Ind-Ra: Excess Capacity in Manufacturing Sector Impacting IIP Growth

Excess capacity in the manufacturing sector is constraining capex leading to a contraction in the Index of Industrial Production (IIP) growth, says India Ratings and Research (Ind-Ra). IIP contracted 0.8% yoy in April 2016 as against Ind-Ra's forecast of 2.2%. The dismal performance of the manufacturing sector pulled the overall IIP growth down.

Factory output in April 2016 is a far cry from the 2.0% growth rate witnessed in February 2016. The eight core industries that comprise around 38% of IIP grew 8.5% in April 2016 compared to 6.4% in March 2016. This had raised hopes that IIP would show a further uptick from the marginally positive 0.3% growth in March 2016. Core sector growth has showed a clear uptrend since November 2015; however this has not found any resonance in IIP growth so far.

Electricity, which has a weight of 10.3% in IIP, continued its upward trend and grew at 14.6%yoy in April 2016. Mining growth has oscillated in the range 0.3% to 5.1% since July 2015. Though mining growth remains in positive territory, there is no indication of a clear trend emerging.

Manufacturing (75.5% weight in IIP) contracted further to negative 3.1% in April 2016 after slipping into negative territory in March 2016 (negative 1.0%) from a marginal uptick of 0.7% in February 2016. At the two-digit level industry grouping that registered sharp negative growth rates are 'food products and beverages (24.5%)', 'electrical machinery (17.6%)' and 'tobacco products (55.9%). Despite a sustained pickup in consumer durables, a sustained contraction in capital goods has taken a toll on the manufacturing sector. GDP data also showed that gross fixed capital formation registered negative growth of 1.9% yoy in 4QFY16, which is also the lowest in two years.

In a classical recovery cycle, the demand pulse is first felt in the consumer durables sector. Thereafter, it is transmitted to the basic and intermediary goods sectors and then it finally reaches the capital goods sector. Although the IIP data since November 2016 suggest that the demand pulse has begun to show up in the basic and intermediary goods sectors, Ind-Ra opines it is still too early to believe that a classical recovery cycle is underway. However, Ind-Ra is also of the view that if the demand pulse continues in the basic and intermediary goods sectors it will help several manufacturing sectors and subsectors that are still struggling with excess capacity and eventually support capex cycle revival.

Consumer durables maintained the upward momentum and grew 11.8% in April 2016 (March 2016: 9.9%) suggesting a pickup in private consumption demand. Ind-Ra believes this trend will get strengthened due to the impetus from rural demand in the wake of a better than normal monsoon this year. The basic and intermediate goods grew 4.8% and 3.7%, respectively, yoy in April 2016, but the production of consumer non-durables contracted 9.7%.

Finally, Ind-Ra believes there is an urgent need to change the base year of IIP to 2011-12 from the present 2004-05 to better reflect the manufacturing activity on the ground.

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