India Does Not Have History of High Inflation

Historically, India's inflation has been lower compared with other emerging markets. Inflation WPI and CPI-Industrial Workers (CPI-IW) have averaged 5.3% and 6.8%, respectively, over the last 15 years compared with 11.2% (CPI) for emerging markets. Double-digit inflation is not the norm. Indeed, over the last 10 years on an annual average basis, WPI inflation crossed 10% not once while CPI-IW crossed 10% only one time. On a monthly basis, the two recent spikes in WPI inflation numbers to double-digit levels have been caused by oil prices spiking above US$140/bbl (in 2008) and severe drought affecting farm output, leading to a sharp rise in food inflation (2009) and other cyclical factors. Typically, double-digit inflation prompts policymaker responses as society at large has begun to expect inflation of around 5-5.5%. 

Recall the Trend in 2003-07: Strong Growth and Manageable Inflation

We highlight that during 2003-07, India's GDP growth averaged 8.9% and WPI inflation averaged 5.5%. In other words, India has been able to transition to higher growth without the significant acceleration in inflation except for the recent cyclical spikes in inflation as discussed above. However, one could argue that in the initial part of the strong period, the country was operating with excess capacity, as measured by the usual trend in the current account, which was in surplus of 2.3% of GDP in F2004 (12 months ended March 2004). However, there was no major inflation pressure in this period. Inflation pressures picked up only in 2008, when oil prices shot up and summer crop/food grain output suffered a decline of 2.3%Y. The current account deficit also remained in the manageable range during this period with peak levels of just 1.3% of GDP in 2008.

What Helped Manage Inflation in 2003-07 Even as Growth Accelerated?

We believe that during 2003-07, there was a steady pick-up in growth and a commensurate rise in investments and productivity. India's investment to GDP gradually rose from 25.2% in F2003 to 37.7% in F2008 and savings to GDP rose from 26.3% in F2003 to 36.4% in F2008. Infrastructure spending also increased from a trough of 4.3% of GDP in F2003 to 6.4% in F2008. Capital deepening, a rise in trade to GDP, increased capital inflows, an improvement in technology and corporate management efficiency helped to improve productivity growth. Total factor productivity growth accelerated to 3.8% during 2003-07 from an average 2.4% in the 1990s.

Cyclical Factors Distort the Inflation Trend

As we explained in Part I (Inflation Challenge: Cyclical or Structural, Part I), the surge in crude oil prices in 2008 and supply shock in food production were the two key factors pushing headline inflation in India to double-digit levels on a monthly basis in the recent past. The spike to double-digit inflation rate was driven by global commodity prices price shock when crude oil prices rose to US$140/bbl in mid-2008. Further, summer (Kharif) food grain output declined by 12.1%Y for the 2009 summer crop, which accounted for about 50% of the full-year output. India saw one of the worst droughts in history in 2009. Note that this was in addition to a 2.3%Y decline in the 2008 summer crop due to bad weather.

Apart from these two supply shocks, in the recent period we believe that the government's desire to accelerate GDP growth at a time when investments and therefore capacity creation was affected temporarily by the credit crisis meant that the cyclical inflation pressures only increased. Generally, in the short term (up to one year), the fundamental capacities are fixed. Hence, it is difficult to increase capacity significantly in response to a sharp rise in demand. Normally, it takes 12-18 months for the work-in-progress to turn into commissioned capacity. The credit crisis had a significant impact on investment in India. India's investment trend tends to be highly influenced by the capital market environment. As the global credit crisis impaired capital markets, private corporate capex declined from 16.1% of GDP in F2008 to 12.7% in F2009 and further to 12.6% (our estimate) in F2010. On the other hand, the quick recovery in domestic demand from April 2009, driven by the government's aggressive fiscal and monetary policy as well as an improvement in global and local sentiment, resulted in a capacity stretch much earlier in the cycle than was normal.

However, in the long term, capacities are variable and can be increased in response to rising demand pressure without stoking inflationary expectations. We believe that the structural inflation trend in India should be lower, not higher, due to the possibility of improved supply-side conditions.

Structural Inflation Will Be Lower as Savings, Investments and Productivity Growth Rises

Over the past decade, India's headline WPI inflation has averaged 5.3%. As we mentioned in India and China: New Tigers of Asia, Part III, August 15, 2010, the combined effect of more favourable demographics and increased productive job opportunities should boost India's private savings level and push aggregate savings to 37-40% of GDP over the next ten years, allowing the country to maintain an investment-to-GDP ratio of 39-42%, we estimate. The increase in capacity through higher investments should ensure a shift in India's growth to a sustained rate of 9-10% in this period without overheating concerns. Recall that over the past five years, India's average GDP growth is 8.5% with infrastructure spending at 6.4% of GDP and inflation (WPI) averaging 5.5%. In this context, we believe that, in the coming three years, India's infrastructure spending to GDP will rise to 9-10%, ensuring that productivity growth remains strong. We expect the structural inflation trend to remain in the 5-5.5% range, with GDP growth likely closer to 8.5-9%.

What About the Structural Rise in Food Demand and Inflation?

Disentangling the cyclical component from the structural component is not easy. Food inflation has averaged 12.2%Y since summer 2008 due to two years of back-to-back poor farm output. Prior to that, during 2006 and 2007 when GDP growth averaged 9.7% and domestic food demand growth was strong, average food inflation was in the 6-7% range. This was higher than the preceding five-year (2001-05) period, when average food inflation was 3.4% and GDP growth was 6.6%. In other words, in the event of GDP growth remaining strong at 8.5-9%, considering the structural supply hurdles, food inflation is likely to remain high in the 6-7% range. The structural component in food inflation is all about protein. Over the last few years, the acceleration in the pace of per capita income growth, particularly in the lower income groups, is reflected in higher protein-related food items. Moreover, a similar trend in other developing nations has meant that the government cannot rely on imports to reduce the pressure on domestic food prices.

While structural demand growth has risen, particularly for protein-related food items, the supply side continues to be affected by structural problems. Productivity growth has remained lacklustre. Government spending on agriculture-related infrastructure services remains low. Land-holding structure is fragmented. About 63% of the farm-land area is with marginal, small and semi-medium farmers (about 100 million land holdings). Penetration of irrigation is still only 44.2% (net irrigated area as percentage of net sown area, F2008).

Moreover, the government's fertilizer policy had distorted the trend in fertilizer consumption, and therefore the mix of soil nutrients has resulted in low productivity. The good news is that the government is beginning to realize that supply-side reforms are key. It has begun to implement a reform in fertilizer pricing policy. The government is also working on increasing investments in the rural infrastructure.

We believe that in the medium term food inflation could average higher at 6-7%, assuming there is no major crop failure. We are also assuming that the government's efforts to improve productivity in the farm sector, inventory management as well as public distribution systems will take some time to improve. However, with the continued rise in non-farm investments, we expect productivity growth in that segment to ensure that overall inflation is maintained in the 5-5.5% range over the medium term.

Similar Trend in Other Asian Economies During Initial Phase of Take-Off

In the initial period of growth take-off, some parts of the economy tend to lag, and capacity creation in those areas is not anchored to high GDP growth. Moreover, investments in the economy tend to be higher than savings. During the initial phase of high growth, other Asian economies also faced slightly higher inflation trends and saw their current account in deficit or in very small surplus. For instance, in China, the current account balance remained in a small deficit or negligible surplus until the mid-1990s. China moved into high growth of 9%-plus on a sustained basis for the first time in the early 1980s from an average of 6.3% in the 1970s. Urban CPI in China averaged 8.1% in the 1980s compared with an average of 1.4% in the 1970s. We have seen a similar trend in other Asian economies such as Korea and Malaysia when they moved to a high-growth trend. Indeed, India appears to have managed the transition to a higher growth trajectory, with minimal inflation pressures compared with the other Asian Tigers.

Key Risk to Our View

The key, we believe, from a cyclical and structural perspective will be the government's policies. If the government and central bank attempt to boost growth through the support of loose fiscal and monetary policy instead of structural reforms, which help boosts savings and investments, inflation will likely be higher than expectations.