Inflation lays siege to margins

After showing signs of abating in November 2010, with a 7.5 per cent increase over a year ago, the wholesale price index (WPI) once again produced a nasty shock in December, with an 8.4 per cent jump. So is there a risk of the WPI gaining momentum once again? If the dual headwinds of rising commodity prices and higher food inflation continue, there does seem to be a clear risk of an elevated headline number and, more importantly, a risk to Corporate India's profit margins. The WPI, after peaking to 11 per cent in April 2010, moved to single-digit territory after July, largely on account of a dip in manufacturing inflation. Whether the WPI remains in the current zone depends on manufacturing inflation.

Sticky manufacturing inflation

Manufacturing inflation has, over the years, gained importance in the WPI and now receives a 65 per cent weight. This number would, therefore, not only influence headline inflation in the coming months but, more importantly, mirror the fortunes of Corporate India. Here's why. The manufacturing sector cost structure is broadly determined by key inputs — raw materials, wages and fuel. Inflation in primary products such as metals and chemicals, besides food articles, do therefore affect the manufacturing sector's costs.

Rise in price of inputs such as steel and copper by as much as 30 per cent (spot price in London Metal Exchange) over the past year, besides an 18.7 per cent 52-week average inflation on primary articles mean a big hike in input costs. Take the case of Bajaj Auto: its latest quarterly numbers have shown raw material costs as a proportion of sales rising by a good 3 percentage points — clearly a result of price hikes in inputs such as steel. Moving on to labour costs; wages hikes are mostly determined by the Consumer Price Index. This index, with heavy weight to food and housing, has ensured that wage increases are sharp, thus loading the corporate wage bill.

Added to this, the 17-30 per cent hike in NREGA wage rates is higher than the CPI-AL average of 12.5 per cent between January-November. The NREGA wage hike may well create two divergent trends. One, it may keep afloat the now strong rural consumption story for a longer period thus providing support to consumer-oriented industries. On the other hand, it poses the risk of labour shortage in agriculture and other industries, driving up labour costs further. Labour-oriented capex too could suffer.

TCS, for instance, recently stated that it would fall short of its targeted infrastructure capex by Rs 300 crore as a result of shortage of construction labour in its centres under development. A result of delayed capex may mean incurring higher costs including interest costs. The third major input component — fuel and power — have been hovering at high levels of 12 per cent (52-week average) making it no easy task for power-intensive industries such as steel or cement to foot the bill.

Margin pressure

Despite all key components of inputs remaining high, a sharp jump in manufacturing inflation (4.5 per cent in December) is not yet apparent. This suggests that corporates are as of now, absorbing a part of the inflation into their margins. A marginal dip in Corporate India's EBITDA margins in the last couple of quarters is evidence to this. Often, in an inflationary trend, the pass-through of higher costs in the final product price comes with a lag. The question, therefore, is how long corporates can continue to raise prices and whether the market is conducive for passing on such hikes? The recent dip in IIP numbers has led to doubts of continuity in a strong demand scenario, a key to passing on price hikes.

Nevertheless, assuming that price hikes do happen, it would become apparent in the manufacturing inflation numbers. That, in turn, could fuel the headline numbers. Headline inflation spikes often influence the inflation expectations of consumers and pose a threat to demand. A win-win situation for consumers and corporates alike would arise only in the event of continuing robust demand, even after the price hikes are put through in full.