped as food, 2010 due to robust demand stemming from emerging markets, largely China and India. Metals was the second highest contributor to inflation in India in January 2011. This is attributable to a low base effect, the high weighting of the product group in the index and the demand for steel and other metals by the construction industry. Metal price inflation has not increased beyond the trends seen globally and should mirror levels in other emerging economies. The mean estimate of a panel of economist surveyed by Frontier Advisory believe that the product group will add 0.93 ppt to inflation in 2011. This is due to the continued recovery of commodity prices fuelled by Eastern demand, volatile global politics and the need for a hedge against food price inflation. What has truly driven Indias inflation to levels surpassing even the inflationary standard of Asian economies is food price inflation. Food price inflation is a global phenomenon though it has several added dimensions which are exacerbated in the Indian case. MARKET DISEQUILIBRIUM The strongest price change in the food article group has been fruit and vegetables, which grew 7% w/w for the week ended 25 December 2010. This does not reveal the total effect of the rise in fruit and vegetable prices as it is common for retail prices to have a wide spread above wholesale prices. India grows 10.4% of all fruit produced globally and 40% of all tropical fruit, according to the Food and Agriculture Organisation (FAO). Fruit production has increased an average of 3% y/y over the last decade. Over the same period, harvested area increased 2.4% y/y on average and yield by 1.5% y/y. While production has increased at a sluggish pace, demand has not held back. The drivers for the surge in demand for fruit and vegetables have been population growth, income, and a more health-conscious consumer. India has a population growth rate of 1.3% according to the World Bank, along with expected economic growth in the range of 8.5% y/y 9.0% y/y for the next decade. This is resulting in a rapidly growing middle class, which already has shown a greater preference for fruit and vegetables in line with the international trend towards more health-conscious consumer preferences. The international preference, however, has little effect on trade as only 3% of Commodity Weight % Inflation % Contribution to inflation Vegetables 1.74 64.86 1.13 Basic metals, alloys and metal products 10.75 6.47 0.70 High speed diesel oil 4.67 14.71 0.69 Chemicals and chemical products 12.02 4.11 0.49 Fibres 0.88 47.63 0.42 Milk 3.24 12.44 0.40 Eggs, meat and fish 2.41 15.09 0.36 Cotton textiles 2.61 13.58 0.35 Fruits 2.11 15.01 0.32 Petrol 1.09 27.37 0.30
- 3. AGRI-SUPPLY CHAIN LEAKAGES The agri-supply chain faces five areas of potential leakage: Pre-processing Transport Storage Processing and packaging Marketing India suffers from severe leakage at every point in the production chain. Loss of produce in post-harvest operations is estimated between 5% 35%, depending on the crop, according to the Planning Commission of the Government of India (GoI). The prevailing inefficient supply system was created in response to the food shortages of the 1940s and 1950s. To combat hoarding by cartels, the government forced farmers to trade through licenced mandis (middlemen), rather than directly with retailers. Each mandi would add his margin to the product before it reached the consumer, but these margins were not always justified by beneficiation of the product as the number of mandis in a chain from farmer to consumer grew longer. This also distanced the farmer from the market both in terms of time and orientation. The system is perpetuated by the debt burden created by the mandi on the farmer as the mandi provides the finance at excessively high rates due to the farmers lack of access to capital. With the farmer distanced from the market and locked in through debt, the result is a very rigid agriculture industry, which has very little way of responding to changes in market demand. The multiple layers of mandi margins result in higher final market prices. While the mandi system may be creating inefficiency and fuelling inflation, it is a necessary evil due to the lack of alternatives in the short-to-medium term. For India to transform its agricultural market structure and the supporting infrastructure, it needs to consider how to change 12 million small-scale retailers to carry the parts of the supply chain currently being managed by mandis. Similarly, it needs to consider how to get the farmers, who are equally small scale, to take over some earlier points in the supply chain, such as initial storage and transport. To achieve this is beyond the capital and knowledge resources of most retailers or farmers. The exploitive finance offered by the mandis is also unfortunate, as despite there being several government-backed finance concessions for farmers, access to position away from fruit and vegetables, due to pressure from local vendors and the difficulties experienced in negotiating a successful supply chain despite major investments into logistics. Reliance Fresh recognised the impediments to a successful supply chain as being due to poor infrastructure and developed its own network thereby minimising a loss of produce. But, despite offering farmers higher prices than those offered by mandis, Reliance failed to break their hold in many states. The co -dependence of states and mandis is due to each state having its own specialised agriculture and the dependence on finance varies between crops. Reliances model was intended to bring lower prices to market but it has been unable to do so as farmers prefer the mandis finance options, rather than receiving higher prices without the finance. Lower prices to consumers and higher prices to farmers would have been achieved by the savings created from Reliances logistics. Transport, storage and packaging systems to maintain quality and minimise losses were implemented. As long as demand increases and the agri-supply chain maintains the status quo, we will see inflationary pressure from the lack of market orientation in the superfluous mandi supply chain and higher leakages as the system takes greater strain from increased demand. MONSOON DEPENDENCE Indias agriculture industry still remains far behind the rest of Asia in terms of the irrigation of agricultural land. Prior to British rule, irrigation was almost non-existent, while minimal work on surface-based irrigation (construction of reservoirs) was done during colonisation. Almost all irrigation in India came from aggressive government investment post-independence. This meant that India was left playing catch-up to other Asian developing economies and the developed world, which had a long history of irrigation. While expenditure on irrigation systems had matured to small-scale projects, 80% of Indian irrigation projects were still of a large-to-medium scale. According to the Indian Water Resource Society, this boom in irrigation investment occurred in the 1960s, slowing to 3% y/y growth in the 1980s and less than 2% y/y in the last decade. A comparison of irrigated rice paddies, a common staple food in Asia, is given in Table 2. Country % Japan 99
- 4. Fifty-seven percent of Indian crop output is irrigated by the monsoon rains. This dependency is so great that a change of 1 standard deviation in rainfall can affect crop yield by 30% 50%, according to a study by the University of Columbia. The study indicated that with groundwater and major surface system irrigation, monsoon dependence could be nullified. Inflation is still a function of monsoon rainfall in modern day India. By increasing irrigation and thereby stabilising yield output, Indias largest inflationary risk factor will cease to be exogenous both in the monsoon season and outside of it as production will be allowed to expand beyond the four-month monsoon rain period. TECHNOLOGICAL INEFFICIENCY Similar to the supply chain, agricultural production is characterised by small-scale farmers who are only slightly more advanced than subsistence farmers. Indias agricultural efficiency per hectare is 50% of Chinas, according to the Economist. Stemming from the mandi system and a move away from agriculture, in the opinion of Nobel laureate Muhammad Yunus, and proven through the decrease in growth of irrigated land, production has been distanced from market orientation so that the correct crops are not produced and yields are below modern day norms. Much scientific research has gone into crop technology, but due to the finance dependence created by the mandi system, farmers are unable to change crops to meet market demand and they lack the finance to use more efficient production methods such as advances in seed technology. POLICY INTERVENTION As inflation has been driven by primary goods, namely vegetables, it is unlikely that monetary policy intervention will be able to have an effect on inflation, at least not to the desired level. Monetary intervention will have a lesser effect by curbing inflation on other goods which have also experienced lagged inflation due to the rise in primary articles, which are production inputs. This is why we believe that though inflation will subside, it will only do so to 7.7% y/y 7.2% y/y by the end of March MACROECONOMIC DEVELOPMENTS INDIA MACROECONOMIC DEVELOPMENTS: ECONOMIC ACTIVITY GDP growth remains on track to achieve real GDP growth of 8.5% in 2010/11. Longer-term concerns for growth are, however, appearing. Industrial growth continued to sink to 1.6% y/y in December 2010 after plunging to 2.7% y/y in November 2010, compared to 11.3% y/y in October 2010. The sudden drop in industrial growth is due to the high base effect occasionally created at quarter end, where spending and capitalisation are higher. The long- term concern for industrial growth, however, is the correlation with the exchange rate. The period from 2004 to 2007 saw the rise of industrial growth to its peak of 14.5% y/y in 2006/07. This was also a time during which the RBI adopted a supportive exchange rate policy through intervention. The RBI currently prefers avoiding market intervention, resulting in the lower industrial growth rates. Without exchange rate intervention, we do not expect industrial growth to achieve double-digit rates in the long term. If single-digit industrial growth rates are maintained, unemployment is likely to rise. Open unemployment stood at 9.4% for 2009/10 according to the Labour Bureau. Figure 1: Growth in industrial production (% y/y), April 2008 December 2010 Source: MOSPI, 2011 Data as at March 2011 For April to October 2010, FDI into the services sector decreased 30% y/y. The cause of the decrease has been the slow pace of -2 2 6 10 14 18 Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar % 2008/09 2009/10 2010/11
- 5. BUDGET 2011/12 The Budget for the fiscal year 2011/12 announced on 28 February 2011 has not shown much change to policy or reform, besides raising the FII corporate bond threshold. It has rather focused on lowering the fiscal deficit to 4.6% of GDP, compared to 5.1% of GDP in 2010/11. This projection is based on a strong growth forecast of 9% y/y, conservative expenditure growth of 3.3% and revenue from the disinvestment programme. We believe that economic growth will be lower than 9% y/y, due to the impact of surging oil prices. India, like other emerging economies, has a higher ratio of oil consumption to GDP than developed economies. India is also a net importer of oil and therefore would be negatively penalised with the rise in oil prices, which is led by both the Arab turmoil and the recovery stemming from August 2010. For this reason, CRISIL Research believes that the fiscal deficit will be 5% and not 4.6%. Table 2: Key indicators of Budget 2011/12 Source: Union Budget 2011/12 Data as at March 2011 Net market borrowing for 2011/12, outlined in the Union Budget, are INR3,430bn, 2.3% higher than 2010/11. This conservative change to the borrowing programme has been bullish for the bond market. The market rallied further because of the announcement of a US$20bn increase to the threshold, from US$5bn to US$25bn, of FII investment in corporate infrastructure bonds. monsoon season has long ended, the focus is now on consumption as mentioned in the inflation section. CURRENCY In the five years prior to the global crisis, 2003 to 2008, the current account deficit averaged less than 0.5%. The collapse of world trade during 2008/09 saw the current account deficit rise sharply to 2.4% of GDP and to 2.9% in 2009/10. Despite the recovery of exports and global markets, the current account deficit rose to 3.7% of GDP in the first half of 2010/11, and continues to widen as portfolio investment dominates capital inflows and imports outgrow exports. A current account deficit in the range of 3.5% 4.5% is not sustainable and will negatively impact on GDP growth. The RBI has so far adopted a position of non-intervention regarding currency, however considering Indian domestic demand orientation and the long-term effects of the Indian economy, a survey of Indian economists by Frontier Advisory shows that there is consensus that they do not believe that the RBI will allow the rupee to strengthen past the USD/ INR44 mark. Figure 2: INR exchange forecasts Source: RMB FICC Research, 2011 Data as at February 2011 INTEREST RATES The repo and reverse repo rate rose as expected by 0.25%, to 6.5% and 5.5% respectively, when the RBI met on 25 January 2011. We expect a further 0.75% increase over the course of 2011. As mentioned earlier, we question the effectiveness of such monetary intervention, and believe that it will only serve to retard the industrial and services sector in the long run. The position being held by the Government of India appears to be 0 30 60 90 120 150 1960 1980 2000 2020 2040 USD/INR EUR/INR GBP/INR JPY/INR ZAR/INR Indicator GDP growth target 9.00% Fiscal deficit projected 4.60% Revenue deficit projected 74.43%
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- 8. This research has been written for FirstRand Bank Limited (acting through its Rand Merchant Bank division) (the Bank) by Frontier Advisory. Whilst all care has been taken by the Bank in the review of the information contained in this report, the Bank does not make any representations or give any warranties as to their correctness, accuracy or completeness, nor does the Bank assume liability for any losses arising from errors or omissions in the opinions, forecasts or information irrespective of whether there has been any negligence by the Bank, its affiliates or any officers or employees of the