RBI Maintains Status Quo – Balancing Growth Concerns vs. Inflation Risks
May 01, 2008
By Chetan Ahya | Singapore and Tanvee Gupta | Mumbai
RBI Hikes Cash Reserve Ratio
In the Annual Monetary Policy Review, the Reserve Bank of India (RBI) decided to leave policy rates unchanged but hiked the cash reserve ratio (CRR) by a further 25bp, to 8.25%. The hike in the CRR will be effective from the fortnight beginning May 24, 2008. The decision to leave repo rate unchanged was in line with our expectations but against the consensus estimate (as per Bloomberg survey) for a 25bp hike. The increase in the CRR is unlikely to cause any tightening in lending rates. The cumulative absorption of liquidity on account of the hike in the CRR is unlikely to be more than the increase in liquidity due to higher capital inflows. While the increase in the CRR (50bp on April 17, 2008 and 25bp today) will cumulatively absorb about US$6.9 billion, FX reserves have increased by US$18.9 billion over the last eight weeks. Why Leave Policy Rates Unchanged? Inflation rise in the current cycle is very different from that in 2006-07. Domestic demand and the overall growth trend have already slowed down significantly. Industrial production has decelerated to close to a four-and-a-half-year low. Industrial production decelerated to 7.4% during the quarter ended February 2008 from the peak of 15.8% in November 2006. During the current cycle, inflation acceleration primarily reflects higher global commodities. Most of the rise in inflation from the trough of 3.1% in November 2007 to 7.3% during the week ended April 12, 2008 has been driven by higher prices in base metals, fuel and food items. The relatively high level of lending rates has already resulted in a sharp reduction in consumption growth. Leveraged spending by households has declined sharply, as reflected in two-wheeler sales, consumer durables production and mortgage lending growth. Consumer goods production growth has slowed to 8.5%Y during the quarter ended February 2008 from 13% nine months prior. Two-wheeler sales have been declining year-on-year for the past 12 months (sans the slight recovery in March due to a cut in the excise tariff). Growth in fresh mortgage disbursements has remained low at single-digit levels for the last few quarters. In addition to the sharp deceleration in consumption growth, the export sector has suffered a slowdown because of weakening demand in the developed world and appreciation in the rupee. Export growth (in rupee terms) decelerated to an average of 8.5%Y during the 12 months ended February 2008 from 25.2% during the 12 months ended February 2007. Leading indicator (US ISM New Orders Index) for India's exports predicts a further slowdown in exports over the next six months. Hence, two out of the three key engines of growth (e.g., consumption, exports and capex) are already faltering. We expect investment growth to slow as well over the next six months. Indeed, we believe that domestic demand is likely to slow further due to (a) the lagged impact of the current high level of prime lending rates; (b) increased risk aversion in the domestic banking system, as reflected in widening spreads for household loans other than mortgages; and (c) increased risk aversion in the global financial markets, which would reflect reduced access to foreign funding for small- and medium-sized Indian companies. In other words, past monetary policy tightening and effective additional tightening due to risk aversion in the financial system are likely to work their way through, resulting in further slowdown. We believe that a rate hike at this critical juncture would have hurt investment growth. The RBI decision to leave rate unchanged suggests that the central bank is considering the broader framework of not hurting the medium-term growth outlook. The RBI policy statement mentions that “domestic factors will continue to dominate the policy setting, with a contextual emphasis on inflation expectations while recognising the significance of maintaining hard-earned gains in terms of both outcomes of and positive sentiments on India's growth momentum”. Government to Maintain Preference for Fiscal Policy Tool We believe that the government will continue to use the fiscal policy tool more aggressively to address any further risk from rise in global commodity prices. Over the last three weeks, the government has announced a number of measures to reduce inflation pressure, including (a) restricting exports of certain products; (b) encouraging imports by reducing import tariffs; (c) lowering excise tariffs; and (d) persuading domestic producers to maintain restraint in resorting to price hikes in line with the increase in prices of global commodity products. We expect the headline inflation to moderate to below 7.0% over the next 2-3 weeks. While the inflation rate will remain higher than the central bank’s comfort zone of 5.5%, the reversal in trend itself may help ward off the political pressure on the government to some extent. Outlook on Monetary Policy The RBI clarified its stance in the monetary policy statement, indicating that the overall monetary policy will continue “to respond swiftly on a continuing basis to the evolving constellation of adverse international developments and to the domestic situation impinging on inflation expectations, financial stability and growth momentum, with both conventional and unconventional measures, as appropriate”. We believe that the central bank could hike CRR further, if capital inflows continue and headline inflation remains above 5.5%. We believe that the decision on policy rate will be data-dependent and that the RBI could potentially choose to hike policy rate if (a) domestic demand picks up (i.e., if there is significant acceleration in industrial production to 9-10%) and/or (b) commodity prices rise 15-20% from current levels, increasing input costs and, in turn, the probability of a pass-through to final goods prices. However, we do not expect industrial production growth to re-accelerate to 9-10%. Hence, unless commodity prices shoot up further from here, we believe that the risk of a policy rate hike remains low.
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Modest Inflation Alert
May 01, 2008
By Takehiro Sato | Tokyo
Reversing Course from Bears on Inflation to Bulls Our stance on Japan’s inflation to date has been steadfastly cautious. But recent growth in food and energy prices has surpassed the range in which companies can stomach the cost on their own, forcing us to raise our outlook on prices. Going forward, the core inflation rate is set to hover in the +1% range from May, and could temporally hit +2% over the course of 2009. What’s New We raise our outlook on the core CPI for 2008 to +1.3% (F3/09: +1.4%) and for 2009 to +1.6% (+1.6%). Our previous forecasts (date back to March 13) were +0.9% (+0.9%) and +0.7% (+0.8%), respectively. This forecast increase owes largely to the following: (1) the landed crude oil price, which is expected to remain high because of tight supplies; and (2) a series of planned hikes by the government to its resale price for imported wheat. Since the landed crude oil price has more or less consistently overshot our assumptions, this time we abandon the subjective forecasts and use the futures contracts immediately preceding the setting of our forecasts (April 23). On the other hand, our FX rate assumptions are based on the outlook from our currency strategy team. These changes in our assumptions work through to our forecasts for not just gasoline and kerosene but electricity and gas charges too, with a time lag of about half a year. Note also that a contract price hike of +230% has been agreed for Australian coal, reflecting the impact of local flooding as well as transportation bottlenecks. Fixed costs occupy a heavy weighting (about 60%) in the electric power industry, but the weighting of coal in generation is about 30%. In keeping with the rules of the fuel cost-adjustment system, comparatively larger price hikes should be implemented in October-December 2008. Moreover, where the second factor behind the increase in our CPI forecast is concerned, the government raised its resale price for imported wheat by 10% in October 2007 and made a further 30% hike in April 2008. Even though the negative spread is still very much with us, we anticipate further hikes of about 20% this October and expect prices to continue rising in F3/10 as well. The effects of such substantial growth in the price of wheat may extend beyond the immediately associated items like bread and noodles to a wide range of processed foods, as well as restaurant businesses. If we look at the pattern of price pass-throughs since the hike last October, we find that although initially there were very few signs of the increase being passed on, prices for bread and noodles have risen over time so that more or less the full amount of the hikes had been passed on six months later by March. Assuming more or less complete pass-throughs of additional price hikes from April too, the impact on the core CPI of these wheat-related products alone should be close to around +0.4ppt year on year at end-2008. When growth in consumers’ purchasing power is limited as we discuss below, there will naturally be questions about whether pass-throughs can be achieved on a large scale. However, this in turn becomes a matter of life-and-death for companies if they cannot pass on extensive increases in input costs to the prices of final demand items. Moreover, it is also hard to envisage that the consumption volume of non-discretionary consumer items such as grains declining significantly, even if prices rise; pass-throughs should take place even if wages remain depressed. Aside from the above, possible wild cards for upward pressure on prices include healthcare, cigarettes and rice. Healthcare (treatment charges) may be affected by changes to the social insurance reimbursement rates for medical treatments and to the healthcare insurance system, cigarettes by changes in tax rates and rice by a shift of demand from wheat-based products. Meanwhile, telecommunications charges top the list for downward risk factors on prices. Given the sense of uncertainty about the timing of when new discount charges will be reflected in the price data, rather than making a random assumption we refrain from incorporating these explicitly into our simulation for now. Our simulation of the core CPI incorporates the aforementioned data that are available at this point. Although we expect growth in the core inflation rate to come to a temporary halt in April as the provisional tax rate on gas expires, we expect growth to be in the mid-1% level to set from the July-September quarter this year, and we think this will briefly hit 2% over the course of 2009. Where We Differ The consensus that has formed on the BoJ’s Outlook Report (the market’s reading of the BoJ’s forecast) is now +0.7% for F3/09 and +0.5% for F3/10 (from the Bloomberg Survey). Our position on inflation has now shifted from the bear to the bull camp. However, primary goods inflation leads via deterioration of terms of trade to purchasing power seeping abroad, and the implication of that is actually deflationary. For example, while the second preliminary GDP figures for October-December showed a relatively strong increase of 0.9%Q, real gross domestic income (GDI) at +0.2% and real gross national income (GNI) at +0.4% were somewhat short of this. Real GDP supplemented by a variable to capture purchasing power (trading gains or trading losses) due to improvement (or deterioration) in terms of trade gives the real GDI, and this plus net income from the rest of the world (interest, dividends, patent fees, etc.) give the real GNI. But since trading losses have recently been outstripping net income from abroad, Japan’s overall purchasing power has not been growing as much as headline GDP. This situation is set to become even more pronounced in the January-March GDP, as energy and international commodity prices continued to soar. The BoJ is also alert to the problem of feeble income growth. The minutes of the MPM on March 6-7 recorded that several members identified that “deterioration in terms of trade is hampering income formation by putting pressure on corporate earnings and wages”. There were also comments that “worsening terms of trade are leading to lower growth in real GDI”. Policy Implications The Fed’s decisive moves to avert a crisis have fueled a bear-market rally for equities, and we acknowledge that the chances of a proactive rate cut by the BoJ in the April-June quarter (as we have been forecasting) are now virtually nil, in the face of a likely robust (annualized 3% or so) GDP growth in the January-March quarter. There is still a slim possibility of a rate cut in June or the July-September quarter, but incoming US data flow should improve, backed by fiscal stimulus measures, and we think monetary policy is likely to slip down the market’s agenda in both the US and Japan. If there is a rate cut in Japan, it will probably be a reactive response to renewed instability in the financial markets, and share prices would be the key in that event. Our equity strategist is forecasting TOPIX to rally to about 1,360, and from that level, any further upside would likely be capped by negative news flow on corporate earnings. Since the season of F3/08 results and F3/09 guidance from late April is expected to spawn a lot of bad news, the market’s foundations are fairly shaky. In this situation, we think the possibility of a rate cut before the end of the year remains alive. Market Implications CPI linkers have traded incongruously with creeping inflation, with BEI (breakeven inflation) for all issues temporarily turning negative as overseas investors unwound their positions. Investors have been selling at a loss, as risk reassessment sweeps across the market. Under this inflation outlook, however, the issue of strengthening the fiscal resources for basic pensions by raising the consumption tax is bound to take center stage for whichever party holds power after the next general election. The markets should draw inferences of this around the time of the election, and we would expect CPI linkers to start pricing in a future consumption tax hike again. The consensus view of the timing of the next general election, incidentally, is some point after the G8 summit in July. We would not rule out the possibility of an earlier poll, however, as the political situation in May and June may become more fluid due to the resolution of the issue of earmarked road funding. Risks The political situation is the wild card. The provisional rates of fuel tax affect the rate of core inflation. The expiration of the pro tem tax rates on April 1 lowers core inflation in April by 0.4pt, but if these rates were restored at the end of the month, the impact on the year-round figure would be -0.1pt at most. Our forecasts are based on that assumption. But fuel taxes have become a political football, and if the provisional rates are allowed to lapse for longer than expected, the impact on inflation in F3/09 could not be ignored. Even if the provisional rates expire permanently, however, the deflationary impact would be entirely confined to F3/09, and that could make core inflation in F3/10 to be quite high in comparison.
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