India’s industrial production slows to lowest growth in 9 months

Inflation is what you should not focus on. Of greater relevance for policy is slowing growth. The number of indicators validating the slipping growth momentum in the economy is increasing. It is now time for the RBI to initiate or signal an exit from monetary tightening. The problem with slower growth is that it will strain an already difficult position. While a fiscal slippage has been widely expected, it has been largely due to higher than budgeted subsidies. A growth related slowdown in tax revenues will be an additional strain. Slowing revenue growth is an additional problem. Managing the attendant increase in the government borrowing programme will require liquidity support from the RBI i.e. implicit monetary easing. Overall, we think that next week, the RBI will raise its policy rate by 25bps for the last time in this cycle.

Industrial production is the variable that is most clearly highlighting the on-going slowdown. Even on the new series which is meant to be a better reflection of India's changing consumption patterns, the slowdown is discernible. In May, industrial production increased only 5.6% yoy, the slowest in nine months. On a sequential basis, industrial production declined 2.5% mom and at the heart of the slowdown was weak manufacturing activity. The slowdown in manufacturing in turn has been broadbased encompassing capital, consumer and intermediate goods.

This slowdown can not be attributed to inventory adjustment but rather to weakening demand. Three indicators which we find useful in assessing the strength of domestic demand including currency held by the public, auto sales and credit are all unanimously pointing to slower growth. A related variable to consider is the incremental credit-deposit ratio. It has declined from a peak level of 102% in January to 79% in June. The decline partly reflects a shift back into deposits, presumably an outcome of an upward revision in rates. In fact, it is time deposits that have risen sharply implying a declining propensity of consume.

Over time, this slowdown will start to have a knock-on effect on government tax revenue collection. It can be seen that the relationship between tax collections and economic activity is tight. A slowdown in tax collections would result in an even larger slippage in the fiscal position.

Public finances have already been suffering due to a sharp rise in the subsidy burden and lack of government divestment in public enterprises. We consider the impact of the recent revamp of fuel prices. The revamp had included a 5% reduction in customs duty on petrol, diesel and crude oil and a 23% reduction in excise duties on diesel. This is expected to hurt government revenues by around 0.4% of GDP. There has also been an increase in retail prices of fuel but even so, the subsidy bill is expected to be closer to INR500bn as opposed to the budgeted level of INR236bn. In GDP terms, this is equivalent to around 0.3%. And there is the disinvestment target of 0.5% of GDP, an activity that has yet to take off and is contingent on the state of the capital markets. In all likelihood and after assuming tight controls over non-subsidy related spending, we expect a slippage of around 0.5%-0.7% of GDP is likely. This implies additional borrowing of INR0.44trn from a budgeted net level of INR3.77tn.

These challenges suggest that the bulk of monetary tightening is now behind us. Admittedly, inflation remains uncomfortably high but is no longer a monetary phenomenon as evident from easing monetary growth. Moreover, we note that even the recent spurt in manufactured product inflation has been narrowly driven by commodity intensive components like metals and chemicals. Furthermore,  the more recent stability in commodity prices suggests that pressure from these sources is unlikely to increase in the coming months. 

We expect that the RBI will raise its policy rate by 25bps next week - this will be the last move in this cycle. There is also a small but growing possibility for a pause. Additionally, we believe that the RBI will need to ensure a smooth passage for the government borrowing programme. Bond yields of above 8% are already quite uncomfortably high and could rise further in the absence of open market support. The H2 FY12 borrowing programme is likely to provide for this.