Manufacturing puts up a good show

Updated: Apr 30 2006, 05:30am hrs
The industrial output grew at an impressive rate of 8.8% during February 2006 over a much lower growth of 5.9% during February 2005. It is also an improvement over 7.9% y-o-y growth during January 2006, with the manufacturing sector, growing at 9.5%, as the key driver. The consistent growth in the manufacturing sector shows that the slight dip in the months of November and December was just a temporary phase. Among the other two sectors, electricity also bounced back growing at 9% y-o-y though it was primarily due to low base. Mining continued with its lacklustre performance.

Consequently, the overall growth during FY06 (till February) recorded 8%, over a slightly higher 8.2% during the corresponding period of last year. Both manufacturing and electricity were consistent with their last years performance. Within manufacturing, capital goods segment, growing at 16.4%, was the most buoyant. This was followed by consumer goods, which posted a growth of 11.7%. This highlights that Indian economic growth has become more balanced and more sustainable - consumption-led growth is being balanced by a strong contribution from investment-led sources of growth.

Thus, the continued buoyancy in capital goods and machinery and equipment, which reflects investment scenario, indicates the sustenance of growth momentum in FY07, but with some moderation. We do not expect any systemic slowing of the growth impetus but just some correction, to accommodate the impact of high oil prices, rising interest rates and moderating corporate profits.

Buoyancy in production is matched by growth trajectory of exports as well. On the external front in March, growth of exports regained its strong upward trend. Growth in imports moderated, but remained at a high level of 18.7%, increasing to $13.8 billion from $11 billion in February. The trade deficit improved to $2.9 billion from $3.2 billion last month. For the whole of FY06, exports grew at 24.7%, exceeding the target level of 16%, to $ 100.6. But, this growth was lower than the 26.4% achieved in FY05. Imports grew at 31.5% and reached a record $140.2 billion, also lower than the growth of 36.4% attained last year.

Balance of payments slipped to negative zone in Q3FY06 as capital account plunged into the red. Current account deficit showed improvement from the first half of the fiscal, to $3.85 billion, due to a pick-up in merchandise exports, higher net software exports and larger inflows of private transfers. In comparison with Q3FY05, the deficit improved by 30%, with a rise in net service exports by nearly 70%, net merchandise exports by 26% and a significant rise in travel receipts. However, for the period April-December 2005, the deficit surged to $13.5 billion, a 126% increase over the April-December 2004 balance.

Capital account balance plunged to deficit worth $0.56 billion from a surplus of $15.3 billion in the first half of the fiscal, owing to IMD redemption of $7.1 billion. In Q3FY05, the account had a surplus of $11.7 billion, and in comparison, Q3FY06 has witnessed a fall in all categories, with a 7% decline in net foreign investment flows. For the period of April-December 2005, capital account resulted in a surplus worth $14.7 billion - 23% lower than the corresponding period of last year. Hence for this period, even though the overall balance of payments is in the positive zone, it is 87% lower than that for April-December 2004.

Yet, outlook for Indias performance on the external front continues to be optimistic. As expected, the current account deficit has shown improvement in the third quarter and is likely to post a further improvement in the last quarter of the fiscal, as exports have shown a substantial gain. With prevailing trends, the current account deficit for FY06 should be around $16 billion. The capital account balance will, however, return to surplus position as the outflows resulting from RBI redemptions are through, and foreign investment flow as regained momentum in the last quarter. Going forward, both exports and imports are likely to continue their excellent performance.

The domestic inflation based on Wholesale Price Index (WPI) for all commodities, meanwhile, slipped further during April, falling to 4.08% from 4.1% during in March, despite escalating crude oil price. Inflation in fuel group went up from 7.9% during February to 8.6% during March. But this rise was offset by the fall in prices of primary articles and manufactured products. FY06 ended with an average inflation of 4.4%, down from 6.5% inflation during FY05. Manufactured products saw the steepest fall in inflation rate despite a ratcheting up of significant manufacturing growth. Inflation in this category went down from as high as 6.3% to just about 3.1% - primarily due to fall in inflation in basic metals, textiles and food products. Inflation in primary articles and fuel also declined moderately compared to previous year.

The inflationary situation in the economy remained benign despite high crude oil prices. However, due to sustained high levels of raw material costs, the corporates are facing a margin squeeze and, hence, increasing pressure to raise prices. So, we expect some pass-through of high oil and commodity prices to come about in the coming months. This, however, will be counter-balanced by some initiatives on the indirect tax front and will help in keeping inflation at around the 5% level in FY07.

In the banking sector, March saw the credit-deposit gap converge, as incremental growth in credit slowed down. However, the highlight of the month was the Annual Credit Policy for 2006-07, announced on April 18, 2006 whereby RBI kept key policy rates unchanged, but imposed selective credit control on specific sectors, including commercial real estate. The targeted growth for non-food credit has been kept at 20% for FY07, against 30.8% growth in FY06. Similarly, the broad money growth has been targeted at 15% for FY07 as against a growth of 16.2% seen in FY06.

The data for the week ended March 31, 2006, indicate a moderate change in the y-o-y growth rate of major indicators of key scheduled comercial banks against that observed a fortnight ago. Growth in aggregate deposits moderated down to 16.9% y-o-y from 17.9% and as on March 17, 2006, investment growth fell by 4.1% over the previous year before registering a y-o-y fall of 1.7% on March 31, 2006. Bank credit growth moderated from 31.1% y-o-y to about 29.9% on account of a slowdown in non-food credit growth. Given the buoyancy in the economy, investment demand is likely to be robust and credit requirements will remain strong. However, the expected moderation in economic growth in FY07 will also moderate the credit growth and assist the credit-deposit gap to narrow down. Liquidity in the banking system will improve.

On the currency front, while February saw the rupee remain range-bound, March saw the rupee-dollar exchange rate depreciate. FII inflows had been balancing rising dollar demand for both oil and non-oil imports, cancelling the downward pressure exerted by a widening current account deficit. However, March saw substantial sterilisation of dollar flows as a result of which the downward pressure on the rupee dominated. During the period March 17 - April 17, 2006, the rupee-dollar spot showed a sharp depreciation, from Rs 44.42 to the dollar on March 17 to Rs 45.15 on April 17, 2006, the most important plan being RBIs resumption of the policy of dollar sterilisation. Sterilisation was conducted in the view of the liquidity shortage that had struck the banking system.

An expected hike in the Fed rate is likely to narrow the interest rate differential between domestic and foreign interest rates and moderate capital inflows in the short run. However, with the outlook on the Indian economy remaining healthy and the stock markets performing well, inflows will sustain their current growth momentum.

The RBI is likely to continue the sterilisation of dollar inflows in a bid to inject rupees into the domestic money market to ease some of the tightness the banking system has seen in the past three months, exerting some downward pressure on the rupee in the short run. However, we expect the rupee to be range-bound in the long run and close around Rs 44-45 against the dollar by the fiscal year-end as strong foreign inflows will continue to offset the downward pressure on the rupee from a widening trade deficit.

Bond yields saw a reversal in movement as easing liquidity conditions and an encouraging Credit Policy buttressed debt instrument buying. The yield curve steepened, as long-end yields remained unresponsive to this changing situation. Yields for the period March 15 - April 20, 2006 fell, as the liquidity condition recovered. Taking a lead from the debt market restructuring measures mentioned in the Union Budget 2006-07 last month, the RBI introduced some new measures that included diversification of primary dealer activities, introduction of When issued market etc use of state loans in overnight transactions, consolidation of illiquid government bonds and improved access to pension funds in electronic trading. The markets responded positively to this as bond yields fell across the board by an average of 7 basis points (bps). Short-end yields continued to be more elastic than yields on long-dated maturities as the yield on the 1 year G-sec fell by 12 bps while the yield on the 10-year G-sec fell by 7 bps.

Going forward, liquidity is likely to ease as government spending gathers momentum, but fresh issuances of the government market-borrowing programme will moderate this improvement. Inflation will continue to pose a threat as crude oil prices rise. Thus, although yields may fall in the short run because of improving liquidity conditions and the impact of the central banks policy of no change, they will remain firm in the medium run as the markets adjust to higher equilibrium interest rates motivated by global developments like escalating US interest rates and crude oil prices. Thus we expect the yield on the 10-year G-sec to lie in the range of 7.25-7.5% with an upward bias in the event of fiscal slippage.

To sum up, we expect the growth to moderate in the new fiscal even as all parameters discussed above point towards continuing of the strong growth momentum. The major risk to the economy in the short-run is the building up of the high oil price pressure on the ability of corporates to pass on the costs into the domestic inflation, and similar reactions in major economies abroad. This could enforce a period of high interest rates, and a trade off growth for price stability.