India’s manufacturing PMI drops to 52.6 in August

The momentum in the manufacturing sector eased further in August, primarily due to a contraction in export orders in the face of stiff global economic headwinds. However, input and output costs continued to head north. The numbers confirm that inflation remains the primary concern for RBI and further action is needed to tame inflation, assuming that the global economy does not take another turn for the worse.

Facts
HSBC's India manufacturing PMI slowed further in August to 52.6 vs. 53.6 in July led by a deceleration in sequential output growth (56.0 vs. 57.2 in July) and a slower expansion in order books. On the latter, total new orders came in at 53.1 vs. 54.5 in July, but export orders contracted significantly (45 vs. 49.2 in July).

With sequential output growth coasting along below the long term average, backlogs of work (49.3 vs. 50.9 in July) and employment (49.5 vs. 51.9in July) fell, although the latter also partly reflects continued labor shortages. However, supplier delivery times did not improve further (50.1 vs. 51.5 in July), testament to the still tight capacity along the supply chain.

At the same time, the quantity of purchases (55.6 vs. 56.7 in July) rose further, albeit at a slower pace, while stocks of purchases (52.8 vs. 52.7 in July) accelerated marginally. However, stocks of finished goods (49.1 vs. 51.3 in July) contracted and fast enough to increase the order-to-inventory ratio, suggesting less risk of an inventory overhang.

Despite the moderation in demand, price pressures continued to build, with input prices (65.6 vs. 64.3 in July) accelerating and output prices (55.6 vs. 56.0 in July) still on to the rise.

Implications
The moderation in growth is clearly not just a blip and is set to continue over the next several months.

The driver of this, as we have highlighted many times before, is the lagged effect of monetary policy tightening, the uncertainty and disposable income effects associated with the high level of inflation, and binding capacity constraints.

Furthermore, stiff global economic headwinds are now also increasingly restraining growth in the sector, with export orders contracting at a pace not seen since March 2009.

On the inflation front, however, things are still not easing up. Price pressures continue to build as higher input costs, without too much trouble, are passed on to final sticker prices. While the continued moderation in growth will eventually help dampen inflation pressures, there is still excess demand in the economy. As such, it will be a while before the growth moderation closes
the output gap, unless the global economy takes a serious turn for the worse and fast-tracks the slowdown in India.

In turn, this will keep underlying inflation pressures firmly in place for the foreseeable future and, therefore, compel the RBI to maintain its tightening bias. We, therefore, still believe that the most likely outcome at the September policy meeting is a 25bp hike. Of course, if global economic headwinds prove more persistent and strengthen further, the RBI could justifiably feel tempted to press the pause button. On that front, the closely watched US August ISM manufacturing index released yesterday came in better than feared at 50.6, vs. consensus of 48.5. While this provided some relief, one shouldn't take too much comfort in the number either. The recovery in the US and Europe basically remains slow and precarious.

Bottom line: Indian manufacturing growth is moderating in response to policy tightening and weaker external demand, but inflation pressures are not abating. Chances are that the RBI will hike in September, barring a further worsening of global economic conditions.