By Invitation. WPI deflation: Good or bad?

Deflation scare has reached Indian shores. WPI inflation fell 4.1 per cent year-on-year in July, the lowest reading since the official monthly series began in 1982. This has led to fear of falling producer prices and a worsening economy. Is the situation really that bad? It is important to differentiate between good and bad deflation. In bad deflation, falling prices result in firms cutting output and jobs, leading to lower wages, weak demand, and a further drop in prices or a deflationary spiral.

Not deflation India is nowhere near this situation. Although inflation rates have fallen sharply, inflationary expectations remain high and positive, indicating that India is witnessing dis-inflation, rather than deflation, which is a welcome development after years of high inflation. More importantly, we would argue that India is witnessing a period of ‘good’ dis-inflation.

We find it instructive to split the WPI basket into two components: input costs, which comprise raw material and intermediary goods, and output prices, which capture the final product prices. Nomura’s analysis suggests that much of the fall in the WPI from its peak (7.3 per cent since August 2014) is due to falling input costs. Lower prices of minerals, fuel products, metals, chemicals and soft commodities like sugar have led to a sharp fall in raw material costs for various sectors. In contrast, output or final product prices have remained relatively stable (up 1 per cent) over the same period.

Profits to grow The gap between output prices and input costs is a good proxy for profit margins, and a widening gap suggests profit margins should expand. A similar gap between output and input prices had opened up in mid-2009 which, along with the ongoing demand recovery, did bode well for corporate profitability.

Of course, there will be losers and gainers in such an environment. A similar splicing of input cost versus output prices for different WPI sub-sectors shows that margins appear to be under pressure for cement and paper product sectors, likely because of weak demand. On the other hand, input costs have fallen sharply in food products, beverages & tobacco, and transport equipment (auto) sectors, which is positive for profits.

Lower WPI inflation also bodes well for CPI inflation. Sure, there are a few differences between WPI and CPI due to different baskets (the CPI has services, while WPI is mainly manufactured goods) and differing weights (for food and fuel). But, over longer periods of time, WPI inflation and CPI inflation do follow a similar trend because WPI captures the pipeline price pressures, at least for food and manufactured products. Therefore, with pipeline price pressures weak, low WPI inflation suggests that there are limited upside risks to CPI inflation. WPI deflation driven by lower commodity prices has other growth benefits as well. For a net commodity importer like India, lower commodity prices are a positive terms-of-trade shock, i.e. the country can import more per unit of export. We estimate that the ratio of India’s export to import price index (or terms of trade) has risen sharply since mid-2014 and is up almost 20 per cent y-o-y in July 2015.

Also, lower inflation has raised households’ real disposable incomes, which indicates that demand for discretionary consumer goods such as cars and other white goods should continue to improve, which should also support growth. As far as earnings are concerned, analysis by Nomura’s Head of Equities Prabhat Awasthi shows that lower commodity price-led WPI deflation tends to adversely impact earnings initially.

This is because commodity sectors, which comprise almost 50 per cent of total net sales of BSE100 companies (excluding banks), witness lower earnings, which more than offsets the benefit to a select few sectors such as autos. However, over time, earnings do see second-order positive effects as well due to falling inflation and lower interest rates, which is positive for consumer spending and overall growth. Hence, lower commodity prices, despite the initial negative impact on earnings, are not necessarily negative for markets.

Overall, while negative WPI inflation driven by lower commodity prices will no doubt have a few negative implications, the net effect on the Indian economy — by lowering pipeline price pressures and thereby improving profit margins and boosting real disposable incomes — stands out as more positive than negative for both growth and inflation. Hence, we see no reason to panic.

The author is Executive Director & India Economist at Nomura

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