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Last Updated : Feb 12, 2018 02:05 PM IST | Source:

The Return of Inflation: RBI likely to start hiking in the middle of FY19, says Saurabh Mukherjea

"Economic theory suggests that larger budget deficits lead to higher inflation as more Government spending (if this spending is not directed towards the creation of productive assets) leads to an increase in the overall price level," says Saurabh Mukherjea is the CEO of Ambit Capital.

By Saurabh Mukherjea
Ambit Capital


Fiscal deficit and inflation are tightly correlated

Economic theory suggests that larger budget deficits lead to higher inflation as more Government spending (if this spending is not directed towards the creation of productive assets) leads to an increase in the overall price level.

In India’s case, this economic theory has worked out in a textbook manner. In almost all the years since FY05, higher budget deficits have led to higher inflation (see exhibits below).

In that context, over the past three and a half years, the NDA Government has shown admirable discipline in reining in the fiscal deficit (partly helped by lower commodity prices) and hence inflation.

Exhibit 1: Budget deficit and inflation are tightly correlated


Unfortunately, in politics, past performance is not a good indicator of future performance. History suggests that fiscal rectitude goes out of the window when General Elections are on the horizon in India.

In specific, subsidy payments in India tend to be higher in the last two years prior to a General Election (see exhibit below).

Exhibit 3: Subsidy payments tend to be higher in the last two years of a five-year election


As is evident, in FY18 itself, the NDA is finding fiscal discipline hard to maintain. Both on the expenditure and revenue, the Government looks to be treading thin ice.

On the spending front, the Government has sought Parliament’s approval for extra spending to the tune of Rs 330 billion (0.2 percentof GDP) on NREGA and on subsidies (

The Government has also sought Parliament’s approval to spend Rs 800 billion (0.5 percent of GDP) on bank recapitalisation bonds (

On the revenue front, the Government’s GST collections are falling woefully short of their target. Although the Government has not given any official target for GST collections (as there was no GST when the budget for FY18 was formed), back-of-the-envelope calculations (using the indirect tax collections target for FY18) suggest that the Government could fall short by Rs 500 billion (0.3 percent of GDP) on GST collections.

The government spending seem likely to rise in the run-up to the 2019 General Elections, but also the Government seems to be trying to please various segments of the electorate.

In the recent months, farmers have received loan waivers and a hike in Minimum Support Prices for wheat (the biggest hike in five years), rural workers have received the biggest outlay ever seen on NREGA and PSU banks are about to receive their mega recap.

In addition, in response to growing discontent in the SME business community, the Government has over the past two months engineered a major rollback in GST.

As a result of this rollback, the monthly run rate on GST collections has fallen from an average of Rs 930 billion per month in July, August and September to an average of Rs 815 billion in Oct-Nov 2017. On an annualised basis, this shortfall amounts to Rs 1.38 trillion or 0.9 percent of GDP.

Higher GST on services and rising commodity prices will also put pressure on CPI inflation

Fiscal profligacy aside, there are two more direct routes via which CPI inflation seems likely to get an impetus: higher GST rate on services and rising commodity prices.

Amongst the constituents that make up the CPI basket, the “miscellaneous” category - which comprises mainly of services - has the second-highest weightage (28 percent). This component has seen some upward pressure since GST has been introduced as the GST rate for most services is higher (18 percent) than the old Service tax rate (14.5 percent).

The recent reduction in inflation was also helped by a reduction in global oil prices. However, if oil prices continue rising, it will put upward pressure on inflation. About ~4 percent of the CPI basket comprises of diesel, petrol, and LPG. A USD 10 per barrel increase in global crude prices could push up overall CPI inflation by 70-80bps.

GDP growth and inflation to rise in sync in FY19

Fiscal profligacy is likely to help boost GDP growth in FY19. In specific, the bank recap plan is likely to boost the system-level lending growth rate for FY19 from 8 percent (as prevalent before the recap was announced) to 12-15 percent with the recap plan in play.

This along with higher Government spending in the run-up to the General Elections is likely to improve prospects of growth for industrial sector as well as services sector, thereby propelling headline GDP growth to 7 percent YoY in FY19 from around 6 percent YoY FY18.

In parallel, a higher fiscal deficit, higher commodity prices and a higher GST rate on services seems likely to push inflation upwards. Our modelling process suggests that CPI inflation could rise to an average of ~5 percent YoY in FY19 (as against an average of 3.5 percent expected in FY18).

What does this mean for interest rates?

The RBI’s inflation target is 4 percent. Hence, if inflation heads towards 5 percent, it will prompt the RBI to raise rates at least by 25-50bps in FY19. I expect the RBI to start hiking in the middle of FY19. In contrast, the consensus view seems to be that the RBI won’t hike rates until the second half of FY19.

Fiscal concerns have already led to yields tightening at both the short and the long end of the yield curve (see exhibits below). A rise in inflation expectations is likely to further harden 10-year G-Sec yield. I expect the 10-year G-Sec yield to rise by another ~50bps (i.e., to around 8 percent) by the General Elections of CY19.


Investment implications:

In a high inflation environment, well-established companies with strong brand names tend to be better placed than their newer, more run-of-the-mill rivals, as the pricing power of the champion company allows it to protect itself from inflation.

In effect, inflation takes profit from weak firms and gives it to stronger firms. Hence the return of inflation could spell trouble for smaller companies.

Secondly, there will be clear winners and losers from the big GST rollback that the Government announced two months ago.

The winners primarily play on discretionary consumption – auto, electricals, apparel, footwear, leisure, travel & entertainment – and companies which rely on a cyclical pick-up in the economy – metals, building materials in the broadest sense of the word and construction.

In fact, the cyclical companies are in line for a triple stimulus: (a) from the reflationary effects of the GST stimulus; (b) from the Government’s Bharatmala roadbuilding programme, and (c) from the USD 30 billion PSU bank recap which should kick in over the next three months or so.

The losers are primarily private sector lenders who rely primarily on the wholesale funding market – the rising yields in the money market will increase the cost of funds for these lenders.

As they push this higher cost of borrowing on to their customers just at the time that the PSU banks are re-entering the Loan against Property (LAP) market, some market-share loss for the private sector lenders looks inevitable.

Disclaimer: Saurabh Mukherjea is the CEO of Ambit Capital and the author of “The Unusual Billionaires”. The views expressed are personal. The views and investment tips expressed by the expert on are his own, and not that of the website or its management.

First Published on Feb 12, 2018 01:45 pm
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