India: How Big Is the Inflation Risk?
by Chetan Ahya (Mumbai) and Mihir Sheth (Mumbai)
What’s new? The headline inflation rate, after remaining between 3.2 and 4.8% for the past five months, is in our view likely to rise over the next four months but stay within the Central Bank’s comfort zone of 5.0-5.5%. We believe the risk of inflation rising above this level is low and even if it does cross this level it will likely decelerate back quickly.
Conclusions: Inflation is not the only measure for assessing the risks of an excessively loose monetary policy, in our view. In an open economy structure, excesses of loose monetary policy are showing up in high current account deficit, flat bank lending rates for funding assets with varying risk profiles and a sharp rise in property prices.
Implications: So far the RBI’s attempts to check some of these adverse trends have not produced the desired results. Hence, we believe that the RBI is likely to raise short-term rates at a faster pace than seen in the past 12 months even as the headline inflation rate remains within the comfort zone.
Headline Inflation Rate Within the Comfort Zone So Far
From the peak of 8.5% YoY during the quarter ended September 2004, the headline inflation rate declined to 5.5% YoY in January 2005 and has remained largely below the central bank’s comfort zone of 5-5.5% over the past 10 months. Headline inflation has declined significantly over this period due to a deceleration in the year on year price trend for global commodity linked products. Government tinkering with domestic oil product prices has also helped this trend.
Global Commodity Linked Products Remain Key Driver
The breakup of the wholesale price index indicates that the global commodity products’ group currently contributes to 56% of the headline inflation rate even while its share of the overall inflation basket is at 37%. While the global commodity linked products’ group index has been very volatile (ranging from zero to 15%), non-global commodity products’ inflation continues to be low in the range of 2-3.5% (with continued weak pass-through effect of higher commodity prices). The commodity linked products’ basket has decelerated to 7% in October 2005 from the peak of 14.6% in August 2004. Some of the key components where such year-on-year price increases have slowed are basic metals & alloy products, minerals, textiles and heavy organic products.
Upside Risk, If Any, Is Likely to Be Temporary
Over the coming three months we expect the inflation rate to rise back as the support of the high commodity price base effect wanes. We expect the headline inflation rate to rise to 5-5.5% by March 2006. The rise above this level if any is likely to be temporary unless global commodity prices see another round of sharp increase or if the rupee depreciates by another 5-10%. Indeed, with our global team expecting crude oil prices to decline going forward, there is a good chance that oil products inflation rate decelerates ensuring that the headline inflation rate remains largely in the comfort zone.
But Is Inflation the Only Measure to Assess Monetary Policy Excesses?
We have long argued that with greater integration with the global trade market, loose monetary policy-sponsored consumption growth being higher than domestic capacity creation (investments) will not necessarily show up in inflation. In a world with low import tariff rates and loose boundaries, inflation pressure in India is unlikely to be high, independently of it being the trend globally. In an open economy structure India’s rising consumption has been reflected in higher trade and current account deficit. The monetary policy excesses are reflected in asset prices, particularly property and deteriorating credit quality.
RBI has already highlighted the issue of credit quality by increasing risk weights on consumer credit as well as mortgage lending. However, these measures have proved to be soft. There has been little change in the risk appetite within the banking system. This is clearly evident in relatively flat bank lending rates for funding assets such as non-AAA corporate loans, mortgages, car loans and two-wheeler loans despite their varying risk profile (see our extract Risk Curves Steepening Again, October 25, 2005). Risk of mis-allocation of capital continues to rise with this persistent trend of credit mis-pricing in the banking system. Property prices have also shot up sharply in many of the major metros by 30-50%.
Tight Monetary Policy Will Likely Continue
We believe that the swing in the current account from surplus to deficit (without a commensurate rise in investments), high risk appetite in the banking system and the sharp rise in property prices are all reflections of the current relatively low level of real interest rates. We believe that the RBI is likely to continue with its tight monetary policy even as the headline inflation rate remains within the comfort zone in reaction to these concerns. We expect the RBI to hike short-term interest rates by an additional 75-100 basis points over the next 12 months to ensure a meaningful correction to these adverse trends. Moreover, reversal in global liquidity conditions and interest rate arbitrage will also in our view warrant a steady uptrend in short-term rates to avoid a sudden disruptive liquidity crunch. In addition to this, we expect RBI to take further quantitative measures and enforce more prudential norms.
Policy Makers Worry More About Inflation than Credit Risks
Policy makers probably face less political pressure for checking risks emanating from the asset bubbles and high credit growth in the banking system than that from a spike in inflation. Hence, we believe a sharp reversal in international crude oil prices, if any, could result in the inflation rate decelerating significantly and increase political pressure on RBI to go slow in hiking short-term rates.
