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Friday, July 18, 2008

Indian Inflation Accelerates Again At The Start Of June

India's inflation accelerated to the fastest pace in more than 13 years at the start of July, putting pressure on the central bank to continue raising interest rates following the two increases made last month. Wholesale prices rose 11.91 percent in the week to July 5, after gaining 11.89 percent in the previous week, according to the commerce ministry in New Delhi on Friday.

It now seems very likely indeed that the Reserve Bank of India (RBI) will continue to tighten policy, since one of the major risks facing India now is that inflation becomes entrenched, and to avoid that eventuality the RBI may well need to implement a further significant policy tightening, and this of course will have implications for an Indian economy where growth is already slowing. However, with inflation at nearly 12% and the repurchase rate at 8.5% we shouldn't lose sight of the fact that India still has negative interest rates (minus 2.5% approx) thus monetary policy could be said to be still pretty accommodative, the problem is that with growth at such a fast pace, and inflation expectations rising, and thus the possibility existing of passing on increased prices to consumers, the situation could simply be self-perpetuating with interest rates at the current level. That is high but negative interest rates can, in the right circumstances (and particularly with high liquidity, and M3 money supply growth of 20.5% per annum) simply perpetuate strong price increases, and fuel compensatory wage demands which only serve at the end of the day to send things spinning round and round in an ever more vicious circle

The RBI currently expects the Indian economy to grow by 8.5 percent in the current fiscal year, slower than the 9 percent pace of the previous 12 months, but this forecast is now looking to be significantly under threat from the downside.

India's economic growth has slowed being slowing and clocked up the weakest pace since 2005 in Q1 2008, as the highest interest rates in six years discouraged consumer spending and investment, while a more complex global environment reduced the opportunities for expanding India's exports. India's economy expanded at a year on year rate of 8.8 percent in the three months to March 31, matching the revised rate of the previous quarter.

Foreign Exchange Reserves

India's foreign exchange reserves were up again in the week ended July 11 - by $123 million - according to the latest Reserve Bank of India data. The rise comes following a series of declines induced by changes in relative currency values and the drying up of earlier substantial net inflows. Forex reserves, including gold and SDR (special drawing rights), rose to $308.52 billion. The $123 million rise in the dollar value of the reserves was mirrored by a Rs 14,133 crore dip in the rupee value of funds, which strongly suggests that the increase has more to do with the value of the rupee vis a vis other currencies than any real increase in the inward flow of funds. Looking at the chart (above) it is clear real heavy net inflows came to a halt around the end of March.

M3 money supply growth slowed to 20.5 per cent during the two weeks ended 4 July - down rom 20.7 per cent two weeks earlier. The loan book at Indian scheduled banks was up by 25.7 per cent y-o-y at the close on July 4, compared with a 24.4 per cent rise a year earlier, ie loan growth is still not slowing significantly, although once you take inflation into account it is, of course, slowing. Deposit growth declined to a 21.7 per cent rate compared with a 24.6 per cent at the same point in 2007.

Money supply has now been rising at an average rate of 21.5% since the current fiscal year began on April 1. This is well above the central bank's target of 16.5% to 17% for the fiscal year ending March 2009.

Cash in the Indian money market, however, is likely to get scarcer in the near future since banks will have to place an additional part of deposits with the RBI as of July 19, when the revised norms on cash reserve requirements come into force. This tightening comes at a time when Indian banks are already been borrowing close to a daily Rs 30,000 crore from the RBI.

The raising of the cash reserve ratio to 8.75% coupled with the rise in the cost of borrowing via the the repo rate rise to 8.5% is thus now producing significant effects on day to day liquidity, and most Indian analysts are talking about a withdrawal of some Rs 16,000 crore of funds from the banking system during the coming week. While the cash reserves hike alone is expected to take Rs 8,000 crore out of the system, the RBI is also planning to issue bonds worth Rs 10,000 crore, which will simply bring cash conditions under further pressure. This move by the RBI would seem to be evidence of a certain conflict of interests between the RBI and the Gingh administration, since it was anticipated that funds from an April bond issue which is due to mature in July would be released into the banking system to ease the current cash crunch. However, since the RBI is expressly trying to create the cash crunch, it immediately announced it was itself going to issue a series of bonds as a market stabilisation measure - and effectively suck these funds straight back out again.

Analysts expect banks to be borrowing up to Rs 45,000 crore from the central bank at the daily repo window next week while borrowing rates in the inter-bank call money market are expected to rise to 9.5%. Thus the Indian banking system has been experiencing tight cash conditions for over a month now, and these conditions are likely to continue.

The Rupee

India's rupee gained for a second week last week as the largest weekly drop in crude oil prices ever spurred speculation import costs will decline. The rupee climbed to its highest level in more than three weeks on Friday as light, sweet crude for August delivery fell 41 cents to settle at $128.88 on the New York Mercantile Exchange — well below its trading record of more than $147 a week earlier. India depends on imports to meet three-quarters of its annual energy needs. The rupee also advanced on speculation gains in local equities will attract global funds.

The rupee gained 0.2 percent on the week to 42.785 per dollar at the 5 p.m. close of trading in Mumbai, the highest since June 26. It had risen as high as 42.66 earlier the day. The currency has now rebounded 1.6 percent from a 15-month low of 43.475 on July 1.

The 37 percent rise in crude oil prices so far this year has boosted the average cost of India's monthly oil imports by 43 percent, and oil imports have averaged $7.8 billion a month so far this year, compared with $5.45 billion in 2007.

An additional factor in the upward pressure on the rupee - apart, of course, from the yield advantage which would derive from the anticipated hike in rates following this weeks inflation data - is the fact that the benchmark Sensex share index climbed for a second week, raising optimism overseas investors will scale back sales of local assets. Funds based outside India have sold $7.13 billion more Indian equities than they have bought so far this year, compared with a net purchase of $17.2 billion in 2007, according to the Securities and Exchange Board of India.

Fitch Downgrade

India's Finance Minister Palaniappan Chidambaram has been busy in recent days, trying to downplay the decision by global rating agency Fitch to lower India's local currency credit rating. Chidambaram said the decision was not a cause for concern since the country's economic fundamentals were strong, and stressed that India would grow by around 8 per cent this year. "We must look at fundamentals, which I believe are still strong, but facing difficulties. I do not think we should worry about the outlook,".

While Chidambaram is evidently right here in big picture terms, it is important not to underplay the seriousness of the problem which is being posed by inflation at the present time, nor should he try to deny the significance of the deteriorating fiscal outlook in India, since, as he is indicating, India is far from being in recession, or even in danger of a serious slowdown, so it is important that these twin problems of fiscal deficit and spiralling inflation be gotten under control now.

The decision by Fitch to revise India's local currency outlook to negative from stable is based on a perception by the ratings agency of a worsening fiscal position and rising inflation. The assignment of a negative outlook suggests an increase in the sovereign default rate may follow if the problem is not corrected, and this would affect the flow of funds - and hence investment - into India. The new revised local currency rating will be 'BBB-' with negative outlook as against the earlier 'BBB-' with stable outlook.

James McCormack - Head of Asia Sovereign Ratings for Fitch - is quoted as saying the "the revision to the local currency outlook is based on a considerable deterioration in the central government's fiscal position in 2008-09, combined with a notable increase in government debt issuance to finance subsidies not captured in the budget." The rating agency has revised its economic growth forecast for 2008-09 from just under 9% to 7.7%, and this seems to be not unreasonable.

Fitch did, however, continue to affirm India's long term foreign currency Issuer Default Rating (IDR) at 'BBB-' with stable outlook, its short-term foreign currency IDR at F3 and the country ceiling at 'BBB-'. The assignment of a local currency negative outlook thus means that agency has effectively put India on watch with the implication that is the underlying causes (inflation and the underlying dynamics of the fiscal deficit) are not addressed over the next 12 to 18 months, the rating could be subject to downgrade. Obviously this is a warning shot as much as anything else, and an attempt to put pressure on the Indian government.

India's total central government deficit - including the subsidies to oil companies - may surpass 6.5% of GDP in the current financial. Even the budgeted deficit could rise to 4.5% of GDP from the projected 2.8% of GDP due to higher on-budget subsidies, together with rising interest payments and public sector wages. In addition to this, Fitch argue that bonds issued to oil and fertilizer companies may well reach 2% of GDP in 2008-09.

Higher oil prices have raised India's oil import bill dramatically in last three years, and the goods trade deficit was equivalent to 7.7% of GDP in 2007-08. The current account deficit, however, was much smaller at around 1.5% of GDP, due to high services exports and the strong remittances inflow (estimated by the World Bank at 2.8% of GDP in 2006).

Fitch forecast that the trade deficit will widen further in 2008-09 to 8.2% of GDP, although they suggest the current account deficit may remain broadly unchanged at 1.5%. The IMF do not seem to be so sanguine on this as Fitch, however, (although please note they are using calender and not financial year data) since the April World Economic Outlook forecast was for a CA deficit 2008 of 3% of GDP (they are also forecasting 7.9% GDP growth WY 2008). As can be seen in the chart (below), whichever way you look at it India's external position is certainly deteriorating.

So their is a slight disconnect here, with a deteriorating fiscal side and a comparatively strong external position, which is what is being reflected in the credit rating differential between local and foreign currency.

In the past four years, the three rating agencies have raised India to investment grade on the back of its positive external financial ratios, improving budget deficit and robust GDP growth. The external position remains strong, but analysts are worried that domestic problems and a flight of capital could combine to bring down the country's credit standing.

Earlier this month, Standard and Poor's said the rising cost of subsidies, debt write-offs and public sector wage rises had increased the risk of a downgrade of the BBB-minus domestic debt rating - the lowest investment-grade rating - they assign to India.

While Standard and Poor's, like Fitch, rates both India's foreign and domestic debt at BBB-minus, Moody's rates its domestic debt two notches lower than its foreign rating. Foreign funds have already cut their investments in Indian debt and stock markets by $6.3 billion this year to $31.2 billion. Any further downgrade will only serve to speed this outflow.