Inflation from Parallel World Contd.

To substantiate the idea, “As GST implementation would force the informal sector to start routing its business through proper channel, traders will start paying taxes and there could be a significant jump in CPI inflation”, discussed in previous blog, one needs to analyze India’s CPI basket.

We have divided India’s CPI basket in two categories. GST Immune sectors, where GST tax rates are equal or lower than previous regime and have relatively less exposure to informal sector. This list includes food (excluding prepared Meals), health, education and housing. GST vulnerable Sectors, where informal sector is largely at play and GST rates are higher than previous regime. This list includes clothing, footwear, household goods, prepared meals, transportation, amusement, personal care and tobacco products.

GST Immune Sectors: Though, majority of CPI basket will have little impact of GST implementation, but it faces an unfavorable base effect along with supply side risk.

 GST immune sectors, which had actually deflated on month on month basis last year, have spiked by 2.21% in July. It is also note-worthy that food inflation is highly volatile and majorly depends upon the supply side risk, including monsoon. 

Above chart depicts, there is little certainty that food inflation will repeat its stellar performance of last year again. Interestingly, food inflation has been on a flip-flop trend on yearly basis as it fell in year 2014 then rebounded in 2015 and fell again in 2016. Food inflation in July 2017 has spiked by 2.81%. GST vulnerable Sectors: GST vulnerable sectors, which constitutes a major part of core inflation, have remained sticky above 3.70%. We expect GST vulnerable sectors to observe a significant spike in inflation in the near term due to higher taxes and higher compliance by the informal sector. But it is difficult to fore-cast extent of inflation.

Source: CPI Data 

Inflation from Parallel World

Globally, GST implementation had led to higher inflation and weaker growth in short term. Against this backdrop, GST council has either reduced or kept unchanged effective tax on list of goods and services, which directly impacts retail inflation. Arvind Subramanian, Chief Economic Advisor, has argued time and again that lower taxes will lead to lower inflation and possibly increase the demand in volume terms. Theoretically, there is little flaw in the argument. In an organized and competitive setup the reduced taxes will let companies to reduce prices and attract higher sales.

Unfortunately, a significant part of Indian economy is contributed by informal sector, which has been evading taxes for ages. Though, this informal sector has little contribution to tax collection but it is highly competitive i.e. traders have to pass on the gain of tax evasion to remain competitive. Hence, theoretically, tax evasion is acting like tax credit by government, which was fuelling the economy. It is note-worthy that first Demonetization and now GST has forced a lot of traders to start routing their business through proper channel. Once, these traders, who works at paper thin margins, start paying taxes, there would be a significant jump in prices. Formal sector is also likely to witness in increase in semi-furnished raw material. It remains to be seen how much its cost would be passed on to end consumer.

Retail Inflation:The latest RBI monetary policy categorically mentions that retail inflation is expected to pick up on account of unfavorable base effect. CPI inflation in month of June has fell to its life time low levels of 1.54% y-o-y basis, interestingly month-o-month inflation rose sharply by 0.53% (6.5% on annualized basis). It is also note-worthy that retail inflation has been on upswing after demonetization as it rose from -0.6% in December to 0.53% in June.

Though, it remains to be seen how inflation in informal sector will push overall retail inflation higher, but there is little hope that month-on-month inflation will ease in current environment. Hence, it is safer to presume that we will see more hawkish tone from RBI in next few months.

How to Trade this hypothesis?

India’s 10 year bond is trading at nearly 40 bps tenor and credit premium from repo rate. We can buy yield at current levels, 6.44% with stop loss below 6.34%, previous low on June 2016, with a target of 6.65%.

Reference: Reuters

GST impact – Arvind Subramanian

CPI Data

First Published on 7th Aug 2017