Hmmm…its that time of the year again. As the industry, bankers, credit rating agencies and the markets watch with bated breath, the RBI Governor will have to think of the changing economic scenario in Indian and take a call on whether the rates can really be cut tomorrow.
One of the biggest arguments in favour of the cut is that the inflation of the country seems firmly under control. Frankly, at a WPI inflation of 1.8% and a CPI inflation of about 5.5%, it looks like there is finally room for Dr. Rajan to switch to a pro-growth stance from the anti-inflation image he has favoured over the past one year. Agreed, the reduction in the inflation has largely come in from an external source: Declining oil prices. But it does look like the chances of oil staying at a range of $70-$75 are rather high and hence it looks like our inflation figures could continue to look benign in the medium term.
How much of an impact do oil prices have on the WPI numbers in India? Given that the fuel group carries a fairly good weight in the WPI, oil price softening will immediately impact the WPI. Whether it will be allowed to spillover into a CPI impact will again largely depend on how the Government is viewing the situation. I have a feeling though that given that the FM is sticking to his “sacrosanct” (and rather annoying, I must say, since it was an unrealistic target to set in the first place) fiscal deficit target of 4.1% of GDP and given that something like 90% of this target has already been met in the first 2 quarters, he is not going to be in a mood to quickly pass through the reduction in subsidies to the consumers in H2. So while we will see a softening of the crude to work its way into the WPI, it may not really help to reduce the CPI numbers.
Ok, so to come back to the point, when the crude prices go down by 30%, by how much do the Indian WPI numbers gain? I chose to do a simple regression here, to give me a basic understanding of how the causality works. So, I downloaded data on OPEC average annual crude prices and Indian annual WPI numbers from 2003 to 2013 and did some simple play with these numbers. Now, before I tell you the results, I already know that this exercise has not been checked for the non-stationarity impact, its constrained due to the lesser degrees of freedom it enjoys etc..I know. But I am just trying your average play-with-numbers-to-get-a-better-picture game. When I regress the numbers, I get an overall significant model and a goodness of fit of about 65%, which is decent enough for starters. The slope co-efficient is the pass-through number, that tells me that when the nominal price of crude in dollar terms goes up by a unit, the WPI in India seems to go up by 1.18 units.
Assuming that the nature of the relationship will hold for one more year, all we have to do is to forecast what the average crude oil prices could be in 2014-15 and voila! we should be able to understand the way the inflation will go led by the oil price reduction; other things blessedly, remaining constant. Now, I worked out three different scenarios for this year: Prices remain between $70 and $75, or they move to $75- $80 range or they push into the $80-$85 range. Frankly, there are reports that the prices could fall below $70, but I am sticking to the obvious ranges we have witnessed so far. Again, I really do not believe, given the global health numbers (The IMF forecast for world GDP growth rate 2014-15 is a morose 3.1%), that the oil prices can move beyond the $85 barrier. So, using these 3 scenarios, I worked out what the average annual crude prices would be for 2014-15 and used the regression equation to make a quick forecast of how the WPI numbers for India will look for the year 2014-15. Folks, the average WPI number shows a decline in 2014-15 over the 2013-14 level under all three scenarios, indicating the possibility of a deflation.
Now, that really means that India seems to be headed into a commodity deflation, led by oil price reductions. This very basic work is of course NOT taking into account the other neutralizing effects, such as the effect of the sub-normal kharif output on food inflation. Now given that we are looking at such benign inflation numbers, letting growth concerns take a priority position seems correct, especially since the newly out GDP data seems to suggest that Q2 has shown damper growth prospects as compared to Q1.
If the Government is serious about sticking to that fiscal target (and so far, it does seem to be), then Government spending cuts will have to be implemented in H2, oil price reductions notwithstanding. That could mean that the growth rates in H2 will also remain muted, unless we allow the private investment to come into its own, quickly.
If the RBI slashes the repo by 25 bps tomorrow, it will give that added sentiment jolt to the industry, which could drive investments in H2. There’s no time like the present, Dr. Rajan. Go for it.