Inflation Paradox: Why rural CPI inflation is higher than urban CPI inflation

The main culprit behind the recent increase in India’s CPI inflation is rural India, while the urban CPI inflation has been largely under control. To put things into perspective, consider these facts. Total CPI inflation in November 2014 was 3.3% of which 1.8 percentage points (ppt) were contributed by rural CPI and 1.5 ppt were contributed by urban CPI. From November’s 3.3%, India’s CPI inflation surged to 5.4% in June 2015 led by 3.5 ppt contribution by rural CPI and 1.9 ppt by urban CPI. The contribution of rural CPI inflation has nearly doubled from 1.8 ppt in November 2014 to 3.5 ppt in June 2015 as compared to relatively lower contribution of urban CPI inflation from 1.5 ppt in November 2014 to 1.9 ppt June 2015.

What is more paradoxical here is that rural inflation has nearly doubled since November 2014 at a time when rural demand is going through the worst down cycle in over a decade. Here are four factors that tell the story of rural distress. One, nominal rural wage grew merely at 2.6% in May’15, the slowest pace since June 2005. Moreover, real rural wages have actually witnessed a contraction in nine of the last 10 months. Two, minimum support price (MSP) of agriculture produce grew at 1.6% and 2.9%, respectively in fiscal 2015 and fiscal 2016, the lowest in last 9 years. Three, foodgrain production of rabi crop contracted by 7.2% in 2014-15 over 2013-2014 as unseasonal rains in March 2015 destroyed a significant chunk of standing rabi crop. Four, the rural economy is reeling under negative wealth effect as the land prices in rural areas have fallen by around 20% since the peak of 2013-14.

What is more baffling is that milk inflation in rural India, which is the source of milk supply for the entire country, at 7.9% is 200 bps higher than milk inflation in urban India. Even inflation for cereals in rural India at 2.8% in June 2015 is 240 bps higher than in urban India. A simple logic suggests that pace of price increase should be lower in rural India than in urban India as the latter completely depends on the former for the supply of these items.

Similarly, rural inflation for recreation and amusement category, which includes cost of movie ticket, hotel lodging charges, monthly charges for TV cable charges etc, has gone up from 4.2% in November 2014 to 5.8% in June 2015 while urban inflation for the same category eased from 5.1% to 4% during the same period.

Is data collection a problem? Price data in rural and urban India is collected by two separate bodies. National Sample Survey Office (NSSO) collects price data for urban CPI and Postal Office is responsible for collecting price data for Rural CPI. While data collection is the core function of the former, it is an additional responsibility on the latter. NSSO has employed thousands of qualified field officers from statistics/economics background for the data collection work. On the other hand, price data in rural India is collected by postmen, who obviously are not the best qualified persons for the job and it is plausible to have a doubt on the quality of price data collected by them. Highlighting this issue, a Reuters article had quoted a postman, “Sometimes during the rainy season, I am unable to go out. Then I have no option but to fill in the prices of different items myself, ...usually I go to shops once or twice in two or three months to check price trends and fill in the price details myself by cross-checking with my wife”. The more worrisome part is that these numbers are key ingredients for monetary policy decision-making by the RBI, risking a case of garbage in garbage out.

There is no reason for such a sharp spike in rural inflation to sustain given that rural demand has slipped to a decadal low. Hence, lower rural demand would pull the rural inflation down in coming months.

Outlook on monetary policy: While RBI kept the policy rate on hold on 4 August 15, it is looking for more clarity on impact of monsoon on inflation trajectory and timing of the Fed “lift-off” before easing the repo rate further. Interestingly, RBI has lowered January 2016 inflation projections by 20bp to 6.1%. CPI inflation, however, is likely to be at 5.4% by January 2016 due to likely fall in rural inflation and lower crude oil prices – both are not factored into RBI’s inflation model – providing a 70bp downside to RBI’s inflation projections. Therefore, RBI may prepone another rate cut of 25bp on 29-Sep’15, given uncertainty over many key issues – sequential increase in food prices over the past two months, monsoon in Aug-Sep and fed rate action etc – will be over by then. Moreover, favourable change in some of the key liquidity enhancing factors – improving CAD, change in household savings from physical to financial assets, strong deposit mobilization and low credit off-take – may push liquidity into surplus, leading to reverse repo becoming the operative rate. It could be an effective 100 bps cut in interest rates. Therefore, we may not be close to the end of the easing cycle yet and there is more downside left to the interest rates in India. 

Easing though liquidity route to continue, 100bps cut in repo rate in 2013

Due to high inflation, the RBI today kept the repo and reverse-repo rates unchanged, at 8% and 7% respectively. However, in order to keep liquidity into its comfort zone, RBI cut the cash-reserve ratio (CRR) 25bps, to 4.25% of net demand and time liabilities (NDTL). The move would inject Rs 17,500 cr liquidity into the system. Taking the liquidity route to ease monetary policy, the RBI has cut the CRR by 175bps in last ten months.

The RBI has revised its FY13 GDP forecast downward to 5.8% from 6.5% in Jul ’12 policy. The WPI inflation target for Mar’13 has been revised to 7.5%, from 7% earlier.  Both deposit and non-food credit growth has been revised downward by 100bps to 15% and 16%, respectively.

100bps cut in repo rate in CY13. Given upside risks to inflation till Dec ’12, a rate cut by RBI until Dec’12 is unlikely. I expect the central bank to focus on easing liquidity through open market operations (OMOs) and by slashing cash reserve ratio. I expect WPI inflation to peak out at 8.5% in Dec’12. Likelihood of a bumper rabi crop and strengthening rupee, coupled with a favourable base effect, are key factors which could soften WPI inflation considerably post Dec’12. I expect WPI inflation to soften to 6.1% in Apr’13. Accordingly, I expect 100bps repo rate cut in 2013 with the first cut starting from Feb-Mar ’13. In its guidance, the RBI also said, “the baseline scenario suggests a reasonable likelihood of further policy easing in the fourth quarter of 2012-13”. Until then, the RBI is likely to continue with the liquidity enhancing measures – CRR cuts and OMOs – to support growth.

India’s services sector: The last bastion also under siege

Indian economy has been undergoing a serious economic downturn for last one year. It’s GDP in 1QFY13 grew merely 5.5%, marginally higher than 5.3% in the previous quarter. The bad news is that the services sector, which contributes near 60% of India’s GDP, is getting impacted by the severe slowdown in the manufacturing sector. 



India's services sector facing a tough time 

 

Growth in services sector decelerated sharply to 6.9% in 1QFY13, - the lowest in over three years. The resilient services sector had been the key driver of India’s GDP until now. The services sector recorded a median growth of 10% in the past 29 quarters.

I expect that India’s GDP growth would moderate to 5.8% in FY13. Despite the marked growth slowdown, upside risks on inflation are unlikely to allow RBI to cut repo rate in CY12.

Here we go again!!!

Petrol prices have been hiked by Rs 3.14 a litre due to a sharp 8% depreciation in rupee in last one and a half months. The petrol price hike decision is coming a day before the RBI’s mid-quarter monetary policy meet tomorrow. However, the impact of the petrol price hike on WPI inflation is going to be merely ~7 bp.


I still feel that the RBI should pause this time since the growth outlook (both global and domestic) has drastically changed since the last policy meet on Jul 26. Moreover, the debt crisis in Eurozone has worsened further.

If you remember, during Jun-Jul 2008, the RBI had hiked the rate by 125 bps and within two and a half months it had to cut the rate by 100bps and then by another 50 bps in next twenty days.

So lesson for the RBI: One should learn from ones mistakes.

Indian economy: Growth slowdown or a transitory dip?

Indian economy grew 7.8% in the fourth quarter of FY11 (Apr-Mar), following 8.3% growth in the previous quarter. For full year FY11, GDP grew 8.5% as against 8% during FY10. 

The agriculture sector saw strong growth of 6.6% in QFY11, the highest in last seven years. Ironically, agriculture sector has been a great savor for Indian economic growth in FY11.  Both the major crops (kharif and rabi) have witnessed a bumper production, thanks to a normal monsoon last year. This year also, the monsoon is expected to be normal, increasing the prospects for healthy agriculture production.

Reflecting the impact of the high interest cost, real investment growth decelerated to 2.2% in 4QFY11, the lowest in eight quarters. Moreover, fixed investment grew only 0.4%, down from 7.8% growth in 3QFY11. However, to some extent, a high base is also responsible for the anaemic investment growth figures.

Private consumption growth at 8% in 4QFY11 (8.6% in FY11 versus 7.3% in FY10) continues to be a major driver for FY11 GDP.

Despite ~10% inflation in FY11, private consumption continued to grow at a healthy pace. With softening of inflation in 2HFY12, I expect private consumption to grow at a healthy ~8% pace. Slowdown in investment growth is a concern. However, forward-looking indicators such as acceleration in credit flow to industry (ex infra), sequential improvement in industrial growth and pricing power with manufacturers show likelihood of investment recovery in the second half of FY12. With a normal monsoon and investment recovery in 2H, 8.5% GDP growth looks likely in FY12.

Therefore, according to me, strong private consumption growth, pick in investment and buoyant exports outlook make me believe that the Indian growth story is likely to remain strong and all the long term fundamentals are very much intact.

India’s current a/c deficit narrows on record high software exports

India’s current account deficit (CAD) for 3QFY11 narrowed to US$9.7bn or 2.3% of GDP, against US$12.2bn or 3.5% of GDP a year earlier. Three key reasons behind the improvement in the current account deficit: One, the software services exports in 3QFY11 increased 14.6% to US$14.7bn, the highest ever in a quarter, against US$12.9bn a year ago. Two, workers’ remittances rose 5.2% to US$13.4bn in 3QFY11 from US$12.8bn in the year-ago quarter. Three, A US$2 bn delta came from the non-software services exports. Though the balance of non-software services exports in 3QFY11 were a drag (a US$2.6bn deficit), it has markedly improved from the US$4.7bn deficit of the year-earlier quarter.

On the capital account front, thinghs were not too rosy. The capital account surplus rose only marginally to US$14.9bn in 3QFY11, against US$14.6bn a year ago. While inflows under portfolio investment, external commercial borrowing (ECB) and banking capital gained some traction over 3QFY10, inflows under foreign direct investment (FDI) and short-term trade credits were subdued. Notably, the ECB inflows rose to US$3.6bn in 3QFY11, more than doubled from the same quarter a year earlier.

The current account deficit is likely to narrow further in 4QFY11 for two reasons: (a) high exports growth vs. imports resulting in narrowing of the merchandise trade deficit; (b) higher invisible surplus on buoyant software services exports and strong remittances. However, high international crude oil price, if persists, may pause a threat to the improvement in India’s current account balance. Therefore, the rupee is likely to be on the upward trajectory in the next two quarters. I expect rupee to reach around 43 per dollar by the end of June quarter.

Cost of loan likely to increase further as the RBI up the policy rate

Continuing with its calibrated monetary tightening cycle, the RBI today hiked the repo and reverse repo rates by 25bps each. This is a reaction to the high and sticky inflation, which continues to be nearly double the medium-term target of the RBI since Jan ’10. RBI now projects WPI inflation at 8% by end-Mar ’11.

The repo rate – the rate at which banks borrow from the RBI – now stands at 6.75% and the reverse-repo rate – the rate at which banks park money with the RBI – at 5.75%. Today’s rate hike in the policy rates marks the eighth consecutive hike since Feb ’10. Overall, the RBI has hiked repo rate by 200bps, reverse-repo rate by 250bps and CRR by 100bps in the ongoing rate hike cycle. However, the effective rate hike in the operative rate has been 350bps as the operative rate has changed from reverse repo to repo rate due to change in the liquidity situation.

The RBI has increased WPI inflation projection for end-Mar ’11 to 8% from 7% earlier. WPI inflation inched up, to 8.3% in Feb ’11, after softening to 8.2% in Jan ’11. Notably, the RBI has mentioned that non-food manufactured products inflation continues to be Ill above its medium-term trend – it rose sharply, from 4.8% in Jan ’11 to 6.1% in Feb ’11 – indicating that producers are able to pass on higher input prices to consumers.

What next. The food articles inflation has started considerably softening on account of improved supply and the trend is expected to continue on a likely bumper rabi crop, which will hit the market early next month. The main pressure to inflation, going forward, is likely to come from manufactured products. I expect inflation to remain elevated (7% average) in FY12. I expect the RBI to hike policy rates once more by 25bps each in the next monetary policy meeting on 3 May ’11.

Now, the cost of loans is likely to go up further. Clearly, this negative for the Real estate, auto industry and other interest rate sensitive industries. So, guys, be ready to face a high interest rate environment and plan your expenditure accordingly.