Weak industry and stubborn inflation hinder India's economic recovery

Mumbai: India's industrial output growth hit a four-month low in July while inflation remained high, underscoring the struggle of Asia's third-largest economy to make a sustained recovery from its longest stretch of sub-par growth in decades.

Output from mines, utilities and factories grew by a much slower-than-expected 0.5 per cent year-on-year, government data showed on Friday, down from June's revised 3.9 per cent rise.

Output growth hit a 19-month high of 5.0 per cent in May.

Retail inflation, which the Reserve Bank of India (RBI) tracks for setting lending rates, edged down marginally to 7.8 per cent in August from 7.96 per cent a month earlier, helped by slower annual rises in prices of fuel and clothes.

The numbers come after the economy posted its fastest growth in 2-1/2 years in the quarter to June, helped by a revival in industry. Prime Minister Narendra Modi seized on that figure to highlight the "huge positive sentiment" behind India's recovery.

However, high inflation would make it tougher for Modi to encourage Indian consumers, who power nearly 60 per cent of the economy, to loosen their purse strings. It would also make the RBI wary of lowering interest rates later this month.

The RBI, which wants to reduce retail inflation to 6 per cent by 2016, left interest rates steady last month, citing inflationary risks from a late monsoon.

While better rainfall in recent weeks, falling global crude prices, moderating vegetable prices and a favourable statistical base will likely help lower inflation, rates are widely expected to remain on hold when the RBI reviews them on Sept. 30.

"The outlook on inflation seems less discomforting than it was a month back," says Upasna Bhardwaj, an economist at ING Vysya Bank, in Mumbai.

"We continue to expect that RBI will keep its policy rate unchanged through fiscal year 2014/15 (March 2015) with a probable action mid-next year."

The prospects of a revival in demand-driven price pressures following a pick-up in economic activity and sooner-than-expected interest rate increases in the U.S. are also expected to weigh on the central bank's rate decision.

Any decision by the U.S. Federal Reserve to raise rates, which have been held near zero since December 2008, will have implications for India, as it could lead to capital outflows, weakening the rupee and inflating costs of imported commodities.

Modi won India's strongest electoral mandate in 30 years in May, vowing to lift sliding economic growth, cool inflation and create enough jobs for its young workforce.

Bullish investors, glum consumers

The optimism fanned by Modi's rise to power has already brought inflows of nearly $14 billion of foreign funds into Indian equities this year as investors bet that his drive to cut red tape will revive stalled projects and underpin the economic recovery.

The 50-share Nifty has gained over 30 per cent in U.S. dollar terms this year to become the best-performing equity index in Asia. Goldman Sachs upgraded its target for the index this week, citing optimism over future earnings of Indian firms.

To sustain this euphoria, economists say, Modi must overhaul India's strained public finances, stringent land acquisition laws, chaotic tax regime and rigid labour rules.

During his first 100 days in office, the new prime minister showed little appetite for such structural changes, and there is concern that sharply higher growth in the last quarter could reduce their urgency.

That could be damaging for an economy that is still hobbled by slack consumption and weak business investment. Persistently high inflation and years of stagnant growth have forced consumers to cut discretionary spending.

Consumer goods output, a proxy for consumer demand, has grown in just two of the last 19 months. It fell an annual 7.4 per cent in July.

Firms are shying away from fresh investments. Capital goods production fell 3.8 per cent from a year earlier.

"The pro-business government has facilitated the investment climate and boosted confidence, but more needs to be done to get back to a period of high growth and low inflation," said Rohini Malkani, an analyst at Citi.