Pickup in Factory Output Not Assuring; Further Price Shocks Cannot be Ruled Out

India Ratings and Research (Ind-Ra) opines the industrial growth will not return to a sustained and high growth path so long as excess capacity in the manufacturing sector remains and private sector investment cycle does not revive. A consecutive month of positive growth in the Index of Industrial Production (IIP) though is encouraging, Ind-Ra believes it is still too early to expect an improvement and stability in industrial growth. Also, Ind-Ra believes that food inflation despite favourable monsoons could surprise on the upside and food items could be anything ranging from potato, tomato, onion, milk, egg, pulses etc., as has been the case in the past.

The retail and wholesale inflation for July 2016 at 6.07% and 3.55% came in higher than Ind-Ra's expectation of 5.83% and 1.8%, respectively. IIP maintained its second consecutive month of positive growth at 2.1% in June 2016 as against 1.1% yoy in May. The IIP growth had turned positive in February and March and negative in April 2016.

Manufacturing output (75.5% weight in IIP) increased to 0.9% yoy in June 2016 from 0.6% in the previous month. Such a marginal increase in manufacturing does not generate confidence that the downtrend in manufacturing has been reversed. The capacity utilisation in manufacturing has been hovering in the range of 70%-75% now for nearly five years.

'Food products & beverages', 'chemicals & chemical products', petroleum products, 'motor vehicles & trailers', non-metallic mineral products and textiles, which together have a weight of 51% in manufacturing, clocked higher growth rates in June 2016 than in the previous month. Mining and electricity grew 4.7% and 8.3% in June 2016 as against 1.4% and 4.7%, respectively, in the previous month.

The disconnect between IIP and industrial gross value added data is making it increasingly difficult to discern the sectoral as well as overall industrial and manufacturing output growth trend. The base year used for IIP calculation is 2004-05, while industrial gross value added is based on 2011-12 prices. The use of 2004-05 means a lot of data relating to industrial/manufacturing output is not captured by IIP.

At the use-base level, capital goods output continued its negative trend. Capital goods output contracted 16.5%yoy in June 2016 against a contraction of 12.3% in May 2016. This reinforces the lacklustre investment demand in the economy. Basic and intermediate goods continued with the positive trend and clocked higher growth rates than the previous month. Consumer durables maintained the positive growth trend, although growth rate moderated to 5.6% in June from 6% in May 2016. Consumer non-durables reversed the seven months of negative growth rate and clocked 1% in June 2016 as against negative 2.3% in May 2016.

Inflation, both retail and wholesale, surprised on the upside, reinforcing the upside risks to the inflation trajectory emphasised upon by the central bank in its second and third bi-monthly monetary policy reviews. Rainfall has been above normal so far and the area sown under pulses and cereals, as reported by the agriculture ministry, is larger than in the previous year. This has raised the expectation that food inflation will moderate in the coming months and bring down the overall inflation.

Retail price inflation rose further to 6.07% in July 2016 from 5.77% in June 2016, led by higher food price inflation. Among the various components of retail inflation, food prices rose for the fourth consecutive month in July 2016 (8.4% in July versus 7.8% in June). Vegetable prices moderated to 14.1% in July from 14.8% in June 2016; however, this was more than offset by a sharp rise in prices of sugar, cereals, egg, milk and pulses. Sugar prices increased to 21.9% in July 2016 from 16.8% in the previous month. Services inflation showed a slight uptick to 4% in July 2016 from 3.8% in June 2016, led by higher inflation in the personal care category (July: 7.3%; June: 5.9%).

Wholesale Price Index (WPI) inflation increased to 3.55% in July 2016 from 1.62% in the previous month, led by the sharp rise in food inflation. WPI excluding fruits, vegetables, pulses and sugar stood at 1.75% in July 2016. Although these four commodities have been the key drivers of WPI, even with the exclusion of these items WPI has picked up pace in the last two months. Core (non-food non-fuel) inflation turned positive and came in at 0.09% in July 2016 after 16 months of consecutive deflation.

Food inflation component of wholesale inflation rose to 11.82% in July from 8.18% in June 2016, once again led by a sharp rise in prices of pulses, fruits, vegetables and sugar. Prices of fruits and vegetables rose to 22.33% in July 2016 from 11% in the previous month. Food grains (cereals and pulses) and sugar prices rose to 13.57% (June: 10.90%) and 32.33% in July 2016 (June: 26.09%). Although part of the reason for price rise could be attributed to the base effect, it is time to question our current understanding of the food economy and its demand and supply dynamics.

An analysis of food inflation data over the past six to seven years suggests that nothing has been able to tame food inflation. The goal post shifts each time food inflation surprises on the upside. It has become routine to put the blame on the failure of monsoon, unseasonal rainfall, the futures market in agricultural commodities and sometimes on hoarding/ black-marketing and so on. Ind-Ra believes that something more structural has happened in the economy about which we talk but are still not ready to admit - shift in the income, consumption and the aspiration dynamics of people who are at the bottom of the pyramid. So long as we do not get this right, addressing food inflation on a sustained basis will remain a pipe dream.

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