EMERGING ASIA ECONOMICS UPDATE

India is virtually certain to tighten again next week

Wholesale price data released today in India were not as bad as widely expected. Nevertheless, the only uncertainty ahead of the 20th April monetary review meeting is whether policy rates move up by 25bp or by 50bp. We still expect that rates will be lifted by 50bp. Wholesale prices climbed 9.9% y/y, the same pace as in February and more slowly than the consensus which was looking for a 10.4% rise. The gain in food costs moderated as expected but the acceleration in the fuel component was not as large as was widely anticipated and manufactured goods inflation eased. (See Chart 1.) Nevertheless, wholesale prices ended the FY09-10 fiscal year (April-March) above the Reserve Banks (RBIs) latest forecast of 8.5% and far in excess of the RBIs comfort limit of around 5%. The upshot is that the RBI has been too slow and needs to accelerate its monetary tightening. Food price inflation will probably ease from now on given increased food supply. But more generalised inflation pressures look set to stay high. The strong economic upswing has squeezed spare capacity and is forcing up wage costs, even in the context of impressive investment growth and rapid productivity gains. Monetary tightening will eventually have a dampening impact but only over the long run. Wholesale price gains are probably peaking but we anticipate that annual inflation will stay in the high single-digits for most of FY10-11, and some way above the RBIs preferred pace of 5%. Few can doubt now that the economic upswing will remain strong. Admittedly, February industrial output growth slowed to 15.1% y/y (see Chart 2), and some core sectors, such as textiles, have been struggling in recent months. But, the overall outlook remains good. Consumer disposable incomes and corporate profits are rising sharply, household and corporate sector debt levels are low, while the heavy on-going investment in infrastructure projects is creating new business opportunities. Whats more, bank lending has picked up. We expect that GDP growth will have accelerated to 7.0-7.5% in FY09-10 as a whole which suggests that Q1 GDP probably climbed around 9% y/y. The rhetoric from the Reserve Bank has been hawkish for a while and in recent days policy-makers in New Delhi too (from the PMs Economic Advisory Council, the Finance Ministry) have recognised the need for rates to move up to help to bring down inflation. At the margin, todays wholesale price data shifts the odds a little toward a 25bp hike on 20th April. However, we believe that the RBI will want to front-load the tightening and still expect that both the repo rate and the reverse repo rate will be lifted by 50bps next week. Overall, we continue to expect that both policy rates will rise a cumulative 125bp over the next 12 months, which would take the repo rate to 6.25% and the reverse repo to 4.75%. Government bond yields have climbed further over the last few days but the monetary tightening to come looks largely priced-in. Yields on benchmark 10-year debt are now just above 8.0%. We expect yields to stay in the 8.0-8.5% range over the next 2-3 months, but then see the 10-year yield dropping back close to 7% by end-2010 as the RBI progresses its monetary tightening and as inflation slows. Kevin Grice Senior International Economist (+44 (0)20 7808 4993, kevin.grice@capitaleconomics.com)
Chart 1: India Wholesale Prices (% y/y)
18 16 14 12 10 8 6 4 2 0 -2 02 03 04 05 06 07 08 09 10
Wholesale Price Index WPI - Manufactured Products WPI - Primary Articles

Chart 2: India Industrial Production (% 3m y/y)

18 16 14 12 10 8 6 4 2 0 -2 50 45 40 35 30 25 20 15 10 5 0 -5 -10 -15 01 02 03 Capital Goods Consumer Durable Goods Industrial Output 50 45 40 35 30 25 20 15 10 5 0 -5 -10 -15 08 09 10

04

15th Apr. 2010

05 06

07

Sources Thomson Datastream, Capital Economics

Source Thomson Datastream

Emerging Asia Economics Update