Healthy takeaway from IIP

The consumption story, and revival in NBFC lending may improve prospects

The rate of change of retail inflation fell to 3.31 per cent, year-on-year (YoY) in October, down from 3.77 per cent in September 2018. Meanwhile, the Index of Industrial Production (IIP) rose to 4.5 per cent YoY for September 2018.

These are good numbers but there are base effects. The key variable for retail inflation is the food basket, with 46 per cent weight in the Consumer Price Index (CPI). Food inflation was negative in October 2018 at minus 0.9 per cent YoY. That was enough to explain the CPI trends. However, core CPI inflation (CPI inflation minus food and fuel) rose to 6.1 per cent in October, up from 5.9 per cent in September.

The Reserve Bank of India's (RBI’s) inflation target is four per cent, plus or minus two per cent. This has been undershot for months. The Monetary Policy Committee left rates unchanged in early October. If CPI doesn't spike in November 2018 (unlikely given lower crude prices and soft food prices), it may leave rates unchanged, or even cut in December.

There is cause for worry in the fact that rural inflation dipped to 2.82 per cent in October, from 3.27 per cent in September. This is harvest season and festival season. Low rural inflation may mean soft demand. Nomura Research points out that two-wheeler and tractor sales grew at 5 per cent in Q2, versus 16 per cent in Q1, 2018-19, a possible sign of soft demand.

But this could also be a quirk caused by the Goods and Services Tax (GST) base effects. In Q1, 2017-18 (April-June 2017) auto manufacturers cut production - GST did not apply to inventory. Hence, the huge surge in Q1, 2018-19.  After the GST launch in July 2017, auto manufacturers pushed out very high volumes. So 5 per cent YoY growth for Q2, 2018-19 may be very reasonable.

Another point: negative food inflation is odd, given higher Minimum Support Prices. Does it mean low procurement at MSP? Food deflation happened after demonetisation – remember farmers threw away produce in early 2017. That was followed by inflation, as supply dried. If there's deflation now, it could mean more farm distress.

Low inflation may be good news for banks. But it could also mean slow rural demand that slows GDP growth and hurts corporates. It could also translate into anti-incumbency votes against the ruling government if it continues into April- May.

The IIP is even harder to understand. In September, IIP rose YoY to 4.5 per cent compared to August IIP of 4.3 per cent. This was much lower than the 6.6 per cent YoY in July 2018. Cumulative growth for April-September 2018 over April-September 2017 was at 5.1 per cent.

Again base effects may be caused by the GST launch. In highly organised categories, like automobiles, production shot up during Q2. In segments with unorganised value chains, such as textiles, there was a negative impact as manufacturers struggled to get paperwork in order and experienced delayed offsets, and slow refunds for exporters.  If we ignore those effects, the first half Index of Industrial Production (IIP) growth rate seems quite reasonable.

There were big base effects. The Industry group ‘Manufacture of furniture’ showed the highest positive growth of 33 per cent and ‘Manufacture of wearing apparel’ rose by 20.9 per cent indicating recovery in textiles. Electricity production jumped by 8.2 per cent YoY in September, and it's up 6.2 per cent for the half-year.  In the use-based classification, primary goods were up 2.8 per cent, capital goods up 5.8 per cent, intermediate goods up 1.4 per cent and infrastructure/construction up 9.5 per cent.

Despite the base effects, taken together, these IIP data do seem to indicate revival in activity. The really healthy takeaways are in power and construction. Higher power demand in the first half of 2018-19 must have been driven by stronger economic activity. Infra/construction with its unorganised elements had been in deep trouble from demonetisation (November 2016) onwards, and hit during the GST launch as well. That downturn may have finally ended.

Fund managers have been plugging the consumption story, and especially the rural consumption story for the last several quarters. That might be playing out. On the other hand, banks may receive some respite and there could be a comeback in the infra/construction space, once the non-banking financial sector stabilises.