PMI data show IIP may throw up unpleasant surprise

HSBC Markit released India's manufacturing purchase managers' index (PMI) data for May on Monday. With the seasonally-adjusted index coming in at 50.1, it recorded a third straight monthly decline and, for the first time since March 2009, threatened to go below the 50 mark, indicating a contraction.

The bigger question, though, is: Does this give an advance signal about the likely performance of index of industrial production (IIP)? A comparison between these two data sets show that during the post-crisis period, the PMI data has not always been a successful lead indicator on IIP.

To understand the reasons, it is important to put the contents of the data in perspective. For starters, while PMI is a monthly data, IIP considers annual change. But more importantly, PMI is a survey data that focuses on large manufacturing units, while IIP data covers all units - big and small.

Nevertheless, the volatility of the IIP data makes comparison between the two quite difficult. If one takes a three-month moving average data (3MMA) for both the series, one can get a better sense.

As can be seen from the chart above, after months of fast-paced growth in manufacturing activity, which resulted in massive built-up in inventory levels, IIP started to dip, although PMI held steady for a fairly long period of time.

That was also the period when RBI embarked on a tightening cycle as inflation started to rise. Both of these began to bite micro, small and medium enterprises (MSMEs) more than their larger counterparts. And, as demand destruction started to took shape, the MSMEs cut production and began to drawdown on inventories to keep the escalating cost under check.

The larger industries reacted much later and PMI started to fall. The protracted fall in IIP is a stark reminder of hardships that the MSMEs had to endure as their margins shrank to dismal levels. In fact, RBI data shows that as of March 2012, there were 85,591 sick micro and small enterprises (MSEs) and 3,044 sick medium units in India.

Now that the PMI data establishes continuous lowering of manufacturing activity, there is every reason to believe that India's IIP will likely surprise on the downside; more so, because the past four quarters have seen substantial built-up of inventories.

The author is a Delhi-based independent economist