Structural food price issues and strong demand pressures have pushed inflation in India well above the norm for Asia, says Mr Richard Iley, Chief Economist, Asia, BNP Paribas. In a telephone interview with Business Line , Mr Iley explains how the inflation problem is different from its Asian peers and why a period of sustained sub-par GDP growth is inevitable.
Excerpts:
How different is the problem of inflation in India when compared with its Asian peers? Is the Indian inflation more worrying?
India's inflation pressures have been among the most acute in Asia for several years now. Inflation performance, as measured by the WPI, has been well above the norm for the region. I think that's essentially a function of two factors. The first is the clear evidence that has emerged over the last 2-3 years that there is an increasingly structural food price issue. More specifically, the price of proteins, led by rising incomes, which in turn has been further accelerated by government policies – particularly the NREGA – has led to stepped up level of demand for proteins. Given that food is about a quarter in the WPI index, this has been a very significant determinant. It has been very noticeable to me that the average food inflation rate in the last four years has been close to 9 per cent, whereas earlier in the last decade, that is the 5-10 years before the global financial crisis, food price inflation was running more along the lines of 4-5 per cent, largely in line with the RBI's aspirations for overall inflation.
Secondly, I think demand pressures in the Indian economy have been among the strongest in the region. A telltale statistic is that nominal GDP growth exceeded 20 per cent in CY-10, the strongest nominal growth since the early 1970s. A combination of too loose fiscal policy and monetary policy and unsustainably fast rate of demand growth really pushed the economy into overheating territory and this in turn has led to a more generalised demand pull inflation in the last 9 months. So, it is a conjunction of these two issues which have led to India having one of the worst inflation performances in Asia.
Do you believe food inflation could remain stubborn for some more time in India, even as food prices are softening globally?
Statistically, I thinkfood inflation in India is not very well correlated with global food price development. There is a big contrast there with China; where we find that Chinese CPI food inflation is closely correlated with global developments.
Domestic factors are much more important drivers of Indian food price inflation. That leads us back to the structural issues that we discussed and, of course, the annual progress of the monsoon. The latest data show that the monsoon is a bit more favourable than it was several weeks ago but it doesn't appear that we are heading for a bumper harvest. My sense is that food price inflation will slowly, but only slowly, retreat. One helpful factor will be the base effects from last year's spiking onion prices. Other things being equal, this should bring down food price inflation by around December or January assuming the monsoon remains about normal. But food price inflation will not fall back to levels we were used to seeing five years ago. So, from 9 per cent to 6-7 per cent in the first half of next year might be a sensible expectation.
Would a slowdown in investments together with capacity constraints seen in some sectors further aggregate the demand-pull situation?
There is a risk that tighter monetary policy and financial condition really choke off the investment that will be crucial in allowing the supply side of the economy to grow rapidly; which is the best medium solution for India's inflation problem, be that in agriculture or in manufacturing.
But having moved above full capacity, and given the evidence of demand-pull inflation, the RBI has rightly recognised the need to set monetary policy sufficiently restrictive to engineer a period of sustained sub-par growth in the economy to make sure that these demand-pull pressures do abate. I think that implies a period of 7 per cent GDP and maybe several quarters of growth in the high sixes (so below 7 per cent) and then perhaps later a return to sustainable growth of probably 8 per cent.
Would more rate hikes become necessary?
Whether or not we need a further rate hike to guarantee this outcome remains unclear.
The strength in exports that the Indian economy has seen over the last year is most certainly going to moderate and that should be an important factor in reducing capacity utilisation in manufacturing and reducing demand pull inflationary pressures. I think we are very close to the peak of the rate cycle: it is touch and go whether we have one more quarter point of interest rate hike by the RBI. But, the bigger point for me is that it is going to be difficult for the RBI to ease the monetary policy any time soon. While food inflation may gently recede and we also expect manufacturing inflation to slowly come off, there remain a number of upside inflation risks lurking in the next 3-6 months, which would be an impediment for easing the policy. Monetary policy is beginning to tighten India and there is little prospect of that changing over the next year.
We find contradicting signals between IIP numbers and PMI with the latter showing more weakness. What should be relied upon for a trend?
I think there is an industrial slowdown in train now which, from the RBI's perspective, to some extent, will be welcomed as it ultimately reduces demand-pull pressures. Between the IIP index and PMI survey, I think the signal from the PMI Manufacturing Survey would be a more reliable one. The official IIP with the capital goods output has been exceptionally volatile over the last couple of years with very significant month on month swings, reflecting the relatively poor quality of this segment of the index. While I attach importance to the IIP index, I strip out the volatile capital goods number and look at the index excluding that. When you do that, the message is that it is more or less in line with the PMI Manufacturing survey. Until a quarter or so ago, developments have been rather robust but, in the last 2-3 months, there has been genuine weakness beginning to set in. That interpretation is also supported by other indicators of demand in the economy – vehicle sales is a key indicator. So, I think PMI gives the cleanest signal.
While exports marginally lost its momentum, it continues to be strong. Would the slowdown in US or Europe begin to hurt Indian exports or would it derive strength from other markets?
I think the developments in the US and Euro zone are inevitably going to dent India's export performance over the next 6-12 months. India's trade is relatively well diversified with exports to the G3 – the US, Euro zone and Japan – accounting for 30 per cent of goods exported. The West Asia is obviously an important market and China has been inevitably growing in importance as an export market as well. But developments in the biggest economies, the US and the Euro zone will affect India's exports. A double-dip recession in the US now looks likely given the recent very disappointing data flow.
It won't be a deep recession as the economy is still recovering from the aftermath of what was the harshest recession since the 1930s but it looks like the US economy has stalled and this will inevitably slow India's export growth.
As I said earlier, the strength of exports has been a genuine bright spot for Indian economy thus far this year.
While domestic demand, particularly investment, has been cooling off, export growth has stayed brisk and has been keeping up the rate of capacity utilisation in the industrial sector. The prospect of a sharp export slowdown should be a key factor in the demand pull inflationary pressures coming off the boil over the next 6-12 months.