India industrial production sharply dips 1.8%

Blame it on the nasty 27.9% contraction in capital goods output growth.

According to Nomura, India's IP contracted by a sharper-than-expected 1.8% y-o-y in June after growth of 2.5% y-o-y in May. Apart from adverse base effects (IP rose 9.5% last June), a sharp contraction in capital goods output growth (-27.9%) was mainly responsible.

Here's more from Nomura:

The deepening slump in capital goods production suggests that investment activity is worsening. In addition, consumer non-durables output growth contracted by 1% y-o-y from an already subdued 1.3% in May, suggesting high inflation may have reduced demand for non-discretionary consumption as well.

Production of consumer durables picked up in June (+9.1% y-o-y), but sustaining this may be difficult given higher inventories with auto dealers. Meanwhile, the sharp contraction in manufacturing output growth was led by electrical machinery, motor vehicles, food and beverages and textile segments. IP growth averaged -0.2% in Q2 versus 0.6% in Q1, lower than our estimates. However, this has been offset by higher-than-expected government spending. As such, we maintain our Q2 GDP growth estimate of 5.4% y-o-y (Q1 was 5.3%).

Going forward, base effects should push y-o-y IP growth back into positive territory, but deficient monsoons, the fall in the exports new orders index, a contraction in non-oil imports and government inaction suggest that the underlying momentum remains weak. Both domestic and external demand components of the manufacturing PMI weakened in July. Plus, the OECD's composite leading index suggests that a real turnaround is not yet in sight.

Notably, July IP growth is likely to be weak as production suffered due to a shutdown in auto companies and the power blackout. While sustained weakening in IP growth calls for policy easing, we expect WPI inflation to rise to 7.5% y-o-y in July from 7.2% in June and core WPI (non-food manufactured) inflation to inch above 5% (from 4.8%). Moreover, rising food price inflation and an impending fuel price hike should push headline WPI inflation above 8% by Q4 2012. As such, we expect policy rates to remain on hold in 2012 with a 50bp rate cut in H1 2013.