RBI spoils the party

Sandip Sabharwal - Uncategorized - RBI spoils the party

The much anticipated monetary policy by the RBI took place today where the Reserve Bank finally gave way to arm chair economists and hiked rates by 50 basis points as against an expected 25 basis points. The apparent reason for the same is to anchor inflationary expectations. However the reality is that this has been done a bit too late in the day. When inflationary expectations were actually building up at that time the RBI was in the process of balancing inflation and growth and in last years 4th quarter policy infact projected a pause in the rate hike cycle. Its projection of inflation in March 2011 was 6% just six months back and it is the same for March 2012 today. This was in November 2010 when most primary commodity prices had already shot up by nearly 50%. Any economist of merit will know that as input prices move up the down the line industries first wait for some time to see if it is a temporary move. Once they realize that the prices are not going to come down in a hurry the second level of pass through happens and then after a lag the third level.

The strangest part of the policy statement has been that inflation will remain at March levels till September before easing off. The question therefore is that if inflation has not come down even after 9 interest rate hikes and several CRR hikes what is actually going to bring it down now?

The fact of the matter is that RBI’s monetary policies are more effective in controlling asset bubbles rather than inflation and this is something that I have pointed out several times in the past too. Given the fact that the prices of a large number of commodities like crude oil, copper, palm oil, other minerals and food products etc shot up sharply from May/June 2010 till November/December 2010 and the magnitude of the rise was 40-70%, a pass through of this kind of price pressure is all but natural. At this stage making a comment that inflation is now passing off to manufactured products is stating the obvious. As an example take the tyre industry. Natural rubber that forms the majority of the cost of raw materials for the industry shot up by an average of 37% last year. Now if tyre manufacturers would not pass on the cost price increase they will make huge losses. As such tyre prices went up by an average of 18% last year and as a result of this the companies were able to cut down the losses; however tyre companies still made losses in the last quarter. However the reality is that the pass through of costs has happened only partially and a part of this cost absorption has happened because of increased volumes and better efficiencies. Now rubber, carbon black & nylon tyre cord that are the three major raw materials for tyre manufacturing are all global commodities. As such how is tight monetary policy of the RBI going to bring down the prices of these commodities? At best a very tight policy will cut down demand of tyres in India and make these companies make more losses.

A second example is that of the textile industry where cotton prices shot up by a whopping 150% from July 2010 to February 2011 before correcting around 15%. In this scenario where cotton forms a huge chunk of the price of yarn and fabric and margins in these products are in single digits what option do manufacturers have but to increase yarn and fabric prices. As such yarn prices have also doubled in this time period. As yarn prices do up so do prices of fabric and finally garments where there has been a hike of around 20-25%. Now all these are manufactured products. So what does RBI want this industry to do, shut down or absorb all costs and start making losses?

A third example of manufactured products lets say is the Auto industry. Key inputs here include steel, various other forged parts, wires, electronics, tyres etc. The input cost of each one of these products has gone up by a minimum of 20%, if not more over the last one year. However the increase in car/truck/motorcycle prices has been in single digits. As such due to higher volumes and better production economics companies have been able to absorb input costs as well as increased wage costs of 10-12%.

A fourth example will be the follow through impact of a rise in crude oil prices. This leads to an increase not only in fuel costs but also of various chemicals, polymers, fibers etc. Now since these are global commodities the prices in India are just a follow through of global prices. Moreover India consumes just around 3% of global crude oil consumption and as such Indian monetary policy is unlikely to impact global crude prices in any significant way.

The point that I am trying to make is that when there is such a huge input cost pressure there has to be a spill over to manufacturing. As such the spill over has to be seen in the perspective of the cost pressures. I would rather argue that with such a primary cost pressure if the manufacturing sector inflation is below 10% it is infact a great achievement.

Ex of the global commodities on which RBI has no control, the only way to reduce price pressures is to improve supply or improve efficiencies. Due to the various inefficiencies and bureaucracy of governance new projects have found it difficult to start up and we have seen a number of industries working at peak capacity at this stage. The way to control inflation as such has to be by boosting production. We have already seen that in an industry like cement where capacity has been added the inflation over the last three years has been much below inflation despite the steep increase in a large number of input costs for the industry. Higher capacity and larger number of players have kept the prices in control in a large number of consumer durable products.

However the same is not true of food products where a lack of farm sector investment in production/storage/transport still has kept Indian production yields much below global averages and post harvest wastage continues to be huge. Despite recognizing these issues there really is no major effort to boost efficiencies in this sector. A false sense of complacency is there due to the normal monsoons of last year and projections of a normal monsoon this year. However I dread to think what will happen to food inflation in a year of below par monsoons. As such huge investments are required in various aspects of this sector.

In my analysis there are two ways that inflation will come down. The first is a crack in the global commodity bull market as a result of slowing global growth and tighter monetary policy, especially by China. There is clear evidence of demand destruction in the consumption of crude oil. This should ultimately manifest itself in lower prices. The statement by the Chinese Central Bank today that the primary objective of monetary policy now is to achieve price stability is also a clear indication that China is likely to tighten faster and this is likely to be a major factor for commodity price correction.

The other major factor here will have to be the stoppage of money printing by the US Federal Reserve. The commodity rally has been supported to a great extent by the USD carry trade. The USD also looks to be heavily oversold at this point of time and QE2 comes to an end next month. This should create a s
hort term pull back for the USD and lead to a fall in commodity prices.

A large part of the Indian Wholesale Price Index that is used by the RBI for setting monetary policy is driven by commodity prices both primary and manufactured. As such the above factors by themselves are likely to lower inflation going forward and the credit for the same will be taken by them. RBI today risks getting downgraded from the best ranked central bank to one of the worse ones due to its poor reading of macroeconomic trends over the last six months and its inaccurate forecast for the next six months.

Anyways enough of Central bank bashing. Now coming to the markets. Clearly this policy has taken away the sting from the banking sector that forms the largest part of the Nifty, at least for the near term. Other interest rate sensitives might also be pressured in the near term. Under the circumstances after the severe sell off seen over the last few sessions the markets at this point of time lack a big trigger to move either ways. And as such I would believe that we are in for range bound trading over the next 3-4 weeks by which time there will be a clearer idea of the direction of inflation and if things turn out the way I think they should then we could see some easing off of concerns. Overall I still believe that we will see a new high and much higher levels this year, however it is likely to be delayed by a quarter beyond my earlier target of it happening over the next 3-4 months.

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