Will inflation take a bite of growth?

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Will inflation take a bite of growth?

CRISIL Insight

April 5, 2017

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Analytical contacts

Dharmakirti Joshi Dipti Deshpande Krupa Parambalathu

Chief Economist, CRISIL Ltd Senior Economist, CRISIL Ltd Economic Analyst, CRISIL Ltd [email protected] [email protected] [email protected]

Media contacts:

Saman Khan Khushboo Bhadani

Media Relations Media Relations

CRISIL Limited CRISIL Limited

D: +91 22 33423895 D: +91 22 3342 1812

M: +91 9594060612 M: +91 72081 85374

B: +91 22 3342 3000 B: +91 22 3342 3000

[email protected] [email protected]

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Executive summary

Inducements to inflation are indeed many in the road ahead.

To wit, pent-up demand after demonetisation, lower bank lending rates, the second tranche of payments based on the Seventh Pay Commission recommendations, and an uptick in global oil, metals and agri-commodity prices after

~3 benign years.

Not surprisingly, the sharper-than-expected fall in inflation over the past few months – led by a plunge in perishables inflation because of demonetisation – has already started correcting as remonetisation gained currency. And food price pressures could build anew if El Niño disrupts the south-west monsoon this year. To boot, core inflation, which has been sticky, could edge up if domestic demand improves.

Then there is the divergence among states in terms of inflation impact of demonetisation. Between November 2016 and January 2017, most states saw a sharp fall in food inflation – of over 200 basis points (bps) – which brought down their overall inflation. However, and very interestingly, this decline was not uniform, and brought to the fore states where non-food inflation was stubborn.

What are the counter-nuances on food inflation? There are two:

1. The impact of weak rains on food inflation has been diminishing in the recent past because of copious buffer stock and pragmatic imports.

2. Then there is a positive relationship between global inflation and domestic consumer price index (CPI)-based food inflation for certain key food items. For sure, global agri-commodity prices influence domestic prices since imports become expensive. Also, if prices are higher abroad, domestic producers tilt that way and supply less at home, which could stoke domestic inflation.

Given the predicament, we foresee CPI inflation averaging 5% in fiscal 2018, 30 bps higher than in fiscal 2017.

More importantly, monetary policy might have to clearly articulate the glide path to the 4% CPI target in the medium term. That’s because, a tight monetary policy can prove sub-optimal given that a large part of the stickiness in inflation arises from factors beyond the Reserve Bank of India’s control, such as in healthcare and education. Fiscal policy and structural reforms, therefore, will be crucial to quelling incipient inflation.

And even if the government were to increase spending in the supply-starved sectors, it will take time for the benefits to work through an enduringly lower inflation.

So the case for a disinflationary monetary policy will exist for a while, which, in turn, could curb near-term growth.

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Inflation down, but not out

The joint efforts of the Reserve Bank of India (RBI) and the government over the past four years have succeeded to an extent in steering inflation towards the comfort zone. CPI inflation averaged 4.6% in the first 11 months of fiscal 2017. Inflation had plunged following demonetisation, printing at low of 3.2% in January 2017.

To be sure, CPI inflation average for fiscal 2017 is more than 500 basis points (bps) down from the peak of 10% seen in fiscal 2013. But that hasn’t convinced the RBI to cut the repo rate further. Instead, it stood pat during the February monetary policy review, and changed its policy stance from ‘accommodative’ to ‘neutral’. Which suggests that, while the battle to rein in inflation below 5% has been won, the war to bring it down to 4% on a sustainable basis hasn’t been. Possibly, the RBI is more concerned about the coming upward pressures on inflation. In a recent report¹, it states that the “currency squeeze due to demonetization, along with seasonal factors, pushed food inflation significantly down but has not had much impact on inflation excluding food and fuel.”

Core inflation (CPI excluding food and fuel items), which measures demand-led inflation, hasn’t fallen much despite sluggish demand and capacity utilisation. Core inflation fell to 4.9% in fiscal 2016 from 8.2% in fiscal 2013, but since then has hardly moved down.

More than half of the CPI index components recorded over 4.6% inflation The average for this chunk was 7.2% in fiscal 2017*

Note: *inflation data is for Apr-Feb fiscal 2017, items next to the bars in graph indicate major heads in the respective category Source: CSO, CRISIL Research

What’s worrying Mint Road?

In fiscal 2018, inflation is expected to edge up and average 5% from ~4.7% estimated in fiscal 2017. While that’s still within the 4% (+ or - 2%) bound set by the government, it is higher than the 4% central value that the RBI is now targeting for the medium run. Interestingly, the RBI hasn’t specified by which year it wants inflation at 4%.

So what’s putting upward pressure on inflation? We see the following factors:

1 March 2017, ‘Macroeconomic Impact of Demonetisation – A Preliminary Assessment, Reserve Bank of India 1.4

4.6

7.2

138 items with inflation < 4%

Overall CPI 162 items with inflation ≥ 4%

Average inflation rate* (%, y-o-y)

House rent, tuition and other school fees, cooked meals, firewood and chips, food articles (potato, sugar, chicken, wheat, gold, and arhar / tur)

milk, rice, medicine, electricity, petrol for vehicle, refined oil, mobile telephone charges, bus fare 54.3% weight in CPI

45.7% weight in CPI

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 Food inflation

 Pick-up in oil and commodity prices

 Stickiness of core inflation

In what follows, we discuss these in detail.

A persistent noise called food inflation

In fiscal 2018, higher global prices, risk of El Niño, fading demonetisation effect on perishables are potential upside risks to food inflation. Interestingly, the drivers of food inflation have changed over time. While monsoons had a dominating influence on food in the past, of late global prices have been steering it.

The gathering clouds of El Niño

Yet again, El Niño is threatening to come into play. Global weather forecasters such as the International Research Institute for Climate and Society, Columbia University, the Japan Agency for Marine Earth Science and Technology and the National Oceanic and Atmospheric Administration have signalled caution as their preliminary forecasts see an El Niño event in the second half of 2017, with some assigning a 50% probability of occurrence. Locally, private forecaster Skymet Weather Services, too, has forecast below-normal rains for India in 2017. Weak or ill-distributed rains can directly impact agriculture production (and therefore prices of some food items) since close to half of India’s agriculture is rain-fed. The Indian Meteorological Department (IMD), though, is yet to release its monsoon forecast.

However, an El Niño effect does not necessarily imply monsoon failure in India. Since 1991, of the nine times that an El Niño condition manifested, only four led to serious monsoon failure and drought.

~44% chance of an El Niño morphing into monsoon failure

1991 1993 1994 1997 2002 2006 2009 2014 2015

Years that an El Niño condition occurred

Years that India experienced weak monsoon Source: IMD, CRISIL Research

Rainfall deficiency less than 10%

Rainfall deficiency higher than 10%

What affects prices of vegetables and other food items?

Historically, volume and spatial distribution of monsoon rains have had significant impact on agricultural production and hence food inflation. However, over the past 20 years, as indicated in the chart below, a weak relation² has been observed between rainfall deviation³ and food inflation, which indicates that although droughts and floods do have the capability to raise food prices alarmingly, factors besides monsoon have held sway off late.

According to a study⁴ by the Ministry of Agriculture, high government deficit, rising farm wages, and transmission of global food inflation together explain 98% of the variations in Indian food inflation between fiscal 1996 to December 2012.

2 The coefficient of correlation between rainfall deviation and food inflation is 0.2

3 Measured as percentage deviation of actual rainfall from normal

4 Gulati, A., Saini, S., (2013): “Taming Food Inflation in India,” Discussion Paper No. 4, Commission for Agricultural Costs and Prices, Department of Agriculture & Cooperation, Ministry of Agriculture.

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Somewhat weak relation between south-west monsoons and CPI food inflation

Source: CEIC, RBI, IMD, CRISIL

Of course, perishables such as fruits and vegetables will continue to be rain-dependent since imports and stocks play a small role in bolstering supplies. Also, with a 23% weight in the food index, perishables inflation can spike if production is disrupted.

Over the past four years, much of the decline in overall inflation came from food prices. Food inflation saw the sharpest fall, from over 12% in fiscal 2014 to 4.4% average in fiscal 2017 (April-February). A mix of factors were behind this – higher cereals and, of late, higher pulses production, declining global prices of agriculture commodities, and moderate minimum support price (MSP) hikes.

Better food-supply management by the government such as releasing excess food stocks, checks on hoarding, and utilisation of the price stabilisation fund to subsidise the cost of imported pulses, also helped lower food inflation.

However, one of the key favourable factors – benign global food prices – is now reversing.

Global food inflation seeping into domestic inflation

There is a mild positive correlation between global and Indian CPI food inflation for certain commodities such as cereals, sugar and edible oil. These together have a weight of 15% in the CPI food index. Global inflation drives up their domestic prices as imports become expensive. Also, with global prices rising, domestic producers cash in by exporting, which reduces supply and lifts local prices.

0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0

-25.0 -20.0 -15.0 -10.0 -5.0 0.0 5.0

CPI food inflation (%)

South-west monsoon deviation from normal (%)

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Food CPI rises as global food inflation rises

Source: FAO, RBI, CEIC

Another factor that culled domestic food inflation was demonetisation. While food inflation fell to a record low of 1.3%

in January, perishables’ inflation was down to -2.3%. However, this is also reversing now.

Demonetisation impacted perishables more, but that effect is waning

After demonetisation, the CPI for food declined from 3.3% on-year in October 2016 to 2.1% in November, to 1.3% in December and further to 0.6% in January 2017. Among food items, the worst hit were perishable⁵ commodities which bore the brunt of the cash crunch. The RBI’s study referred to earlier said, “…during November-January every year, vegetable prices usually exhibit seasonal moderation; however, during this season, the decline in prices was more pronounced than … in the previous years.” Also items which do not see typically a seasonal decline in inflation during this period witnessed sharp fall in prices.

The weighted average of CPI for perishable commodities declined from 1.2% on-year in October 2016 to -2.3% in January 2017. The impact of demonetisation on non-perishable⁶ commodities, however, was less severe with inflation falling from 5.7% on-year in October 2016 to 3.9% in January 2017. However, as indicated by inflation data for February 2017, the impact of demonetisation is now easing as remonetisation gathers pace. While inflation in perishables increased to 300 bps compared with January, the inflation in non-perishables fell by 40 bps in February 2017.

5 Perishable commodities include meat and fish, egg, milk and milk products, fruits, and vegetables

6 Non-perishable commodities include cereals and products, oil and fats, pulses and products, sugar and confectionary, spices, and prepared meals, snacks, sweets, etc.

-0.5 0 0.5 1 1.5 2 2.5

-8 2 12

CPI Inflation (%)

Global Inflation (%) Cereals

-1 -0.5 0 0.5 1 1.5 2 2.5 3

-9 1

CPI Inflation (%)

Global Inflation (%) Edible Oil

-4 -2 0 2 4 6 8 10

-20 -10 0 10 20

CPI Inflation (%)

Global Inflation (%) Sugar

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Little impact of demonetisation on non-perishables inflation

Source: CEIC, RBI, CRISIL

A 2016 study⁷ by the International Monetary Fund (IMF) on India’s food inflation suggests that supply-side factors are critical determinants of food inflation. As India’s economic growth picks up, rising incomes will prompt shifts in food consumption away from simple, starchy, plant-dominated diets towards more nutritious and high-value foods that include a range of dairy products, vegetables and fruits, and meat, increasing demand pressures for these commodities. The IMF study concludes that in the absence of a stronger food supply response, relative food inflation can contribute about 1.25% to headline CPI inflation annually. So as private consumption demand strengthens given stagnant supply, the pressures of food inflation will stay firm.

Food inflation pressure points in fiscal 2018

Factors Fiscal 2016 Fiscal 2017 Fiscal 2018^F

Demonetisation –

Monsoon*

Global agriculture commodities prices

Domestic demand

Note: * Monsoon may prove to be a risk to food inflation on account of the probability of El Niño, however, the IMD is yet to confirm the possibility of the same, F=Forecast

Downside to inflation Upside to inflation

Gradual pick-up in oil and commodity prices

So far, global oil and commodity prices were benign, but they are now rising. In fiscal 2018, CRISIL Research expects global oil prices to rise 7.8%. For calendar 2017, World Bank forecasts a 2.4% increase in metals prices and a 1.1%

pick-up in agri-commodity prices. This, along with a weaker rupee, will put upward pressure via imported inflation.

Currently, the rupee has been appreciating, which is beneficial to inflation. But we do not expect this trend to continue.

The rupee could see some weakness in fiscal 2018 as the dollar strengthens on the back of anticipated reforms, Fed rate hikes, and stronger recovery in the US.

7 Anand, R., Kumar, N., and Tulin, V., (January 2016): “Understanding India’s Food Inflation: The Role of Demand and Supply Factors,” IMF Working Paper WP/16/2

1.2%

-0.5%

-1.8%

-2.3%

0.7%

5.7%

4.9% 4.7%

3.9% 3.5%

Oct-16 Nov-16 Dec-16 Jan-17 Feb-17

CPI perishables inflation CPI Non-perishables inflation

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Deconstructing the ‘core’ of inflation

Core inflation is simply a measure to separate the noise from the signal⁸. Increasingly, the RBI is pointing to the stubbornness of core inflation, although it officially targets overall CPI inflation. The RBI has not explicitly stated how it computes core CPI, and it can be calculated in more than one way: by excluding food, fuel and light, or by excluding food, fuel and light, and petrol and diesel. Data is limited for the second method. We therefore look at the first method and study the trend since fiscal 2013.

Core inflation measures show stickiness in fiscal 2017

CPI (%, y-o-y) Weight (%) FY13 FY14 FY15 FY16 FY17 (Apr-Feb)

Core CPI* 54 8.2 7.7 5.8 4.9 4.9

Where there is persistent supply-shortage 20 7.4 7.3 6.5 5.3 5.1

Housing 10.1 7.2 7.6 6.9 4.9 5.2

Health 5.9 7.2 6.4 5.2 5.4 4.6

Education 4.5 8.2 7.8 7.2 6.3 5.3

Where monetary policy can impact 31 8.6 7.8 5.3 4.2 4.6

Non-alcoholic beverages 1.3 7.6 8.3 4.7 4.5 3.9

Prepared meals, snacks, sweets etc. 5.6 11.5 11.2 8.1 7.1 5.7

Clothing, and Footwear 6.5 11.0 9.3 7.3 5.8 5.1

Household goods and services 3.8 8.6 7.6 5.9 5.3 4.4

Transport and communication 8.6 5.5 6.6 2.5 0.4 2.8

Recreation and amusement 1.7 4.5 6.0 5.1 4.7 4.1

Personal care and effects 3.9 9.5 3.8 3.5 3.7 6.7

Pan, Tobacco and Intoxicants 2 10.0 9.1 8.1 9.3 6.9

Below 4% 4-7% 7-10% >10%

Note: *Excludes food, fuel and light Source: CSO, CEIC, CRISIL Research

The fact that core inflation has stayed stubborn in fiscal 2017 in the face of weak capacity utilisation, and hit to consumer demand from demonetisation has been intriguing. Core inflation fell to 4.9% in fiscal 2016 from 8.2% in fiscal 2013, but since then has hardly moved down.

What is behind the rigidity?

i. 37% of core inflation comprises items in chronic shortage, which translates into perpetual upward pressure on inflation. These include health, education, and housing. Given severe shortages, especially in public health and education facilities, most people turn to the higher-cost private sector. Monetary policy can only play a limited role in such sectors, as demand in health and education are less sensitive to prices and interest rates. Inflation control in these categories is thus a function of fiscal policy, about reorienting government spending towards supply expansion.

ii. The rest of the core index comprises items where inflation is ‘more demand-led’. Here, a large part includes consumer services such as household services, transport and communication, recreation and amusement, and

8 ‘Noise’ in inflation comprises highly volatile prices whose impact on inflation is usually transitory. ‘Noise’ mainly arises due to factors that are hard to predict such as supply disruptions in food, currency volatility, and movements in international crude and commodity prices. ‘Signal’

reflects the demand-side pressure on prices and provides an indication of the likely inflation path ahead.

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personal care and effects. An RBI study⁹ finds that in the case of consumer services, demand has unit elasticity to income. A tight monetary policy will be more effective in trimming demand, and therefore inflation, in these categories.

Over the past four years, inflation in products suffering from persistent supply shortage fell only 230 bps whereas in those where income-led push to demand has a larger role to play slid nearly 400 bps. That means a disinflationary monetary policy will have limited impact on core inflation.

iii. Finally, an increase in effective service tax rates during fiscal 2017 (from 14% to 15%) also has a role to play in keeping core inflation sticky and elevated. That’s especially true of services such as maintenance, housing (rent), tuition fees, air fares mobile/telephone bills, and movie tickets, among others, where the higher tax rate is naturally passed on to the end-consumer regardless of the impact on demand. Close to 20% of the weight in the core index is taken up by such items and inflation in these has stayed sticky at 5.2% so far, unchanged from last year. Since it is known that the impact of any tax rate hike on inflation is only temporary, the RBI should take cognisance of this when looking at trends in core inflation. With the Goods and Services Tax (GST) being soon implemented, inflation could rise further in this category as it proposes raising the service tax rates. A report¹⁰ by the Ministry of Finance finds that in several economies, GST implementation boosted inflation for a year.

Once these prices enter the base, inflation dissipates, indicating low persistence of such inflation caused by the tax rate hike.

Meanwhile, the ratio of core to non-core inflation has been showing a sustained pick-up suggesting stickiness and explains why policymakers are increasingly focussing on this measure of inflation.

Core to non-core inflation show a steady pick-up

Source: CSO, CEIC, CRISIL Research

Sharp and sustained decline in overall inflation will necessitate a tight fiscal stance, and perhaps a tighter – more disinflationary – monetary policy stance over the medium term. The latter implies a built-in tendency for monetary policy to lower inflation even if this calls for compromise on GDP growth. Studies suggest that the developing countries transitioning to inflation targeting saw relatively modest gains with growth only moving closer to the trend rate, and not necessarily beyond it. A possible explanation cited is that developing economies have less stable

9 2002, ‘Exploring the slowdown’, the Reserve Bank of India

10Ministry of Finance, 2015, Report on the Revenue Neutral Rate and Structure of Rates for the Goods and Services Tax (GST) 0.00

0.50 1.00 1.50 2.00 2.50 3.00 3.50

Feb-12 May-12 Aug-12 Nov-12 Feb-13 May-13 Aug-13 Nov-13 Feb-14 May-14 Aug-14 Nov-14 Feb-15 May-15 Aug-15 Nov-15 Feb-16 May-16 Aug-16 Nov-16 Feb-17

Ratio of core to non-core inflation

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macros with high inflation expectations and less credible policies. So, transitioning to a low-inflation regime may require a tighter monetary policy for an extended period of time, which may cost growth.

Should the RBI therefore choose to extend the glide path or raise the interim CPI inflation target (within the prescribed band) so that the growth trade-off is milder?

Conclusion

The focus on inflation control promises to bring more predictability to policymaking. Low and stable inflation will facilitate lower real interest rates in the economy which favours both, investments and consumption. Also, sustained low inflation can be self-reinforcing in that households as well as businesses are confident of inflation control in the long term and will not react as quickly to short term price pressures by raising prices or wages.

While the government has set a CPI target range of 4% (+ or - 2%) for the medium term, the RBI’s target is more rigid at the 4% central value. It is not clear when will the 4% target come into effect. Attempts to achieve 4% target quickly can create trade off on the growth front.

Monetary policy might need to reconsider the timing of a rigid 4% CPI target in the medium term especially taking into cognisance the trade-off to growth in the current environment of weak domestic demand and investment climate.

Some studies¹¹ conclude that the even if inflation is slightly higher than the optimal target, but is stable, the cost in terms of growth trade-off is often less than three-hundredths of a percentage point of annual GDP growth. Others argue that the economy’s level of output could be about 1% lower for each percentage point that inflation rate is above the optimal target. In his book, ‘India’s Long Road: The Search for Prosperity’, noted economist Vijay Joshi writes¹², “The output cost of bringing down inflation may well be greater in the future than in the past. In other words, India will unavoidably face a sharper short-run trade-off between inflation and growth than hitherto.”

A tight monetary policy (aimed at achieving 4% inflation target) may prove to be sub-optimal given that a large part of the stickiness in inflation arises from factors which are outside the control of monetary policy. Fiscal policy and structural reforms, therefore, will now have to play an even bigger role than before in inflation control. Even if the government were to increase spending and create capacity in the supply-starved sectors such as health, education and housing, it will take time for the benefits to work through and lower inflation.

Monetary policy, therefore, may be compelled to remain disinflationary till such time there is a material change in supply of these items. That, in turn, can curb near-term growth.

11 Anderson R., (2006): “The Long-run benefits of sustained low inflation,” Central Banker Summer 2006 issue, Federal Reserve Bank of St.

Louis.

12 Joshi V., (2016): “India’s Long Road: The Search for Prosperity”, pages 321-322

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Annexure

Regional dynamics of inflation post demonetisation

Regional variations in CPI during demonetisation period show a sharp fall in food inflation across most states.

However, in a few (mainly North-west and Eastern states), the drop in food inflation was unaccompanied by a proportionate fall in overall CPI. This suggests that in these regions, the non-food component of CPI in some states stayed more stubborn than in others.

Fiscal 2017, average change in CPI during Nov-Jan Vs Apr-Oct

CPI inflation rose Fall in CPI is between 0 and 200 bps Fall in CPI is more than 200 bps

Manufacturing inflation dances to the tunes of capacity utilisation Excess capacity leads to low inflation

Another factor influencing inflation is capacity utilisation levels in manufacturing. As indicated in the figure below, there exists a positive relationship between capacity utilisation and manufacturing wholesale price index (WPI) inflation. This means that existence of underutilised capacity¹³ leads to low inflation in the manufacturing sector and vice versa. Since capacity utilisation is a function of demand, at lower capacity utilisation levels, the producer is unable to pass-on the increase in input cost to the end-users and is forced to bear the burden of the rise in cost.

However, at higher capacity utilisation levels, with higher demand, the producer is able to pass on the rise in input prices to the end-users, thus pushing up inflation.

Strong positive relation between capacity utilisation and WPI inflation in manufacturing

13 Data on capacity utilisation is sourced from the latest OBICUS survey if RBI, which is computed based on a set of 857 companies

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Source: CEIC, RBI

Lower capacity utilisation levels squeeze manufacturing margins

When demand for manufactured products is high, the manufacturing industry operates at higher capacity utilisation to produce enough to meet the demand. At higher capacity utilisation levels, with demand high, producers are better- positioned to pass on the cost of production to the end users and have a comfortable profit margin. However, when demand is sluggish, industry operates at low capacity utilisation levels, and are unable to pass on the complete cost of production to the end-users, thus squeezing producer margins.

To understand this dynamics better, a comparison of the ratio of output prices to input prices¹⁴ at the wholesale level for manufactured products and the growth in the index of industrial production (IIP) of the manufacturing sector has been undertaken and depicted in the figure below. Higher growth in IIP manufacturing reflect higher capacity utilization and vice versa, and higher output to input (O/I) ratio reflect higher pricing power of the producer and vice versa.

WPI based output to input ratio Vs IIP growth for manufacturing sector

Note: IIP manufacturing data for FY17 includes data up to January 2017 Source: CEIC, CRISIL Research

14 The output prices considered for this analysis include WPI of final manufactured products which are directly consumed by end-users (for example, food products, textile, machinery, etc.), and the input prices considered for this analysis include WPI of intermediate manufactured products (e.g. metals, basic chemicals, leather, timber, etc.) as well as fuel inputs (for example electricity, high speed diesel, naphtha, etc.)

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

68.0% 70.0% 72.0% 74.0% 76.0% 78.0% 80.0% 82.0% 84.0%

WPI manufacturing inflation

Capacity Utilisation

-5.00 0.00 5.00 10.00 15.00 20.00

0.76 0.78 0.80 0.82 0.84 0.86 0.88 0.90 0.92 0.94 0.96

FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17

IIP Manufaturing growth (%)

WPI Manufacturing output to input ratio

Ratio (O/I) IIP-Mfg (right scale)

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As seen in the chart above, the shock from the global financial crisis brought dented demand for manufactured products in fiscals 2008 and 2009, which, in turn, caused industrial production growth to slump. Correspondingly the concentration, or O/I, ratio also declined indicating that producers’ pricing power had reduced. Fiscal 2010 onwards however, the domestic policy-led push to consumption demand, revived industrial production growth and also raised the O/I ratio. Again since fiscal 2012 however, withdrawal of domestic policy stimulus dampened demand for manufactured goods and pulled down industrial production growth. There was a mild uptick in demand in fiscals 2015 and 2016 causing the growth in manufacturing IIP to plateau. But with falling global crude prices¹⁵ which brought down the input costs, the O/I ratio saw a significant rise.

Impact on GDP as divergence in CPI and WPI closes

The new gross domestic product (GDP) series faces flak for not being aligned with ground- level indicators. A particular crib is that it bumps up manufacturing GDP compared with what the Index of Industrial Production (IIP) generally reflects. Since the onset of the global financial crisis in 2008, manufacturing GDP¹⁶ growth has been faster than IIP growth.

Coinciding with this trend is the divergence in wholesale (as measured by the wholesale price index, or WPI) and retail (as measured by the consumer price index, or CPI) inflation. Since the crisis, WPI inflation has trended below CPI inflation.

Since the financial crisis, IIP has trailed GDP… …WPI also slower than CPI

Note: Dates refer to fiscal ending of the respective year Source: Central Statistics Office, CRISIL Research

As per a CRISIL Report¹⁷, the variance may be because, while the IIP measures the volume of output, manufacturing GDP aggregates the value added. ‘Value added’ is obtained by subtracting the value of intermediate goods from the value of output. In addition, the basket of goods used to calculate the IIP is different from the data used to calculate the manufacturing GDP.

One reason for the faster growth in manufacturing GDP is that the growth in value of inputs used for production has been slower than the value of final output. As a result, the value added has grown faster than the volume of output.

The former is used for calculating GDP and the latter IIP.

Why has growth in value of inputs been slower than the value of output? The reason may be prices of inputs fell more relative to the prices of output. This is confirmed by inflation trends, where WPI inflation (which captures inflation in commodities used as inputs) was consistently lower than CPI inflation (which captures inflation in goods sold in

15 Brent crude prices fell from an average of $85.7/bbl in FY15 to an average of $47.5/bbl in FY16

16 As measured by manufacturing sector’s gross value added (GVA) at basic prices

17 Joshi, D. and Tandon, P. (March 2017): “Answers to the GDP-IIP conundrum soon?,” CRISIL Economy Quick Byte -2

0 2 4 6 8 10 12 14 16

Pre crisis (2006 to 2008)

Crisis (2009)

Post Crisis (2010 to

2011)

2012 to 2015

2016 2017

(Apr-Dec)

Average y-o-y growth (%)

GVA manufacturing IIP manufacturing

-4 -2 0 2 4 6 8 10 12 14

Pre crisis (2006 to 2008)

Crisis (2009)

Post Crisis (2010 to

2011)

2012 to 2015

2016 2017 (Apr- Dec)

Average y-o-y growth (%)

CPI WPI Manufacturing GDP deflator

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the retail market) since the global financial crisis. Moreover, real manufacturing GDP is obtained by dividing nominal GDP by the manufacturing GDP deflator. This deflator is composed of the relevant WPI for each sub-sector within the manufacturing sector. Hence, the fall in WPI inflation had a greater impact on real manufacturing GDP than CPI inflation. This further induced real manufacturing GDP growth to increase more than the IIP growth.

However, there have been signs of reversal in this trend of late. Since January 2017, WPI has grown faster than CPI.

While CPI grew 3.65% on-year in February 2017, WPI rose 6.55%. WPI inflation has moved in tandem with global commodity prices, which started rising in the latter part of 2016. Prices are expected to rise further, with the World Bank projecting energy and non-energy commodity price indices to rise 26% and 3%, respectively, in 2017. Owing to this, we expect WPI inflation to increase from 3.44% this fiscal so far¹⁸ to ~5% in fiscal 2018, while CPI inflation will see a milder rise from 4.7%¹⁹ to 5%. Correspondingly, the manufacturing GDP deflator would also accelerate from 2.4%²⁰ in fiscal 2017 to ~4% in fiscal 2018, and bring down real manufacturing GDP growth. In such an event, the gap between manufacturing GDP and IIP is likely to narrow.

Additionally, the imminent release of the new IIP series, and the revision of its base year, are expected to lead to better capturing of ground data. The current IIP series is based on the industry’s production structure in 2004-05, and therefore does not capture the output of the new industries which have sprung up since then. With the revision of base year in the new IIP series, the new industries will be incorporated in its database. This would further reduce the discrepancy between IIP and GDP numbers for the manufacturing sector.

18 Average y-o-y growth from April 2016 to February 2017

19 CRISIL’s forecast for fiscal 2017

20 CSO estimate

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CRISIL is a global, agile and innovative analytics company driven by its mission of making markets function better. We are India’s foremost provider of ratings, data, research, analytics and solutions. A strong track record of growth, culture of innovation and global footprint sets us apart. We have delivered independent opinions, actionable insights, and efficient solutions to over 100,000 customers.

We are majority owned by S&P Global Inc., a leading provider of transparent and independent ratings, benchmarks, analytics and data to the capital and commodity markets worldwide.

About CRISIL Research

CRISIL Research is India's largest independent integrated research house. We provide insights, opinion and analysis on the Indian economy, industry, capital markets and companies. We also conduct training programs to financial sector professionals on a wide array of technical issues. We are India's most credible provider of economy and industry research. Our industry research covers 86 sectors and is known for its rich insights and perspectives. Our analysis is supported by inputs from our network of more than 5,000 primary sources, including industry experts, industry associations and trade channels. We play a key role in India's fixed income markets. We are the largest provider of valuation of fixed income securities to the mutual fund, insurance and banking industries in the country. We are also the sole provider of debt and hybrid indices to India's mutual fund and life insurance industries. We pioneered independent equity research in India, and are today the country's largest independent equity research house. Our defining trait is the ability to convert information and data into expert judgements and forecasts with complete objectivity. We leverage our deep understanding of the macro-economy and our extensive sector coverage to provide unique insights on micro-macro and cross-sectoral linkages. Our talent pool comprises economists, sector experts, company analysts and information management specialists.

CRISIL Privacy

CRISIL respects your privacy. We use your contact information, such as your name, address, and email id, to fulfil your request and service your account and to provide you with additional information from CRISIL and other parts of S&P Global Inc. and its subsidiaries (collectively, the “Company”) you may find of interest.

For further information, or to let us know your preferences with respect to receiving marketing materials, please visit www.crisil.com/privacy. You can view the Company’s Customer Privacy at https://www.spglobal.com/privacy

Last updated: April 2016

Disclaimer

CRISIL Research, a division of CRISIL Limited (CRISIL) has taken due care and caution in preparing this Report based on the information obtained by CRISIL from sources which it considers reliable (Data). However, CRISIL does not guarantee the accuracy, adequacy or completeness of the Data / Report and is not responsible for any errors or omissions or for the results obtained from the use of Data / Report. This Report is not a recommendation to invest / disinvest in any company covered in the Report. CRISIL especially states that it has no financial liability whatsoever to the subscribers/ users/ transmitters/ distributors of this Report. CRISIL Research operates independently of, and does not have access to information obtained by CRISIL’s Ratings Division / CRISIL Risk and Infrastructure Solutions Limited (CRIS), which may, in their regular operations, obtain information of a confidential nature. The views expressed in this Report are that of CRISIL Research and not of CRISIL’s Ratings Division / CRIS. No part of this Report may be published / reproduced in any form without CRISIL’s prior written approval.

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Will inflation take a bite of growth?