Food inflation rose for the fourth straight week in early February, heightening worries that it was driving up headline inflation past official forecasts and increasing the chance of the Reserve Bank of India (RBI) pushing up rates.
The food price index rose 17.97 percent in the 12 months to Feb. 6, higher than an annual rise of 17.94 percent in the previous week, data released on Thursday showed.
The fuel price index rose an annual 9.89 percent in the same week, down from a rise of 10.4 percent on year the previous week.
A persistent rise in food and fuel prices along with a pick up in manufacturing prices are expected to push headline inflation from 8.56 percent in January to 10 percent by March, according to analysts and chief statistician Pronab Sen.
The wholesale price inflation has already leapt over the central bank's revised end-March inflation forecast of 8.5 percent.
Inflation in manufacturing picked up to 6.55 percent from about 5 percent in December, a sign that inflationary pressures were spreading to other sectors of the economy.
"I do not expect headline inflation to come down near term," said Kevin Grice, an economist with Capital Economics in London.
"Base effects should continue to work through, food price pressures will probably stay high for a time while price pressures from the rapid economic upswing will continue to come through too."
A relentless build-up in price pressure is also putting pressure on the RBI to take sterner measures like raising rates ahead of its April policy review.
The RBI is widely expected to raise borrowing rates at its April review after surprising markets with a bigger-than-expected rise in banks' cash reserve requirements in January.
On Wednesday, Farm Minister Sharad Pawar said food prices have started to ease and will dip further next month, while Finance Minister Pranab Mukherjee said higher food prices continue to be a worry.
The government last month ordered the sale of stocked grain and extended duty-free sugar imports by nine months and remained hopeful that higher food supplies would moderate food prices.
However, the result on the ground has been slow, putting the Congress-led government under immense political pressure to find a solution to prevent any drift in its poor urban support base.
SCENARIOS - Scope of possible fiscal roll backs in budget
With the economy picking up steam, winding down the fiscal stimulus may be the central theme in the federal budget scheduled to be presented on Feb. 26.
The government has provided fiscal stimulus worth about 1.86 trillion rupees ($40 billion) in tax concessions and a further $4 billion in new spending since 2008, but this has strained the deficit and borrowing.
Here are some possible scenarios for the budget and its policy and market impact:
PARTIAL WITHDRAWAL OF FISCAL STIMULUS
A partial rollback would help the government bring down the fiscal deficit to it forecast of 5.5 percent of gross domestic product in 2010/11 from a projected 6.8 percent in the current fiscal year.
But the gross market borrowing figure for 2010/11 could still touch 4.61 trillion rupees ($100 billion) because of higher redemptions, according to a Reuters poll of 28 economists.
That would be broadly in line with what the central bank seems to have factored in. It has said it expected gross borrowing to be "slightly higher" than this year's record 4.51 trillion rupees.
Such an outcome would cement expectations that the central bank continue to unwind its loose policy and raise interest rates by 25 to 50 basis points at its April review following last month's rise in banks' required reserves.
The government may start unwinding its stimulus by hiking factory gate duties -- effectively a tax on manufactured goods -- by about 2 percentage points for sectors such as automobiles, consumer durables, and metals, which are now growing at 20-45 percent in annualised terms.
The government may also raise service tax by 2 percentage points or bring more services under the tax net.
This would yield the government around $9 billion in revenue and would go some way in bringing the deficit down just below 5.5 percent of the GDP.
Lower duties may remain in slow sectors like textiles, food products, beverages, paper, non-mineral metals and other export-oriented sectors, where growth is still below 5 percent.
PROBABILITY: High
MARKET IMPACT: Very limited, given that both a partial unwinding of tax breaks and a moderate policy rate tightening are priced in.
COMPLETE ROLLBACK OF FISCAL STIMULUS
Record industrial growth of 16.8 percent in December has increased speculation a rollback could be more extensive than markets expect, though policymakers believe the recovery is still uneven and driven largely by the stimulus.
A complete reversal would mean factory gate rates going up by 6 percentage points and service tax rate by 2 percentage points to pre-crisis levels. This would fetch the government over $21 billion in revenue, pushing down the fiscal deficit to below 5.2 percent of GDP and gross borrowing even below the 4 trillion rupees mark.
But such radical action may endanger the recovery in the sectors, which are showing only tentative signs of revival. It also runs the risk of fanning inflation, as companies may choose to pass on the higher tax burden on to consumers.
Such a risk might prompt the central bank to act to anchor inflationary expectations, but it may opt for not more than a 25 basis point rate rise, wary of possible slowing in demand due to a higher tax burden.
PROBABILITY: Unlikely
MARKET IMPACT: Analysts say the stock markets may slide if the government decides to completely roll back the stimulus measures but bond traders say bond yields may not be much affected by the move.
NO ROLLBACK OF STIMULUS
Theoretically, with the advance estimates suggesting an annual economic growth of 7.2 percent in the current fiscal year, the government could bet on higher tax revenues to beat the loss of revenue through fiscal concessions.
Another revenue stream could be stake sales where the government hopes to raise nearly $7 billion.
But the decision to keep all of the crisis schemes in place would still leave a huge fiscal and funding holes driving both the fiscal deficit and borrowing well above current levels.
Analysts say under such scenario the deficit could stay above 6 percent and gross borrowing could climb above 4.8 trillion rupees ($104 billion), pushing up bond yields.
Much higher government borrowing could crowd out corporate borrowers and might prompt the central bank to delay rate increases until later in the year to help the government raise funds in the markets.
Indian federal bond yields hit 16-month highs of 7.97 percent on Monday on concerns about heavy government debt supply.
PROBABILITY: Very unlikely.
MARKET IMPACT: Analysts who track the bond markets closely say yields will spike but may be capped at 8 percent on expectation that the central bank might delay a rate rise.
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