High inflation negates prospects of growth,” said RBI governor D Subbarao while recently speaking at the Indira Gandhi Institute of Development Research in Mumbai. In a nutshell it reflects the status of the current Indian macro economic situation that has been struggling with high inflation for quite some time. Now add to that the recent price rise in petrol and the expected hike in diesel prices which will further fuel inflation and you would see why the situation is not that comfortable. Persistently high inflation adversely impacts the growth of the corporate sector. Till now we have not witnessed much of an impact of rising inflation and interest on India Inc’s financials but going for-ward we believe it will definitely hurt the growth of the Indian companies.

Prof B B Bhattacharya, economist and former VC, JNU, explains the probable impact of high inflation on Indian companies by saying, “The current phase of inflation is quite disturbing and in the long run it will also impact the sales of the companies.” Therefore, it becomes very important to control inflation and the recent hike in interest rates by the RBI is a step in the same direction. “It is true that there is a short-term impact on some of the sectors like automobiles and housing as borrowing cost would increase for the consumer but overall for every sec-tor it is very much necessary to curb inflation,” he adds. We believe that this will have a short-term impact and particularly so on the interest sensitive sectors. Let us analyse the reasons for such high inflation and why the RBI has to take such actions.

The Inflation Itch
After taking baby steps for almost a year and raising rates by 25 basis points (bps) eight times, on May 03, 2011 the RBI hiked the policy rates by 50 bps. It went in for a higher rate hike this time as the earlier rate hikes had failed to yield the desired result to address the key issue of rising inflationary pressures. Why have inflationary pressures not come under control despite having hiked rates eight times prior to the latest hike? “RBI’s steps are not at all enough to reign in inflation and it needs major policy initiatives from the government as well. In fact there should be a proper coordination between the fiscal policy initiatives and the monitory policy. Only then can inflation be tamed in an effective way,” Prof Bhattacharya opines.

This move has decisively tilted the RBI policy towards curbing inflation, signalling that growth can take the backseat for a while. The current inflationary situation is way above the central bank’s comfort zone of 5-6 per cent. Higher inflation is not the only factor that is disturbing but it is also its stickiness that is frustrating. Headline inflation that is measured by the WPI (wholesale price index) has not come down to RBI’s comfort level since December 2009 and has stayed above 8 per cent consistently from January 2010 onwards. In fact in the last 56 years it is only nine times that inflation has remained at such a high level in double digits. The last time that inflation remained so high was from March 1994 to May 1995.

The current rise in inflation started from July 2009 (-0.62 per cent) from when it started to accelerate while the economy was still recovering from the significant global slowdown. From July 2009 it continued to show rising trends before reaching its recent peak of 11 per cent in the month of April 2010 (see graph). Thereafter, moderating for some time, it again accelerated in the last three months. Inflation for the month ending March 2011 stood at 8.98 per cent. There were arguments that as a higher base effect factors in, inflation will moderate from the first quarter of the CY11. Nonetheless, we are almost five months into CY11 and there is no trace of inflation coming down. This is making the situation even worse. So what are the reasons for the inflationary monster not lying low?[PAGE BREAK]
Supply And Demand
It is commonly believed that it is the supply side constraint and structural bottlenecks that lead to a high rate of inflation every time the economy picks up. The current situation seems to be no different. However, if we dissect the WPI data the reason for such a sharp increase can be attributed to both supply as well as demand side factors. Initially it was the supply side reaction due to the deficient monsoon of 2009 in most parts of the country, which led to lower agricultural production and higher prices. This fact is clearly reflected in the food inflation that has remained constantly in double digits from June 2009 to January 2011. Prior to that (between FY05-FY09), food inflation largely remained in single digits.

Apart from food inflation, fuel and power saw a significant rise in their prices due to a sudden and steep rise in the price of the crude oil due to the geo-political risks that came up. However, it is not only the supply side alone that is making the RBI’s effort less effective. We find that the demand side pressures are equally playing their own part to fuel inflation. As the economy picked up thanks to the fiscal and monetary stimulants, demand also started to gather momentum, thus leading to demand side pressures. This can be inferred from the inflation figure of manufactured products and non-food manufactured products that primarily reflect the demand side pressures.

It is up from (-) 0.74 per cent at the end of July 2009 to 6.21 per cent for the month of March 2011. The above clearly brings out the fact that both internal as well as external factors as well as demand and supply side constraints are fuelling inflationary pressures in the Indian economy. All these factors have warranted such a drastic step by the RBI to reign in the inflation so that in the long term the economy can grow at its potential rate.

Impact On Economy
One of the major functions for any central bank is to strike a balance between inflation and growth. Rise of any one can imbalance the other. Therefore the current high inflationary situation and consequently higher interest rates are definitely impacting the growth of the economy. The fact is well-captured in the observations based on Composite Leading Indicators (CLIs) developed by the OECD (Organisation for Economic Cooperation and Development) on the basis of parameters like IIP data, passenger car sales, call money rate, etc that provide early signals of turning points with regard to economic expansion and slowdown.

From March 2010, CLI for India has started showing signs of falling (see graph) and for the month of March 2011 it was 99.59, down from 99.78 computed in the month of February. The way this figure is interpreted is that if CLI is decreasing and is below 100 it connotes a slowdown in the economic activity which is the case with India. CLI for India has been below 100 since January 2011 and is decreasing month on month. The fact that the economy is decelerating is further reiterated by the recent ‘on the record’ acceptance by the finance minister that the Indian economy will expand at a rate of 8 per cent for the year FY12, lower than what he had projected in his last budget speech of February 2011.

Therefore, it is quite clear that rising inflation and interest rate is weighing heavy on the economic growth rate. But the worse news is that despite raising rates by nine times since March 2010, the interest rates have not peaked out. According to S Raman, CMD, Canara Bank, “Going forward there will be a rate hike in the range of 50-75 bps depending upon how the current increase in interest rates affects the macro-economic factors.” One can thus expect a further hike in interest rates in the months of June and July. This will ultimately impact the business growth which is already struggling from higher commodity prices. Here is a check on the sectors and companies that are likely to face a higher level of pressure.[PAGE BREAK]

Impact On Sectors
Needless to say that interest rate-sensitive sectors and companies with a larger debt to equity ratio will be most affected by the rising interest cost. Some of the sectors due to the nature of being more capital intensive like construction, power, telecom, etc are likely to be hit most due to their high leverage. Apart from the increase in the interest burden it also seriously impacts any capex plans by the companies. According to data compiled by CMIE (Center for Monitoring Indian Economy), India Inc has a pipeline of projects worth Rs 22,00,000 crore lined up for 2010-13. Out of these, projects worth Rs 5,50,000 crore were expected to be commissioned in 2010-11, Rs 8,50,000 crore in 2011-12 and Rs 8,00,000 crore in 2012-13.

Moreover, according to reports, CMIE estimates that power, steel, road transport and allied services, telecom-munications and petroleum are the sectors (in that order) wherein companies have announced mega investments for the next few years. The power sector alone is expected to commission projects worth Rs 4,40,000 crore by March 2013 to add generation capacity of 81,000 MW. Though these are long-term investment programmes and financial closures must have been achieved earlier, the interesting thing to point out is the implementation of the base rate. As banks now cannot lend below these rates any increase in the base rate will increase the interest burden for the companies and will directly hurt their financials.

Since the implementation of the base rate requirement from July 1, 2010, different banks have revised their base rate upwards by more than couple of times in the range of 75-200 bps. For example, PNB has increased its base rate by 200 bps since its implementation. The other option available with the companies is to go abroad and borrow where interest rates are still hovering at comparatively lower rates. But this is an opportunity that is available only to companies with good credit rating and that too comes with an added risk of carrying foreign exchange in their balance-sheet. Hence, there are very few companies and very few avenues that can help Indian corporates to escape from the current hike in the interest rates.

Therefore, we may see some deferment and slowdown in the capex programmes going forward that will only accentuate the supply bottlenecks and further increase the inflation rate. The slowdown in the capex is evident from the laggard movement in the IIP data and that too of capital goods which has been showing a declining trend since December 2010, and has some-what resurrected for the month of March. But economists believe that if we remove the seasonality factors it will be zero and will probably not show the same growth in the coming months. What about the order inflows for some of the leading capital goods companies? We find that some companies like L&T and BHEL have seen their order inflows growing whereas companies like Thermax and BGR Energy have seen some moderation.

If we analyse the interest cost of India Inc we find that it has already started showing signs of stress on the P&L accounts of the companies. For the 1,065 companies that have already declared their Q4FY11 results (excluding finance companies), the finance cost has increased from 1.69 per cent of sales in Q4FY10 to 1.87 per cent of sales in Q4FY11. Some of the sectors that have been hit the hardest are construction, telecommunication, steel, etc that saw their interest cost as percentage of sales increasing anywhere between 2-10 bps. Some of the sectors that remained largely untouched are IT-enabled services that saw their interest burden declining. The above analysis shows that the rising interest rate has not yet dented India Inc’s financials as much.[PAGE BREAK]

Even if we see the ratio of operating profit to interest as proxy to the debt service coverage ratio it has only partially decreased from 8.2 times to 7.3 times and has also not shown signs of a significant downside. We believe that though the transmission of the monetary policy has become faster after the implementation of the base rate, the significant effect of any interest rate hike will be reflected only after a lag. Further, India Inc’s leverage is quite low. For the same companies the median debt to equity ratio at the end of FY10 was just 0.17 times. One of the reasons for high inflation is higher commodity prices that are equally responsible in puncturing growth.

Commodity Prices
After touching a low towards the dusk of 2008 and dawn of 2009, the commodity prices started to show signs of revival as various economies around the world provided stimulants to get out of the worst ever economic slowdown since the Great Depression. By the start of the year 2011, the prices were raging. The S&P GSCI, a bench-mark for investment in the commodity markets and as a measure of commodity performance comprising 24 commodities from all commodity sectors, is up by more than twice from where it was in February 2009. The reasons for such high commodity prices are not only growing economies, which demand more and more raw materials to fuel the growth, but several other factors too.

Chief among these is the emergence of commodities as an asset class. Since early 2000, commodity futures have surfaced as a popular asset class for many financial institutions. According to a CFTC staff report (2008), the total value of various commodity index-related instruments purchased by institutional investors had increased from an estimated USD 15 billion in 2003 to at least USD 200 billion in mid-2008. The reason for this increase was the lower or negative correlation that existed between commodity returns and stock market returns before 2000. But things changed with the dotcom bust and the collapse of the equity markets in the year 2000 with commodities starting to attract lot of funds as a hedge against stock market volatility.

However, after that the correlation changed between the stock market and commodities. What did not change was the monetization of the commodity market. It can be inferred from the rise in the flow of funds to the commodity market, which rose to USD 9.61 billion in the first quarter of CY11 compared to just USD 2.77 billion in the same time last year, according to EPFR Global. What further helped increase the prices is the accommodative monetary policy provided by the Federal Reserve Bank resulting into QE2 (Quantitative Easing 2). This fundamentally changed the way commodity prices are currently deter-mined.

The law of demand and supply which used to be the prime factor for the price determination of commodities no longer holds true. It has become more of a portfolio re-balancing act between the different asset classes that is driving the prices. Commodities have beaten stocks, bonds and the dollar for five consecutive months till the end of April. However, this year there have been some black swan events too like the floods in Australia, earthquake in Japan and political unrest in the Middle East and North Africa, which have somewhat influenced prices of some of the commodities.

Impact On India Inc
Whatever may be the reasons for the increase in the prices of commodities, it is always bad news for India Inc. The 1,065 companies that have announced their Q4FY11 results so far (excluding financials companies) have seen their raw material prices going up by 31 per cent compared to last year. And with regard to the percentage of topline, it has increased from 44 per cent of sales (Q4FY10) to 48 per cent of sales (Q4FY11). Some of the major sectors that saw a steep rise in their raw material cost include aluminum, steel, pharmaceuticals and auto ancillary. Their raw material cost as a percentage of sales increased by 12 per cent, 9 per cent, 7 per cent and 5 per cent respectively. We might find some relief in the commodity prices going forward. As Prof Bhattacharya puts it, “In the next two quarters there can be a bust in the prices of commodities.”[PAGE BREAK]

When we see the overall impact of the rising interest rates and commodity prices on the bottomline of the companies, we believe it is yet to make any sizeable impact. The net profit margin is down marginally by seven basis points. The reason for this is better explained by Adi Godrej, Chairman, Godrej Group, “We always follow a twin strategy of improving efficiency whether there is a rise in commodity prices or not as well as of passing on the price rise in raw materials to customers and hence keeping the margins intact.” But we believe this might hurt the overall demand. For example, Marico saw some moderation in demand rep-resented by volume growth at 10 per cent for Q4FY11 compared to 15 per cent for 9MFY11.

Conclusion
In our opinion, despite RBI’s desperate attempt to bring the monster of inflation under control, it will take some time (more than a year) before it reaches the comfort level of the RBI. It is being argued that if the monsoon is normal, as forecasted by the Indian Meteorological Department, inflation will come down. IMD has forecasted that for 2011 the south-west monsoon season (June to September) rainfall for the country as a whole is most likely to be normal (96-104 per cent of the long period average). But the same kind of argument was given at the start of the year, stating that inflation would be calmed once the Rabi crops come into the market. Nothing of this sort was experienced. On the contrary, a good monsoon may increase the demand side inflation in the short run.

The other factors that will keep the inflation at elevated levels are a hike in the fuel prices. The government has already hiked the petrol price and an increase in diesel prices looks imminent. This will have a cascading effect and FMCG and consumer durable companies will find their distribution cost increasing. Going forward we feel that these factors will impact the over-all growth of the Indian economy in the short run. The sectors that are going to be hit the hardest are auto, cement and steel. Rising interest rates and commodity prices will slow down the demand for autos and it may even dampen the capex cycle, hurting the demand for steel and cement.

Banks might also face higher NPAs going forward and their credit growth may get keyed down. The least affected will be IT companies. The last time such a scenario (rising interest rate and commodity prices) was witnessed was in the year 2006-07. That time the market shrugged these off and went ahead to touch a new high. What the RBI is doing will probably hurt growth in the near term but is definitely a step which will help in setting straight the various anomalies that are currently inflicting the economy and in turn India Inc at the macro level. All this will put the Indian economy back on the growth track helping it to grow at its true potential rate.