Identifier
Created
Classification
Origin
08MUMBAI321
2008-07-03 14:01:00
UNCLASSIFIED
Consulate Mumbai
Cable title:  

INFLATION, INTEREST RATES, AND GROWTH IN INDIA

Tags:  ECON EFIN EINV ENRG EPET TRSY IN 
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P 031401Z JUL 08
FM AMCONSUL MUMBAI
TO SECSTATE WASHDC PRIORITY 6402
INFO AMCONSUL MUMBAI PRIORITY 
AMCONSUL KOLKATA PRIORITY 
AMEMBASSY NEW DELHI PRIORITY 
AMCONSUL CHENNAI PRIORITY 
DEPT OF TREASURY WASHINGTON DC
DEPT OF COMMERCE WASHINGTON DC
DEPT OF ENERGY WASHINGTON DC
NSC WASHINGTON DC
CIA WASHDC
UNCLAS MUMBAI 000321 


DEPT PLEASE PASS TO TREASURY AND USTR
TREAS PLEASE PASS TO FED AND OCC

E.O. 12958: N/A
TAGS: ECON EFIN EINV ENRG EPET TRSY IN
SUBJECT: INFLATION, INTEREST RATES, AND GROWTH IN INDIA

UNCLAS MUMBAI 000321


DEPT PLEASE PASS TO TREASURY AND USTR
TREAS PLEASE PASS TO FED AND OCC

E.O. 12958: N/A
TAGS: ECON EFIN EINV ENRG EPET TRSY IN
SUBJECT: INFLATION, INTEREST RATES, AND GROWTH IN INDIA


1. Summary: In recent weeks, the Reserve Bank of India has
raised the main monetary policy rate over 75 basis points in
order to fight rising inflation. At the same time, India's main
stock market indicator, the Sensex, has continued its slide, and
is now almost 38 percent off its January 2008 peak. With a
rising import bill widening India's current account deficit, the
rupee has continued to depreciate, exacerbating the inflationary
impact. Analysts and market players in Mumbai are settling in
for slower growth and activity, and expect this period to last
for at least the next six months. While they acknowledge that
the RBI is right to raise rates to fight inflation, there is
major concern about the increase in government spending, which
is also contributing to inflation and has not been reigned in.
With credit becoming more expensive, and most equity issuance
drying up, analysts think that Indian companies will have to
rely on their "structural tailwind" to ride out the troubles in
the economy over the next few months. Nevertheless, at 7 plus
percent growth, India is still growing at a relative premium to
much of the rest of the world, even if this rate is not enough
to fuel the kind of overall economic transformation its leaders
want. End Summary.


RBI Raises Rates to Fight Inflation
--------------


2. On June 24, the Reserve Bank of India (RBI) unveiled a two-
pronged strategy to combat inflation. The RBI raised the repo
rate by 50 basis points (bps) to 8.50 percent. (Note: The repo
rate is the rate at which RBI injects liquidity in the system.
The RBI had raised the repo rate by 25 bps on June 11. End
Note.) The central bank also raised the Cash Reserve Ratio
(CRR),the proportion of deposits that banks need to maintain
with the central bank, by 50 bps to be effective in two
tranches-- 8.50 percent from the fortnight starting July 5 and
8.75 percent from July 19. This move came in four days after
inflation, measured by the wholesale price index (WPI),touched
a 13-year high of 11.05 percent for the week ended June 7. The
RBI said these moves were intended to fight inflation and
establish price stability, while still not stalling growth. In

its explanation, the RBI also resolved to "respond swiftly on a
continuing basis to the evolving constellation of adverse
international developments and to the domestic situation
impinging on inflation expectations, financial stability and
growth momentum, with both conventional and unconventional
measures, as appropriate." The RBI had already acted to address
inflation concerns by raising the CRR three times in April and
May 2008.


3. Analysts and observers in Mumbai largely concurred that
while initial inflation was due to a raise in domestic food and
metals prices, the current high inflation is largely "imported;"
the rising price of oil is having an impact not only in the
crude that India must import as fuel, but also in many of the
major products India needs, such as edible oils. The
depreciation of the rupee over the last six months has made this
global trend more expensive, as the rupee has decreased in value
against the dollar roughly 10 percent from January. In
addition, India's major stock markets have continued on a slow,
downward slide since their January 2008 highs, amidst some
volatility. From its peak of 21,206 in January 2008, the
Sensex, one of India's two major market barometers, is now
hovering just below 13,000, a decline of 39 percent and a
15-month low. One of the reasons for this decline, besides
expectations of slower growth, is the exit of foreign
institutional investors (FIIs). FIIs brought in over $17 in
portfolio capital in 2007, but have been net sellers so far this
year, withdrawing approximately $6.44 billion to date.


4. Analysts and economists in Mumbai told Congenoffs that the
RBI has clearly embarked on a tightening phase after high
inflation took the bank - and everyone else - by surprise. Atsi
Sheth, Chief Economist for Reliance Equities, expected that,
despite the recent decrease in domestic food prices due to an
above average harvest, inflation will remain high for several
more months due significantly to the oil price pass through, but
also rising prices for imported or manufactured food (such as
edible oils) and from steel and cement, whose manufacturers
still have potent pricing power.


5. As for the performance of the RBI, she said that had higher
oil prices and commodity-led inflation not hit so suddenly, the
bank may have been able to cut rates to stem slowing growth. Up
until that point, the bank still had flexibility, but it now had
to raise rates to fight inflation instead. Stating that much of
the inflation is imported, she suspected that the RBI would try
to use the rupee to fight inflation, but given the consistent
capital outflows, the RBI would not be able to coax the rupee
beyond 43/dollar; pushing it to 42/dollar would be "an uphill
battle" and send the wrong market signals, she said. She
estimated that the economy would continue to slow until
December, after which things would likely pick up, including
interest from foreign institutional investors.


6. Sachchidanand Shulkla, Economist at Enam Securities, a major
Indian brokerage, expected inflation to be in the double digits
for the whole of July and August, with some moderation seen from
September onwards. He expected another 25 bps repo hike or, if
liquidity is substantial, another CRR hike in July. He agreed
with the market view that the RBI had fallen behind the curve,
and that the impact of the RBI's efforts on inflation would be
reflected only after September. Inflation may also ease then due
to the expected bumper crop, helped by improvements in logistics
and food distribution. He added that barring the edible oil
segment in the WPI, most food prices were moderating. He
averred that since this is an election year, however, the
government would not allow further oil price rises to pass
through to the public.


7. Indranil Pan, Chief Economist for Kotak Mahindra Bank,
applauded the RBI for not "giving into market expectations"
(cutting interest rates when the Fed was doing so) but still
felt that the Central Bank could have moved faster. He expected
the RBI to raise the repo rate by another 25 bps to indicate to
the market that they are not yet done fighting inflation. He
stated that the impact of these policy decisions on economic
growth wouldn't be seen for at least one year. More hawkish, the
director of research for Merrill Lynch, Indranil Sen Gupta,
argues that the RBI will have to continue to raise the CRR and
the repo rate, and take a much tougher stance over a longer
period to turn the inflationary tide. In a recent research
paper, Tushar Poddar of Goldman Sachs agreed, and expects that
with inflation continuing in the double digits until the end of
2008, the RBI will raise the policy rate and CRR again.


Corporate Financing Costs Rise..
--------------


8. Sheth told Congenoff that companies are finding credit
harder and more expensive to get, but those who want growth
capital can still get it. Companies who want growth capital are
still riding a "structural tailwind" provided by the previous
growth cycle. Infrastructure firms, however, are still growing,
as the long-term demand makes these projects sensible, if
perhaps slightly more expensive. Separately, the CEO of Ispat
Energy expressed his view that only short-term financing costs
had risen as compared to long-term financing. With energy costs
so high, it was viable for them to undertake any energy-saving
or power production project. "In the current climate only
individuals and businesses that were heavily invested/ dependent
on the stock market were affected", he added. However, Jamshed
Irani, Director of Tata Sons, told Congenoffs that increasing
cost of financing is holding them back on new projects.


9. Chetan Modi, India's Moody's representative, said that
corporate India's true state will be revealed at the end of
July, when quarterly earnings are released, but believed that
companies will likely acknowledge a cut-back in capital
expenditures. He expected that credit growth will slow
considerably, and that banks may have to take a "benign view" of
struggling companies and potential non-performing loans.


10. With the price of credit rising, and most foreign debt
options closed off, Pan said that Indian companies would likely
rely on accumulated internal surpluses rather than looking to
banks or other sources of credit. He pointed out that the
Treasury departments of many companies had used their ample cash
reserves to generate profits in the market, and companies would
now have to put this capital back into their business. However,
he highlighted that most infrastructure companies and SME were
still deprived of funds. Shukla predicted that while the balance
sheets of Indian corporates were sound, they would adopt a
'review and wait' strategy, stalling new projects.


11. The Managing Director of PriceWaterhouseCoopers also told
Congenoff that while new activity by Indian corporates has
slowed significantly, PWC is much more active in serving foreign
clients interested in Indian public or private equity
investments. M.K. Sinha, the President of IDFC's Private Equity
Infrastructure Fund, observed that U.S. investors are hesitant
to enter new asset classes, such as infrastructure, but there is
still a great deal of interest in private equity investments in
India, now that valuations are much less expensive. He added
that Indian infrastructure companies are eager to attract
private equity investments, as it is too difficult to raise
equity on the markets and debt is more expensive.


And Growth Will Slow in Many Areas..
--------------


12. Sheth told Congenoff that companies, especially auto,
financial services, and consumer goods companies, are slowing
down to reflect a slowing growth cycle and responding - rightly,
she believes - to the wider economic and monetary policy
signals. According to Pan, 9-10 percent annual growth was never
sustainable. Despite slumping markets and growth, he forecast
that the growth figures wouldn't fall drastically below 7
percent, due largely to the service sector's ability to "buffer
the downside risk." He stressed that India always had a trade
deficit, but successive India governments "never focused on it."
He added that India's exports are almost equal to India's non
oil imports; but with oil imports constituting almost 30-35% of
the import bill, he predicted that for every 10 dollar increase
in oil prices, the trade deficit would widen by about $800
million.


13. Shukla argued that even if only half of expansion plans
were put on hold, growth would still remain significant. Shukla
felt that high oil prices were due to speculative interest, not
supply shortages, and that demand would slacken as growth in
India and China slowed. He predicted that India's GDP would
still grow at around 7.8-8.0 percent for FY09, as policy
measures gradually take hold. Similarly, he expected that FII
interest would return after October, prompting another rise in
equity markets. However, he cautioned that should oil prices
continue to rise, growth and markets would take much longer to
recover.


Though Some International Investors Losing Interest
-------------- --------------


14. Overall, Modi said that international markets are "turning
against India," looking at the country more critically and
giving greater weight to political risk. Modi commented that
India's leaders have missed many opportunities to introduce
reforms that would lock in growth; while he expressed sympathy
for the challenges of India's leaders, he said "India's leaders
have sat on their hands and basked in the international
adulation." Without a continual stream of reforms, he suggested
that "India's baseline growth is probably below 7 percent."


15. The head of equities for Goldman Sachs agreed that foreign
investors are pricing in greater political risk for India, more
in line with other emerging markets. He said that India's
market should have begun to fall in line with other Asian
markets in September and October, but the ongoing confusion over
Participatory Notes made some investors wary of selling
immediately, for fear that they could not come back in later.
Pointing out that $6.5 billion has already flowed out of India
this year, he said "this could easily double this year," as
Indian markets remain expensive. He reported that many Indian
companies are cancelling or putting on hold expansion projects,
especially in real estate investments.



Fiscal Deficit A Major Concern
--------------


16. Market analysts continue to worry about India's growing
fiscal deficit, citing a wave of ongoing and upcoming
expenditures - including a national election within the year --
as a major problem for both inflation and fiscal health. Pan
estimates that all planned expenditures - oil and fertilizer
bonds, farm waivers, and higher salaries due to the pay
commission recommendations - would add almost $20 billion in new
expenditures this year, all of which is so far unaccounted for
in the budget. "No government has ever addressed the fiscal
mess," he remarked. Instead, successive governments have cut
capital expenditures in important areas like irrigation and
infrastructure rather than reducing debt and subsidies. Sheth
echoed Pan in warning that the biggest problem is the fiscal
deficit; successive Indian governments have had five years of
growth, but failed to make tough decisions on subsidies and
other expenditures, which should have been cut.


17. Comment: A recent article in the paper Mint notes that the
last time the RBI tightened interest rates - in the mid-1990s,
also due to inflation - the impact on growth and equity markets
was felt at least a year later, with markets taking a longer
time to recover. While India's economy is structurally
different than it was 15 years ago, it is possible that growth
could continue to slow, and markets could continue to drop,
especially if oil prices stay high and FII interest in India
take much longer to return. Analysts and companies are resigned
to weathering a slower growth period - especially in an election
season where fighting inflation will be the main priority -
though India's growth will still likely outpace most other
countries around the world. End Comment.

OWEN