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India's Inflation Accelerates to 7.31% in December
January 20, 2010

With inflation declared at 7.31% for the month of December 2008, we take a quick look at the key monetary and economic indicators for India, and how you can hedge your portfolio in this climate.

Author : Dhruva Raj Chatterji

Untitled Document
Chart 1:  Food Inflation is expected to subside due to base effect
Chart 2: Inflation picked up sharply mid 2009
Chart 3:  Bond Yields harden on the back of monetary tightening and inflationary fears
Chart 4:  Reverse Repo volumes remain below mean levels of past one year
Chart 5: Industrial growth rises to a 2 Year high of 11.7% in November 09

Key Points

  • Inflation accelerated to 7.31% in December compared to 4.78% in the previous month.

  • Food inflation came in at 19.17% for the month of December.

  • Expectation of monetary tightening by the RBI in the January 2010 end monetary policy review is putting upward pressure on bond yields.

  • Liquidity conditions presently remain comfortable with reverse repo volumes below mean levels over the past one year.

  • Economic growth and sharp pick up in industrial activity will continue to put pressure on inflation.

  • With interest rates expected to harden, we recommend floating rate funds to debt fund investors, to hedge the inflation risk.

Wholesale Price Inflation in India jumped to 7.31% (YoY) for the month of December 2009, following a 4.78% gain (YoY) in November. The main cause for the spurt in inflation has been escalating food prices which rose to an 11-year high in the month of November. Food articles, which have close to 15% weightage in the wholesale price index (WPI) rose 19.17% in the month of December. The rise in food prices is due to one of the worst monsoons that the country has witnessed in close to four decades since 1972, followed ironically by floods in certain regions of India. Both these events hampered farm output substantially last year. However, economists also feel that a lower price base in the corresponding period a year ago is causing food inflation to pick up, and that it may start to subside gradually from June onwards when the base is higher. Refer to Chart 1 for the wholesale price food articles index highlighting the base effect.

Inflation has been on the rise since mid of 2009 after briefly turning negative in the month of June 2009 and continuing in the red for the following 2 months. Prior to that, the year 2008 had seen inflation climb to a 16-year high of 12.82% in the month of August 2008. Refer to Chart 2 for historical trend in WPI inflation. Even though the central bank revised the fiscal year-end target for inflation to 6.5% (from 5% earlier), analysts now expect inflation to approach closer to the 7-8% mark by fiscal year end.

Monetary Policy and Interest Rates

The sharp rise in inflation has also raised speculation that the Reserve Bank of India (RBI) will initiate monetary tightening after following an expansionary monetary policy by cutting key interest rates since mid of 2008 to help support the economy. In its monetary policy review due at the end of January 2010, the RBI is widely expected to raise the Cash Reserve Ratio (CRR) by 50 basis points to suck out liquidity to the tune of about INR 20,000 crores from the system and help tame inflation. This has put significant pressure on bond yields, with the benchmark Indian ten year bond yield hardening by about 40-50 basis points since the beginning December 2009. Refer to Chart 3 for movement of ten year Bond yield.

Liquidity Condition in the System is Comfortable

Liquidity conditions as indicated by the reverse repo volumes remain comfortable and below their mean levels over the past one year. This indicates that excess liquidity is not the cause that is fuelling inflation to spike up recently. Reverse Repo is a short term instrument used by the central bank to borrow money from banks. Reverse repo volumes indicate the surplus short term funds that are available with banks for lending, and are an indicator of liquidity within the system. A higher than normal outstanding reverse repo volume would indicate surplus liquidity in the banking system that would put upward pressure on inflation. Thus, reverse repo volumes indicate the surplus cash available in the system with banks. Refer to Chart 4 for outstanding reverse repo volumes.

Economic and Industrial Activity Pick Up

The macro-economic conditions within the country are also improving, with GDP growth clocking in 7.9% during the second quarter of the fiscal year, ahead of expectations. The economy had expanded 6.7% in the previous FY ending March 2009, its slowest pace in six years. The government recently revised upwards the GDP growth rate for this year to 7.75% - 8% from the earlier 7%. Growth next year is largely expected to breach the 8% mark comfortably.

Industrial production has also seen an upsurge since the mid of this year with the index of industrial production (IIP) growing by a robust 11.7% in the month of November 2009, making it the fastest pace in the past 25 months. In the past year, as a result of the slowdown, IIP had dropped sharply towards the end of 2008 and early 2009, with growth even ending up in the red at -0.2% during the month of December 2008. The good performance in 2009 has been supported by double-digit manufacturing growth, boosted primarily by a sharp rise in consumer durables. Refer to Chart 5 for IIP growth figures.

Conclusion: Floating Rate Funds Can Work in this Climate

We expect that the RBI will hike the CRR by up to 50 basis points in its month-end monetary policy review, but is not likely to tinker with key policy rates like the repo or reverse repo rates yet. The market already seems to have factored in the hike in CRR with the recent spike in bond yields, but a hike in policy rates can dampen sentiments further. With a rising interest rate view in mind, we would recommend debt fund investors to look at adding floating rate funds to their portfolio, to help hedge against inflation. Floating rate funds, invest primarily in papers with a floating rate of interest. The coupon on these securities is usually linked to a market driven rate like the MIBOR (Mumbai Inter Bank Offered Rate), and every time the market fluctuates, the coupon rate is adjusted accordingly. Thus these funds are less volatile than traditional income funds, and are preferred in a rising interest rate scenario, due to heir lower interest rate risk. The assets of floating rate funds have increased dramatically in the past one year, surging by more than 500% (YoY) at the end of December 2009. These funds have also reduced their average portfolio maturities, and are focusing more on the shorter end of the yield curve, to reduce the interest rate risk. However, investors should note that presently floating rate funds have a relatively lower allocation to floating rate papers and primarily invest in Certificate of Deposits, Debentures and Treasury Bills. This could be because of the lower issuances of floating rate paper in the market presently. We feel that as interest rates harden, the issuances of floating rate securities will pick up and subsequently their allocation in portfolios of floating rate funds.

At the moment, the priority for the government is to control spiraling food prices that is fuelling the inflation problem; and it has already initiated some steps to help curtail the issue. The pick-up in industrial growth and economic conditions will continue to put pressure on inflation and keep it buoyant. Besides that, the central banks of some other countries in the Asia – ex Japan region are also looking to hike rates with a resurgence of economic activity within the region. China’s central bank raised the reserve requirements by 0.5% recently, effective January 18, 2009, to help manage inflationary expectations and the sharp rise in credit growth.

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