Sourajit Aiyer - Finance Monthly Magazine, UK - Catching Up On The India Stor...
India Monthly_March 2011
1. 14 November 201614 November 2016
ROBUST GROWTH DESPITE HIGH INFLATION
INSIGHT: INDIA’S INFLATION
India’s 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 March’s 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 January’s 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 India’s 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 farmer’s 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. Reliance’s 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 Reliance’s 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
India’s 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, India’s 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. India’s agricultural
efficiency per hectare is 50% of China’s, 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
