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Inflation Challenge to Hurt Growth
Growth to moderate in F2012: We expect GDP growth to moderate to 7.7% in F2012 from 8.6% in F2011. We expect government spending and consumption growth to slow in F2012. Investments will pick up but only gradually. We also expect exports to remain strong, but not enough to offset the slower growth in domestic demand.
Consumption growth to slow: We expect the central government to slow its expenditure growth to single-digit levels in F2012. Moreover, private consumption growth is likely to moderate in F2012 as higher inflation affects purchasing power, higher deposit rates encourage savings, and the government’s transfer to households slows.
Macro environment for private corporate to remain difficult: After a sharp decline in private corporate capex to GDP due to the credit crisis, the pickup in investment has been gradual in F2010 and F2011. After-effects of corruption- related investigations and persistently higher inflation as well as cost of capital will restrain growth in private corporate capex in F2012.
Fiscal policy exit will pick up in F2012: Aggressive hikes in the bank deposit rate since December 2010 mean that the effective monetary tightening is now done. We believe a reduction in government expenditure to GDP and fiscal deficit will now be critical for inflation outlook. We expect fiscal deficit (excluding one-off telecom licence fees) to moderate from 9.7% of GDP in F2011 to 8.5% of GDP in F2012, which we believe is still expansionary.
Inflation risks remain on higher commodity prices: While inflation has decelerated from close to double-digit levels to 8.3% in February 2011, it remains way above Central Bank’s comfort zone of 5-5.5%. We expect WPI inflation to average 7.6%YoY in 2011. We believe that prices of global commodities including crude oil will be key to the inflation outlook
Overall Growth Trend: Trailing Growth Indicators Have Been Strong
GDP growth stays strong: Lagged impact of loose fiscal policy, low real interest rates, revival in capital inflows and low base effect driven strong growth in farm output ensure strong GDP growth of 8.6% (our estimates) in F2011.
Corporate revenue growth holding up strong: The broad market revenue growth for QE Dec-10 has been reported at 19%YoY (for the companies reported till date) compared with 22%YoY during the QE Sept-10.
Overall Growth Trend: Trailing Growth Indicators Have Been Strong
Excise duties collections (proxy for domestic production) have been robust: Tax collection on domestic production (excise duties) remained strong at 32.4% YoY in February 2011. FYTD excise duties revenues grew by 35%, well ahead of the BE of 33%. This data is also corroborating our view that recent industrial production data indicating a sharp collapse in industrial activity is not correctly representing underlying economic activity.
Non-oil import growth has also picked up: Strong domestic demand, particularly consumption is also reflected in seasonally adjusted non-oil import growth, which has increased by 43.4% over the past five months.
Consumption: Discretionary Spending Moderating From A High Base
Household spending, a key driver of growth, stays strong: Urban consumption has remained strong. Passenger car and two- wheeler sales growth remained strong despite high base effect at an average of 20.4% YoY and 24% YoY, respectively, during the three months ended February 2011, compared to 38% YoY and 45.2% YoY in the year-ago period. Similarly, consumer durables production grew 15.5% YoY during the three months ended January 2011 compared with 35.2% YoY in the year-ago period.
Consumption: Staples and Modern Retail Sales Growth Remain Strong
Fast moving consumer goods (FMCG) sales have maintained healthy growth trend: Domestic FMCG sales growth picked up to 14%YoY during the quarter ending Dec-2010 from 12%YoY during the quarter ending Sept-2010. Similarly, urban high and middle income consumers spending in the modern retail format has been strong through Dec-2010.
Exports: Rebounding Sharply – Driven by Developed Markets
Strong rise in exports: In line with the recovery in US and Europe, India and other Asian countries have already seen a major rise in exports over the past few months. Seasonally adjusted goods exports have increased by 35.5% over the past five months
Sharp rebound in AXJ exports in the past five months: As discussed earlier, other Asian countries have already seen a major rise in exports over the past few months with the recovery in G3. The much-feared EU debt concerns did not materialize into sustained weakness in external demand for AXJ. After a brief downtick, exports recovered sharply from September 2010. Indeed, cumulatively AXJ exports have risen by 23.4% (not annualized) between September 2010 and January 2011
Capex: The Weak Spot – Macro Environment Holding Back the Pace of Recovery
Capex recovery held back: The credit crisis has resulted in a significant decline in total investment to GDP (excluding investments in gold by households) to 33.2% of GDP in F2009 from 37.1% of GDP in F2008. More important, private corporate capex, which we believe is the most productive component of total investments, declined from the peak of 17.3% of GDP to 11.5% of GDP in the same period.
New capex orders have slowed: In 2010, corporate confidence recovered only gradually as the global macro environment was still not comfortable enough. Right up to August 2010, the sovereign debt concerns in EU meant that the companies were not ready for an aggressive capex plan. Just as the global environment improved, domestic factors such as corruption-related investigations and the rise in inflation and cost of capital have held back the investment cycle. Indeed, we did see a recovery in order backlog (order book) for engineering and construction companies in the first half of 2010. Order backlogs again decelerated during the quarter ended December 2010, however
II. Where Are We on Macro Stability Risks?
Current Account Deficit, Inter-bank Liquidity and Inflation
Aggressive growth push has brought macro imbalances: Since the credit crisis unfolded, India’s policy makers have been aggressive in quickly returning growth to pre-crisis levels. We believe that policy makers cut policy rates and widened fiscal deficit excessively to insure against the potential downside of an extremely adverse developed world growth trend. However, we believe that as soon as there were clear signs of the global growth outlook improving, there was a need to reverse fiscal and monetary policy. This approach from policy makers to push growth with the support of fiscal and monetary policy has been accompanied by risks to macro stability in the form of (a) high current account deficit ; (b) tight interbank liquidity and disruptive rise in short-term rates; and (c) rise in inflation.
#1. Current Account: After Major Widening, Current Account Deficit Has Narrowed But……
Trade deficit has narrowed as exports bounce back: After widening for a sustained period when recovery began in the second half of 2009, the trade deficit has shown a clear trend of moderating over the last six months. Monthly trade deficit stood at US$8.1 billion (5.7% of GDP annualized) in February 2011. The trade deficit has narrowed steadily from a peak of US$11.8 billion deficit (10.5% of GDP annualized) in December 2009. On a 3-month trailing basis, the deficit narrowed to 4.4% of GDP, annualized in February, from 4.7% of GDP in January 2011 and a high of 9.8% of GDP in December 2009.
Current account deficit has narrowed to manageable levels too: We maintain our view that the current account deficit peaked during QE Sept-10. Indeed, the current account deficit narrowed to US$9.7bn (2.4% of GDP, annualized) in QE-Dec 10 compared with a deficit of US$16.8bn (4.3% of GDP, annualized) in QE- Sep 10.
Rising oil prices can reverse narrowing of trade and current account deficit again: A further rise in crude prices (Dubai light) post December 2010 means that current account deficit may have widened again in QE Mar-10. Our oil sensitivity analysis indicates that a US$10/bbl change in crude oil prices would result in India’s import bill and current account deficit rising by about US$8.1 bn (0.42% of GDP) for the full year.
\#2. Inter-bank Liquidity – Still Tight, Inflation Outlook is Key
Gap between credit and deposit growth remains high: Liquidity conditions are tightening because of the persistent gap between bank credit and deposit growth. As of March 11, 2011 bank credit growth was 23.2% YoY vs. 16.6% YoY deposit growth. Deposit growth has started rising since the deposit rate hikes began in December 2010 but not enough. Banks' credit- deposit ratio (C/D ratio) remained extremely high at 75% as of March 11, 2011 compared with 74.5% as of end November (before the recent deposit rate hikes). This level of C/D ratio is high considering that banks also need to statutorily invest 24% of deposits in government securities (SLR requirement) and park 6% of deposit with RBI as cash reserve ratio (CRR).
Inter-bank liquidity has remained tight: The inter-bank liquidity has been in deficit mode since second week of September 2010. The main reason for this tight inter-bank liquidity is the gap between credit and deposit growth and high C/D ratio. The net liquidity in the banking system (repo less reverse repo balance) remained in a deficit of US$18 bn in March, compared to the average deficit of US$17 billion and US$20 billion in February and January 2011. Until recently, we were expecting a quick improvement in inter-bank liquidity due to acceleration in deposit growth. For instance, we thought the deposit rate hikes were aggressive and had expected deposit growth to respond much faster, resulting in banks beginning to cut deposit rates by 25- 50bp. However, with the persistent rise in crude oil and other commodity prices, we believe that inflation expectations will remain sticky and inter-bank liquidity may remain tighter for longer. We believe banks will need to slow credit growth, unless deposit growth accelerates to 22-23% quickly, which is unlikely.
#3. Inflation Has Peaked, Yet Much Higher Than The Comfort Zone
Inflation is still a challenge: Strong domestic demand in the context of slow growth in investments coupled with supply shocks of higher food, oil and other global commodity prices have ensured that headline inflation (WPI) has remained above the RBI’s comfort zone of 5-5.5% for the past 15 months. Headline inflation averaged 9.2% during this period
Inflation expectations remain high: Persistent high level of headline inflation has meant that inflation expectations remain high. This is reflected in high growth in currency with the public and slow growth in deposits. While we expect WPI inflation to decelerate, we expect headline inflation (WPI) to average 7.6% YoY in 2011 unless global commodity prices pull back meaningfully. In other words, we expect headline inflation to remain significantly above the Central Bank’s comfort zone of 5- 5.5%.
Rise in Price of Crude Oil and Commodities Could Compound the Inflation Problem
Rise in crude oil prices and other global commodity prices is a concern: CRB metals and CRB food prices have increased by 48% and 40% respectively since June 2010. Crude oil (Dubai light) has spiked up closer to US$110/bbl. If crude prices were to rise by another US$10/bbl (for the full year), it would result in an increase in wholesale price inflation by 0.8-1ppt if the government were to pass the full increase on to consumers (a cascading effect of a similar amount would also be felt). We were expecting WPI inflation to average 7.6% YoY in 2011 unless global commodity prices pull back meaningfully. If crude oil prices reach US$125/bbl for a sustained period of six months or more, we believe headline inflation (WPI) could spike to 9-10%. This would increase the risk of unexpected policy actions to manage inflation pressures such as intervention in essential commodities prices and eventually hurt growth. Indeed, this could remind us of the macro environment in mid-2008.
III. Reversal in Policy Support - Fiscal Policy Is The Key
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‘Effective’ monetary tightening is done: With the Central Bank continuing to be slow to hike policy rates, banks had delayed deposit rate hikes. However, given persistent tightness in inter-bank liquidity, banks have hiked deposit rates aggressively since December 2010. State Bank India, the largest bank, has increased its deposit rates for the one to two-year period by 325bps to 9.25% since July 2010. Indeed, some banks are offering 9.5-9.75% deposit rates for the same tenure. We believe that as far as inflation management is concerned, the monetary policy has been ‘effectively’ tightened considerably with bank deposit rates having moved up to close to 11-year highs if we exclude the period that was hit the hardest by the credit crisis.
Fiscal policy reversal is more critical: While fiscal policy remains expansionary, we believe the government has finally moved in the right direction targeting meaningful reductions in underlying fiscal deficit for the first time since credit crisis unfolded. We expect the government to cut its expenditure growth in F2012 to reduce the fiscal deficit. In F2012, the central government’s fiscal deficit is likely to be lower at 5.2% of GDP compared with 6.4% of GDP (excluding revenue from telecom license fees) in F2011. In the absence of support of one-off revenues, we believe the government’s expenditure growth will decelerate to 7.5% YoY in F2012 from 18.7% YoY in F2011. Indeed, the central government’s expenditure has been growing at an average rate of 19.2% YoY over the last five years. We believe that even after the reduction in deficit in F2012, it remains expansionary
IV. Growth Outlook – Investment Is The Key
GDP Growth to moderate in F2012: We expect GDP growth to moderate to 7.7% in F2012 from 8.6% in F2011. We expect government spending and consumption growth to slow in F2012. The investments will pick up but at a gradual pace. We also expect exports to remain strong, but not enough to offset the slower growth in domestic demand.
Consumption growth to slow in F2012: Persistent higher inflation will likely hurt private consumption growth. Moreover, higher bank deposit rates will encourage households to increase savings. Similarly, we expect the government to cut back its expenditure growth in F2012 to reduce fiscal deficit. We believe this rising government expenditure to GDP (a large part of which was revenue expenditure) over the last five years has played a key role in boosting private consumption. Hence, a slowdown in government expenditure will be another factor resulting in moderation in private consumption
Recovery in exports will help partly offset moderation in consumption: Considering the strong growth estimated by our US economics team for 2011, we expect export growth to remain robust. We believe that to some extent this will help to offset slower-than-expected domestic demand growth. Strong growth in exports is also helping contain current account deficit close to 3% of GDP.
Acceleration in investment growth will be key but….: In the context of moderation in consumption growth, acceleration in investments is important. However, we expect investment to pickup but at a gradual pace. After a sharp decline in private corporate capex to GDP due to the credit crisis, the pickup in investment has been gradual in F2010 and F2011. After-effects of corruption-related investigations and persistently higher inflation as well as cost of capital will restrain growth in private corporate capex in F2012. In this context, the further rise in crude oil and other global commodity prices has only increased the risk of inflation remaining higher for longer and the cost of capital remaining higher for longer.
V. Key Upside and Downside Risk Factors
Key Upside/Downside Risk Factors
Upside and downside risks to our estimates: In our base case, we expect F2012 and F2013 GDP growth of 7.7% and 8.7%, respectively. We believe the following developments can bring upside/downside risks to our growth forecasts: (a) Global growth: Our economics team estimates global growth will remain strong at 4.3% in 2011 and 4.6% in 2012. If there is a double dip in the developed world growth resulting in extreme risk aversion, then this can impact the capital flows to the country and hence growth. (b) Inflation: In our base case, we expect inflation (WPI) to average 7.6% in 2011 assuming oil averages US$110/bbl (Arab light crude oil). We believe that as far as inflation is concerned, monetary policy has effectively tightened considerably with bank deposit rates having moved up to close to 11-year highs if we exclude the period hit hardest by the credit crisis. While fiscal policy remains expansionary, we believe the government has finally moved in the right direction targeting meaningful reductions in underlying fiscal deficit for the first time since credit crisis unfolded. Increasingly, we believe that global commodity prices are key tothe inflation outlook. If global commodity prices moderate quickly with better supply response, it will help reduce inflation pressure faster than expected. At the same time, any major further spike in commodity prices will make inflation management even more difficult, hurting growth. (c) Sentiment for Capex: For overall growth outlook, in the current environment where policy makers are unlikely to be able to support growth with loose fiscal and monetary policy, we believe investment growth is key. Our base case currently assumes a gradual recovery in capex considering the macro environment. If the government manages to implement an aggressive "campaign- style" effort to clear investment projects transparently with coordination from all ministries to revive corporate capex, than this will bring upside risks to our forecasts. Similarly, if the government fails to pursue a concerted effort to ensure a gradual recovery in capex, then there will be further downside risks to our estimate. In this context, apart from the general macro environment, we would be tracking announcements from various government ministries, anecdotal evidence on various investment projects and quarterly order book data of engineering and construction companies.
Theme I: Long-term Growth Outlook: An Interplay of Three Macro Factors
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Growth Driven by an Interplay of Three Macro Factors: India’s GDP growth moved from about 6% in the early 2000s to 8-8.5% currently. We believe this shift has been premised on three key factors – demographics, reforms, and globalization. This interplay of demographics, reforms, and globalization is crucial for the virtuous cycle of faster growth in productive job creation – income growth – savings – investment – higher growth. Over the past 10 years, India’s ratio of savings to GDP has risen from 24-25% to 33-36%. Similarly, its ratio of investment to GDP has risen from 24-25% to 35-38% and GDP growth has accelerated to a trailing five-year average of 8.6% in 2010 from 5.9% in 2000.
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Demographics: The ratio of the elderly and children to the working age (aged 15-64 years) population has declined from 68.6% in 1995 to 55.6% in 2010, according to UN estimates. This has helped support a structural rise in domestic savings. India will account for almost 26% of the increase in global working-age population over the next 10 years, according to UN estimates. The large surplus in India’s working population is forcing recognition in the world economy of the country’s role in global competition and output dynamics.
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Reforms: A positive demographic trend may be a necessary condition for strong growth, but it is not sufficient. Favorable demographics need to be converted into a virtuous cycle of acceleration in growth. A critical step in this process is the opening up of productive job opportunities through reforms. Over the years, India’s government has been initiating reforms to encourage private sector investment, which helps create the platform of employment for the working-age population. In this context, one of the long-standing challenges for India was acceleration in infrastructure spending. The government is working to to address this. We expect infrastructure spending to rise to 9% of GDP in 2012 from 7.9% of GDP in 2010 and 5.4% of GDP in 2005.
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Globalization: Globalization, as reflected in the steady rise in exports to GDP and capital inflows to GDP, has also helped accelerate the pace of growth. India’s integration with the global economy started to accelerate in the early 1990s. India has relied on both goods and service exports. India’s performance in services has been a key differentiating factor. India’s share in global services exports increased to 2.6% in 2009 from 1.1% in 2000.
The combined effect of demographics, structural reforms, and globalization will help create a virtuous cycle of productive job creation, income growth, savings, investments, and higher GDP growth.
Theme I: India to Offer Best Growth Opportunity Over the Next 25 Years
Over the next 20-25 years, we expect India to remain the highest growth economy among large countries. India could have the advantage of maintaining its high-growth phase for a longer period than East Asia did, as UN data show that India’s age dependency will continue to decline until 2040.
UN projections show that India will be the only large country that will still have favorable demographics after 2010. Japan, Europe, and the US (in that order) will have a significant rise in their ageing populations.
So, while in the past 20 years, China has benefited ahead of India from a faster fall (improvement) in the age-dependency ratio, over the next 20-25 years India will have this advantage.
Theme I: Internal Challenges to Sustain Strong Growth Story
We believe there are several challenges to India’s high growth story.
First, infrastructure development: The government needs to ensure that it executes in this area. The trend in China over the past 25 years indicates that, for 10% sustainable GDP growth, India would need to increase infrastructure spending to 10% of GDP from the current 7.9%. We believe the government would need to focus on laying down the policy framework and support to ensure a sustained increase in investment in key sectors, such as electricity, highways, and railways.
Second, ongoing fiscal/revenue deficit reduction: One of the key pillars of our strong outlook for India is a structural rise in domestic savings and investments. In that context, reduction of the government’s revenue deficit would be critical. The government made a move in that direction in February 2011 by targeting a lower fiscal and revenue deficit, but such efforts would need to continue over the next few years.
Third, labor law reform needs to be prioritized: We believe sustained strong growth in SMEs will be an important driver of India’s growth. There are more than 40 labor-related laws from the central government on such issues as compensation, retrenchment, industrial disputes, and trade unions. State governments also have several pieces of labor legislation. Most of these laws are not in sync with the practical realities of a highly competitive globalized world. We believe labor law reforms would be needed to support growth in labor-intensive industries.
Fourth, development of less-developed states: Rising income inequality and high poverty levels in some states have increased the probability of social instability. Already a few states have faced insurgency from Naxalites, and the internal security threat from this movement is a concern.
Fifth, secondary and tertiary education infrastructure: As discussed, significant progress has been made in improving primary and tertiary education. The success of primary education has meant the demand for secondary education infrastructure is beginning to rise rapidly. We believe measures to further improve secondary and tertiary education infrastructure would be required to help sustain the strong growth story.
Theme II: Reassessing Macro Sensitivity to Oil Prices
Dependence on imported oil is high: India’s proven reserves of oil and oil production have remained largely stable over the last decade. As a result, increasing oil consumption has meant greater reliance on crude oil imports for India. India imports about 70% of its crude oil and petroleum products requirement, up from 44% in 1995. Crude oil accounted for about 25% of India’s total imports in F2010 (5.3% of GDP). India’s overall oil balance (crude oil and petroleum product imports less exports) is higher than that for the AxJ region.
Policy regime – deregulation in progress: Domestic fuel prices in India are implicitly marked to crude oil prices of US$65/bbl. However, we believe that if crude oil prices rise sharply, the government may influence the decision of the oil distribution companies and delay the pass through in domestic gasoline prices. Prices of other petroleum products like ATF, Naphtha, lubricants, etc., are market determined.
Share of oil in energy consumption is relatively low…: India’s share of oil in energy consumption is at 31.7%, the second- lowest in the region after China. India depends on coal to meet 52.4% of its energy requirement, due to its easy availability. The balance is accounted for by natural gas (10%) and nuclear & hydro power (5.9%).
Oil Intensity higher than the world average: India’s efficiency of oil usage, as measured by oil intensity (primary oil consumption per unit of GDP), is higher than the world average and marginally higher than other emerging countries.
….But share of world oil consumption is high: Despite oil having a low share in overall energy consumption, India is one of the leading consumers of oil in the emerging world owing to the relatively larger size of the economy. It has high share (3.8%) of world oil consumption.
India’s fiscal balance sheet most vulnerable: India’s headline deficit is the highest in the region. Indeed, if we include all off- budget expenditure items, the fiscal deficit will be 8.2% of GDP in F2011E. While Malaysia also has high deficit, its oil subsidy burden is largely an internal liability as it is a net oil exporter. China is also a net importer of oil but has a strong balance sheet with public debt to GDP of 35.5% compared to 68.5% for India.
The typical macro impact of oil price movements: The government’s involvement in domestic oil pricing means that movements in oil prices can have a less- or greater-than proportionate impact on key macro indicators such as inflation, consumption and growth. We estimate the typical macro impact would be as discussed in the table above.'
Oil subsidy sensitivity to crude oil prices: In our base case for F2012, we have assumed crude prices (Arab Light) average about US$110/bbl. In this case the overall oil subsidy burden will rise to 1.2% of GDP, with typically close to half being borneby the government in the form of direct subsidy and issuance of oil bonds. Our oil sensitivity analysis indicates that every US$10/bbl increase in oil prices increases fuel oil subsidy in India by US$6.3 bn (0.31% of GDP) if domestic fuel prices are unchanged.
Exchange rate movement: As international oil prices adjust, the initial impact on the domestic economy can be offset (or exacerbated) depending upon the strength of the exchange rate at that point in time. In the past, when commodity prices rose rapidly, we have observed that central banks were less hesitant to allow appreciation of the currency against the US dollar, particularly when the US dollar was weakening against all currencies.
Governments’ influence on domestic fuel prices: Domestic prices of oil products (other than industrial products such as naphtha and aviation turbine fuel) historically have been directly or indirectly controlled by the government. For a brief period between April 2002 and April 2004 (when crude oil prices were US$24-35/bbl) oil companies could independently determine the price of diesel and gasoline. In 2010, the gasoline prices in India were made market linked. The retail price of diesel, kerosene and LPG is currently regulated by the government.
Theme III: Structural Inflation Outlook
Theme III: Structural Inflation Outlook
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India, unlike other EMs, does not have a history of high inflation: Inflation WPI and CPI-Industrial Workers (CPI-IW) have averaged 5.4% and 6.8%, respectively, over the last 15 years compared with 9% average (CPI) for emerging markets. Double- digit inflation is not the norm. Typically, double-digit inflation makes policy makers respond as society at large has begun to expect inflation of around 5-6%.
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Structural inflation should be lower as savings, investments, and productivity growth rises: We believe that the combined effect of more favorable demographics and increased productive job opportunities should boost India’s savings-investments, lifting productivity growth and sustaining structural inflation at 5-6% in the medium term and even lower in the longer term.
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Key risk to our view: The key, we believe, from a cyclical and structural perspective will be the government's policies. If government and central bank attempt to boost growth through the support of loose fiscal and monetary policy instead of structural reforms, which help boost savings and investments, inflation will be higher than expectations.
Historically, India’s inflation has been lower compared with that in other emerging markets. Inflation WPI and CPI-Industrial Workers (CPI-IW) have averaged 5.3% and 6.8%, respectively, over the last 15 years compared with 11.2% average (CPI) for emerging markets. Double-digit inflation is not the norm. Indeed, over the last 10 years on an annual average basis, WPI inflation crossed 10% not once while CPI-IW crossed 10% only one time. On a monthly basis, the two recent spikes in WPI inflation numbers to double-digit levels have been caused by oil prices spiking above US$140/bbl (in 2008) and severe drought affecting farm output, leading to a sharp rise in food inflation (2009) and other cyclical factors. Typically, double-digit inflation prompts policy maker responses as society at large has begun to expect inflation of around 5-6%.
Recall the trend in 2003-07: Strong growth and manageable inflation: We highlight that during 2003-07, India’s GDP growth averaged 8.9% and WPI inflation averaged 5.5%. In other words, India has been able to transition to higher growth without significant acceleration in inflation, but for the recent cyclical spikes in inflation as discussed above. However, one could argue that in the initial part of the strong period, the country was operating with excess capacity, as measured by the usual trend in current account, which was in surplus of 2.3% of GDP in F2004 (12 months ended March 2004). However, there was no major inflation pressure in this period. Inflation pressures picked up only in 2008, when oil prices shot up and summer crop/food grain output suffered a decline of 2.3% YoY. Current account deficit also remained in the manageable range during this period with peak levels of just 1.3% of GDP in 2008.
Inflation will be managed even as growth accelerates: Over the past 10 years, India's headline WPI inflation has averaged 5.3%. The combined effect of more favorable demographics and increased productive job opportunities should boost India’s private-savings level and push aggregate savings to 37-40% of GDP over the next 10 years, allowing the country to maintain an investment-to-GDP ratio of 39-42%, we estimate. The increase in capacity through higher investments should ensure a shift in India’s growth to a sustained rate of 9-10% in this period without overheating concerns.
Productivity growth is rising: Recall that over the past five years, India’s average GDP growth was 8.5% with infrastructure spending at 6.4% of GDP and inflation (WPI) averaging 5.5%. In that context, we believe that in the coming three years, India’s infrastructure spending to GDP will rise to 9-10%, ensuring that productivity growth remains strong. We expect the structural inflation trend to remain in the 5-6% range with GDP growth likely closer to 8.5-9%.
Structural outlook: The structural component in food inflation is all about protein. Over the last few years, the acceleration in the pace of per capita income growth, particularly in the lower income groups, is reflected in higher protein-related food items. Moreover, a similar trend in other developing nations has meant that the government cannot rely on imports to reduce the pressure on domestic food prices. While structural demand growth has risen, particularly for protein-related food items, the supply side continues to be affected by structural problems. Productivity growth has remained lackluster.
We believe that in the medium-term food inflation could average higher at 6-7%assuming there is no major crop failure. We are also assuming the government’s efforts to improve productivity in the farm sector and the inventory management as well as public distribution systems will take some time to improve. However, with continued rise in non-farm investments, we expect productivity growth in that segment to ensure that overall inflation is maintained in the 5-6% range over the medium term.
Similar trend in other Asian economies during initial phase of take off: In the initial period of growth take off, some parts of the economy tend to lag, and capacity creation in those areas is not anchored to high GDP growth. Moreover, investments in the economy tend to be higher than savings. During the initial phase of high growth, other Asian economies also faced slightly higher inflation trends and saw current account in deficit or in very small surplus. For instance, in China the current account balance remained in small deficit or negligible surplus until the mid-1990s. China moved into high growth of 9%-plus on a sustained basis for the first time in the early 1980s from an average of 6.3% in the 1970s. Urban CPI in China averaged 8.1% in the 1980s compared with an average of 1.4% in the 1970s. We have seen a similar trend in other Asian economies such as Korea and Malaysia, when they moved to a high growth trend. Indeed, India appears to have managed the transition to higher growth trajectory with minimal inflation pressures compared with the other Asian Tigers
Theme IV: Fetish for Gold
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India’s gold consumption has picked up again: After a short weak trend in 2009 due to the global credit crisis, India’s spending on gold bounced back sharply in 2010. India’s gold consumption (in US$ terms) rose by almost 106% YoY in 2010 after declining 7.3% YoY in 2009.
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India remains the world’s largest consumer of gold: On an annual basis, India is the world’s largest consumer of gold in tonnage terms, followed by China. During 2010, India accounted for 31.5% of global gold demand.
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A shift away from gold into financial savings is unlikely to happen in a hurry: We believe there is a complex set of drivers behind Indian households’ fetish for gold. While the government is continuing its efforts to channel these savings into more productive financial assets, we believe this shift is unlikely to materialize in the short term.
Gold consumption is rising sharply again: After a short weak trend in 2009 due to the global credit crisis, India’s spending on gold bounced back sharply in 2010. India’s gold consumption (in US$ terms) rose by almost 106% YoY in 2010 after declining 7.3% YoY in 2009. Cumulatively, India now holds over 18,000 tons of above-ground gold stocks worth approximately US$800bn at the current gold price – nearly 50% of the country’s GDP. This represents 11% of the world’s stock, according to World Gold Council (WGC) estimates. On an annual basis, India is the world’s largest consumer of gold in tonnage terms, followed by China. In 2010, India’s gold demand accounted for 31.5% of global gold demand.
Gold is one of the key assets in household balance sheets: Gold holdings among Indian households at current market value are about 2.8x the current equity stock holding of US$290 billion. Bank deposits by households are currently valued at US$675bn, according to our estimates. While the share of gold in household savings declined to 5.7% in F2008, we estimate that this has risen back to 9-10% currently. On an annual basis, household savings in gold and bank deposits stood at US$38bn and US$120bn, respectively; in equities it was US$0.8bn as of the four quarters ended December 2010. The share of gold in household savings appears to have risen again in F2010. Our analysis based on stake holdings trend of around 1,200 NSE-listed companies and purchase of mutual funds indicates that Indian households’ allocation to equity has fallen sharply following the credit crisis. On the other hand, their investment in gold has been trending upward
Share of financial savings remains low: After rising to an average of 60% in the mid-1990s, over the last 10 years, the share of financial savings in total household savings has remained largely stagnant at an average of 48%. Indeed, low real interest rates have provided little incentive to increase allocation from physical savings (which include gold, property and household investments in small businesses). The share of financial savings in total decreased to 46% in F2009 from 64% in F1997 as real interest rates fell to -0.5% from 9.1% over the same period. Indeed, this decline in real interest rates has only encouraged households to increase the allocation to physical savings (including gold, property and household investments in small businesses). However the share of financial savings increased to 50% in F2010 as real interest rates increased to 3.6%. Yet the penetration of financial savings in India still remains low. Apart from this, incidence of unaccounted money (black money) is also a reason for the low share of financial savings.
Financial sector reforms needed to increase the share of financial savings: To increase the share of financial savings, deepening of financial sector reforms would be the key. Apart from increased easy access to banking and financial services facilities, one of the most important areas that need attention in this context is reforms related to long-term savings schemes. Although the government has initiated some reforms recently, the desired results are still not reflected in the share of long-term savings.
A shift away from gold into financial savings is unlikely to happen in hurry: We believe there are a complex set of drivers behind Indian households’ fetish for gold. While the government is continuing its efforts to channel these savings into more productive financial assets, we believe this shift is unlikely to materialize in the short term.
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Inflation Challenge to Hurt Growth
Growth to moderate in F2012: We expect GDP growth to moderate to 7.7% in F2012 from 8.6% in F2011. We expect government spending and consumption growth to slow in F2012. Investments will pick up but only gradually. We also expect exports to remain strong, but not enough to offset the slower growth in domestic demand.
Consumption growth to slow: We expect the central government to slow its expenditure growth to single-digit levels in F2012. Moreover, private consumption growth is likely to moderate in F2012 as higher inflation affects purchasing power, higher deposit rates encourage savings, and the government’s transfer to households slows.
Macro environment for private corporate to remain difficult: After a sharp decline in private corporate capex to GDP due to the credit crisis, the pickup in investment has been gradual in F2010 and F2011. After-effects of corruption- related investigations and persistently higher inflation as well as cost of capital will restrain growth in private corporate capex in F2012.
Fiscal policy exit will pick up in F2012: Aggressive hikes in the bank deposit rate since December 2010 mean that the effective monetary tightening is now done. We believe a reduction in government expenditure to GDP and fiscal deficit will now be critical for inflation outlook. We expect fiscal deficit (excluding one-off telecom licence fees) to moderate from 9.7% of GDP in F2011 to 8.5% of GDP in F2012, which we believe is still expansionary.
Inflation risks remain on higher commodity prices: While inflation has decelerated from close to double-digit levels to 8.3% in February 2011, it remains way above Central Bank’s comfort zone of 5-5.5%. We expect WPI inflation to average 7.6%YoY in 2011. We believe that prices of global commodities including crude oil will be key to the inflation outlook
Overall Growth Trend: Trailing Growth Indicators Have Been Strong
GDP growth stays strong: Lagged impact of loose fiscal policy, low real interest rates, revival in capital inflows and low base effect driven strong growth in farm output ensure strong GDP growth of 8.6% (our estimates) in F2011.
Corporate revenue growth holding up strong: The broad market revenue growth for QE Dec-10 has been reported at 19%YoY (for the companies reported till date) compared with 22%YoY during the QE Sept-10.
Overall Growth Trend: Trailing Growth Indicators Have Been Strong
Excise duties collections (proxy for domestic production) have been robust: Tax collection on domestic production (excise duties) remained strong at 32.4% YoY in February 2011. FYTD excise duties revenues grew by 35%, well ahead of the BE of 33%. This data is also corroborating our view that recent industrial production data indicating a sharp collapse in industrial activity is not correctly representing underlying economic activity.
Non-oil import growth has also picked up: Strong domestic demand, particularly consumption is also reflected in seasonally adjusted non-oil import growth, which has increased by 43.4% over the past five months.
Consumption: Discretionary Spending Moderating From A High Base
Household spending, a key driver of growth, stays strong: Urban consumption has remained strong. Passenger car and two- wheeler sales growth remained strong despite high base effect at an average of 20.4% YoY and 24% YoY, respectively, during the three months ended February 2011, compared to 38% YoY and 45.2% YoY in the year-ago period. Similarly, consumer durables production grew 15.5% YoY during the three months ended January 2011 compared with 35.2% YoY in the year-ago period.
Consumption: Staples and Modern Retail Sales Growth Remain Strong
Fast moving consumer goods (FMCG) sales have maintained healthy growth trend: Domestic FMCG sales growth picked up to 14%YoY during the quarter ending Dec-2010 from 12%YoY during the quarter ending Sept-2010. Similarly, urban high and middle income consumers spending in the modern retail format has been strong through Dec-2010.
Exports: Rebounding Sharply – Driven by Developed Markets
Strong rise in exports: In line with the recovery in US and Europe, India and other Asian countries have already seen a major rise in exports over the past few months. Seasonally adjusted goods exports have increased by 35.5% over the past five months
Sharp rebound in AXJ exports in the past five months: As discussed earlier, other Asian countries have already seen a major rise in exports over the past few months with the recovery in G3. The much-feared EU debt concerns did not materialize into sustained weakness in external demand for AXJ. After a brief downtick, exports recovered sharply from September 2010. Indeed, cumulatively AXJ exports have risen by 23.4% (not annualized) between September 2010 and January 2011
Capex: The Weak Spot – Macro Environment Holding Back the Pace of Recovery
Capex recovery held back: The credit crisis has resulted in a significant decline in total investment to GDP (excluding investments in gold by households) to 33.2% of GDP in F2009 from 37.1% of GDP in F2008. More important, private corporate capex, which we believe is the most productive component of total investments, declined from the peak of 17.3% of GDP to 11.5% of GDP in the same period.
New capex orders have slowed: In 2010, corporate confidence recovered only gradually as the global macro environment was still not comfortable enough. Right up to August 2010, the sovereign debt concerns in EU meant that the companies were not ready for an aggressive capex plan. Just as the global environment improved, domestic factors such as corruption-related investigations and the rise in inflation and cost of capital have held back the investment cycle. Indeed, we did see a recovery in order backlog (order book) for engineering and construction companies in the first half of 2010. Order backlogs again decelerated during the quarter ended December 2010, however
II. Where Are We on Macro Stability Risks?
Current Account Deficit, Inter-bank Liquidity and Inflation
Aggressive growth push has brought macro imbalances: Since the credit crisis unfolded, India’s policy makers have been aggressive in quickly returning growth to pre-crisis levels. We believe that policy makers cut policy rates and widened fiscal deficit excessively to insure against the potential downside of an extremely adverse developed world growth trend. However, we believe that as soon as there were clear signs of the global growth outlook improving, there was a need to reverse fiscal and monetary policy. This approach from policy makers to push growth with the support of fiscal and monetary policy has been accompanied by risks to macro stability in the form of (a) high current account deficit ; (b) tight interbank liquidity and disruptive rise in short-term rates; and (c) rise in inflation.
#1. Current Account: After Major Widening, Current Account Deficit Has Narrowed But……
Trade deficit has narrowed as exports bounce back: After widening for a sustained period when recovery began in the second half of 2009, the trade deficit has shown a clear trend of moderating over the last six months. Monthly trade deficit stood at US$8.1 billion (5.7% of GDP annualized) in February 2011. The trade deficit has narrowed steadily from a peak of US$11.8 billion deficit (10.5% of GDP annualized) in December 2009. On a 3-month trailing basis, the deficit narrowed to 4.4% of GDP, annualized in February, from 4.7% of GDP in January 2011 and a high of 9.8% of GDP in December 2009.
Current account deficit has narrowed to manageable levels too: We maintain our view that the current account deficit peaked during QE Sept-10. Indeed, the current account deficit narrowed to US$9.7bn (2.4% of GDP, annualized) in QE-Dec 10 compared with a deficit of US$16.8bn (4.3% of GDP, annualized) in QE- Sep 10.
Rising oil prices can reverse narrowing of trade and current account deficit again: A further rise in crude prices (Dubai light) post December 2010 means that current account deficit may have widened again in QE Mar-10. Our oil sensitivity analysis indicates that a US$10/bbl change in crude oil prices would result in India’s import bill and current account deficit rising by about US$8.1 bn (0.42% of GDP) for the full year.
\#2. Inter-bank Liquidity – Still Tight, Inflation Outlook is Key
Gap between credit and deposit growth remains high: Liquidity conditions are tightening because of the persistent gap between bank credit and deposit growth. As of March 11, 2011 bank credit growth was 23.2% YoY vs. 16.6% YoY deposit growth. Deposit growth has started rising since the deposit rate hikes began in December 2010 but not enough. Banks' credit- deposit ratio (C/D ratio) remained extremely high at 75% as of March 11, 2011 compared with 74.5% as of end November (before the recent deposit rate hikes). This level of C/D ratio is high considering that banks also need to statutorily invest 24% of deposits in government securities (SLR requirement) and park 6% of deposit with RBI as cash reserve ratio (CRR).
Inter-bank liquidity has remained tight: The inter-bank liquidity has been in deficit mode since second week of September 2010. The main reason for this tight inter-bank liquidity is the gap between credit and deposit growth and high C/D ratio. The net liquidity in the banking system (repo less reverse repo balance) remained in a deficit of US$18 bn in March, compared to the average deficit of US$17 billion and US$20 billion in February and January 2011. Until recently, we were expecting a quick improvement in inter-bank liquidity due to acceleration in deposit growth. For instance, we thought the deposit rate hikes were aggressive and had expected deposit growth to respond much faster, resulting in banks beginning to cut deposit rates by 25- 50bp. However, with the persistent rise in crude oil and other commodity prices, we believe that inflation expectations will remain sticky and inter-bank liquidity may remain tighter for longer. We believe banks will need to slow credit growth, unless deposit growth accelerates to 22-23% quickly, which is unlikely.
#3. Inflation Has Peaked, Yet Much Higher Than The Comfort Zone
Inflation is still a challenge: Strong domestic demand in the context of slow growth in investments coupled with supply shocks of higher food, oil and other global commodity prices have ensured that headline inflation (WPI) has remained above the RBI’s comfort zone of 5-5.5% for the past 15 months. Headline inflation averaged 9.2% during this period
Inflation expectations remain high: Persistent high level of headline inflation has meant that inflation expectations remain high. This is reflected in high growth in currency with the public and slow growth in deposits. While we expect WPI inflation to decelerate, we expect headline inflation (WPI) to average 7.6% YoY in 2011 unless global commodity prices pull back meaningfully. In other words, we expect headline inflation to remain significantly above the Central Bank’s comfort zone of 5- 5.5%.
Rise in Price of Crude Oil and Commodities Could Compound the Inflation Problem
Rise in crude oil prices and other global commodity prices is a concern: CRB metals and CRB food prices have increased by 48% and 40% respectively since June 2010. Crude oil (Dubai light) has spiked up closer to US$110/bbl. If crude prices were to rise by another US$10/bbl (for the full year), it would result in an increase in wholesale price inflation by 0.8-1ppt if the government were to pass the full increase on to consumers (a cascading effect of a similar amount would also be felt). We were expecting WPI inflation to average 7.6% YoY in 2011 unless global commodity prices pull back meaningfully. If crude oil prices reach US$125/bbl for a sustained period of six months or more, we believe headline inflation (WPI) could spike to 9-10%. This would increase the risk of unexpected policy actions to manage inflation pressures such as intervention in essential commodities prices and eventually hurt growth. Indeed, this could remind us of the macro environment in mid-2008.
III. Reversal in Policy Support - Fiscal Policy Is The Key
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‘Effective’ monetary tightening is done: With the Central Bank continuing to be slow to hike policy rates, banks had delayed deposit rate hikes. However, given persistent tightness in inter-bank liquidity, banks have hiked deposit rates aggressively since December 2010. State Bank India, the largest bank, has increased its deposit rates for the one to two-year period by 325bps to 9.25% since July 2010. Indeed, some banks are offering 9.5-9.75% deposit rates for the same tenure. We believe that as far as inflation management is concerned, the monetary policy has been ‘effectively’ tightened considerably with bank deposit rates having moved up to close to 11-year highs if we exclude the period that was hit the hardest by the credit crisis.
Fiscal policy reversal is more critical: While fiscal policy remains expansionary, we believe the government has finally moved in the right direction targeting meaningful reductions in underlying fiscal deficit for the first time since credit crisis unfolded. We expect the government to cut its expenditure growth in F2012 to reduce the fiscal deficit. In F2012, the central government’s fiscal deficit is likely to be lower at 5.2% of GDP compared with 6.4% of GDP (excluding revenue from telecom license fees) in F2011. In the absence of support of one-off revenues, we believe the government’s expenditure growth will decelerate to 7.5% YoY in F2012 from 18.7% YoY in F2011. Indeed, the central government’s expenditure has been growing at an average rate of 19.2% YoY over the last five years. We believe that even after the reduction in deficit in F2012, it remains expansionary
IV. Growth Outlook – Investment Is The Key
GDP Growth to moderate in F2012: We expect GDP growth to moderate to 7.7% in F2012 from 8.6% in F2011. We expect government spending and consumption growth to slow in F2012. The investments will pick up but at a gradual pace. We also expect exports to remain strong, but not enough to offset the slower growth in domestic demand.
Consumption growth to slow in F2012: Persistent higher inflation will likely hurt private consumption growth. Moreover, higher bank deposit rates will encourage households to increase savings. Similarly, we expect the government to cut back its expenditure growth in F2012 to reduce fiscal deficit. We believe this rising government expenditure to GDP (a large part of which was revenue expenditure) over the last five years has played a key role in boosting private consumption. Hence, a slowdown in government expenditure will be another factor resulting in moderation in private consumption
Recovery in exports will help partly offset moderation in consumption: Considering the strong growth estimated by our US economics team for 2011, we expect export growth to remain robust. We believe that to some extent this will help to offset slower-than-expected domestic demand growth. Strong growth in exports is also helping contain current account deficit close to 3% of GDP.
Acceleration in investment growth will be key but….: In the context of moderation in consumption growth, acceleration in investments is important. However, we expect investment to pickup but at a gradual pace. After a sharp decline in private corporate capex to GDP due to the credit crisis, the pickup in investment has been gradual in F2010 and F2011. After-effects of corruption-related investigations and persistently higher inflation as well as cost of capital will restrain growth in private corporate capex in F2012. In this context, the further rise in crude oil and other global commodity prices has only increased the risk of inflation remaining higher for longer and the cost of capital remaining higher for longer.
V. Key Upside and Downside Risk Factors
Key Upside/Downside Risk Factors
Upside and downside risks to our estimates: In our base case, we expect F2012 and F2013 GDP growth of 7.7% and 8.7%, respectively. We believe the following developments can bring upside/downside risks to our growth forecasts: (a) Global growth: Our economics team estimates global growth will remain strong at 4.3% in 2011 and 4.6% in 2012. If there is a double dip in the developed world growth resulting in extreme risk aversion, then this can impact the capital flows to the country and hence growth. (b) Inflation: In our base case, we expect inflation (WPI) to average 7.6% in 2011 assuming oil averages US$110/bbl (Arab light crude oil). We believe that as far as inflation is concerned, monetary policy has effectively tightened considerably with bank deposit rates having moved up to close to 11-year highs if we exclude the period hit hardest by the credit crisis. While fiscal policy remains expansionary, we believe the government has finally moved in the right direction targeting meaningful reductions in underlying fiscal deficit for the first time since credit crisis unfolded. Increasingly, we believe that global commodity prices are key tothe inflation outlook. If global commodity prices moderate quickly with better supply response, it will help reduce inflation pressure faster than expected. At the same time, any major further spike in commodity prices will make inflation management even more difficult, hurting growth. (c) Sentiment for Capex: For overall growth outlook, in the current environment where policy makers are unlikely to be able to support growth with loose fiscal and monetary policy, we believe investment growth is key. Our base case currently assumes a gradual recovery in capex considering the macro environment. If the government manages to implement an aggressive "campaign- style" effort to clear investment projects transparently with coordination from all ministries to revive corporate capex, than this will bring upside risks to our forecasts. Similarly, if the government fails to pursue a concerted effort to ensure a gradual recovery in capex, then there will be further downside risks to our estimate. In this context, apart from the general macro environment, we would be tracking announcements from various government ministries, anecdotal evidence on various investment projects and quarterly order book data of engineering and construction companies.
Theme I: Long-term Growth Outlook: An Interplay of Three Macro Factors
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Growth Driven by an Interplay of Three Macro Factors: India’s GDP growth moved from about 6% in the early 2000s to 8-8.5% currently. We believe this shift has been premised on three key factors – demographics, reforms, and globalization. This interplay of demographics, reforms, and globalization is crucial for the virtuous cycle of faster growth in productive job creation – income growth – savings – investment – higher growth. Over the past 10 years, India’s ratio of savings to GDP has risen from 24-25% to 33-36%. Similarly, its ratio of investment to GDP has risen from 24-25% to 35-38% and GDP growth has accelerated to a trailing five-year average of 8.6% in 2010 from 5.9% in 2000.
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Demographics: The ratio of the elderly and children to the working age (aged 15-64 years) population has declined from 68.6% in 1995 to 55.6% in 2010, according to UN estimates. This has helped support a structural rise in domestic savings. India will account for almost 26% of the increase in global working-age population over the next 10 years, according to UN estimates. The large surplus in India’s working population is forcing recognition in the world economy of the country’s role in global competition and output dynamics.
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Reforms: A positive demographic trend may be a necessary condition for strong growth, but it is not sufficient. Favorable demographics need to be converted into a virtuous cycle of acceleration in growth. A critical step in this process is the opening up of productive job opportunities through reforms. Over the years, India’s government has been initiating reforms to encourage private sector investment, which helps create the platform of employment for the working-age population. In this context, one of the long-standing challenges for India was acceleration in infrastructure spending. The government is working to to address this. We expect infrastructure spending to rise to 9% of GDP in 2012 from 7.9% of GDP in 2010 and 5.4% of GDP in 2005.
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Globalization: Globalization, as reflected in the steady rise in exports to GDP and capital inflows to GDP, has also helped accelerate the pace of growth. India’s integration with the global economy started to accelerate in the early 1990s. India has relied on both goods and service exports. India’s performance in services has been a key differentiating factor. India’s share in global services exports increased to 2.6% in 2009 from 1.1% in 2000.
The combined effect of demographics, structural reforms, and globalization will help create a virtuous cycle of productive job creation, income growth, savings, investments, and higher GDP growth.
Theme I: India to Offer Best Growth Opportunity Over the Next 25 Years
Over the next 20-25 years, we expect India to remain the highest growth economy among large countries. India could have the advantage of maintaining its high-growth phase for a longer period than East Asia did, as UN data show that India’s age dependency will continue to decline until 2040.
UN projections show that India will be the only large country that will still have favorable demographics after 2010. Japan, Europe, and the US (in that order) will have a significant rise in their ageing populations.
So, while in the past 20 years, China has benefited ahead of India from a faster fall (improvement) in the age-dependency ratio, over the next 20-25 years India will have this advantage.
Theme I: Internal Challenges to Sustain Strong Growth Story
We believe there are several challenges to India’s high growth story.
First, infrastructure development: The government needs to ensure that it executes in this area. The trend in China over the past 25 years indicates that, for 10% sustainable GDP growth, India would need to increase infrastructure spending to 10% of GDP from the current 7.9%. We believe the government would need to focus on laying down the policy framework and support to ensure a sustained increase in investment in key sectors, such as electricity, highways, and railways.
Second, ongoing fiscal/revenue deficit reduction: One of the key pillars of our strong outlook for India is a structural rise in domestic savings and investments. In that context, reduction of the government’s revenue deficit would be critical. The government made a move in that direction in February 2011 by targeting a lower fiscal and revenue deficit, but such efforts would need to continue over the next few years.
Third, labor law reform needs to be prioritized: We believe sustained strong growth in SMEs will be an important driver of India’s growth. There are more than 40 labor-related laws from the central government on such issues as compensation, retrenchment, industrial disputes, and trade unions. State governments also have several pieces of labor legislation. Most of these laws are not in sync with the practical realities of a highly competitive globalized world. We believe labor law reforms would be needed to support growth in labor-intensive industries.
Fourth, development of less-developed states: Rising income inequality and high poverty levels in some states have increased the probability of social instability. Already a few states have faced insurgency from Naxalites, and the internal security threat from this movement is a concern.
Fifth, secondary and tertiary education infrastructure: As discussed, significant progress has been made in improving primary and tertiary education. The success of primary education has meant the demand for secondary education infrastructure is beginning to rise rapidly. We believe measures to further improve secondary and tertiary education infrastructure would be required to help sustain the strong growth story.
Theme II: Reassessing Macro Sensitivity to Oil Prices
Dependence on imported oil is high: India’s proven reserves of oil and oil production have remained largely stable over the last decade. As a result, increasing oil consumption has meant greater reliance on crude oil imports for India. India imports about 70% of its crude oil and petroleum products requirement, up from 44% in 1995. Crude oil accounted for about 25% of India’s total imports in F2010 (5.3% of GDP). India’s overall oil balance (crude oil and petroleum product imports less exports) is higher than that for the AxJ region.
Policy regime – deregulation in progress: Domestic fuel prices in India are implicitly marked to crude oil prices of US$65/bbl. However, we believe that if crude oil prices rise sharply, the government may influence the decision of the oil distribution companies and delay the pass through in domestic gasoline prices. Prices of other petroleum products like ATF, Naphtha, lubricants, etc., are market determined.
Share of oil in energy consumption is relatively low…: India’s share of oil in energy consumption is at 31.7%, the second- lowest in the region after China. India depends on coal to meet 52.4% of its energy requirement, due to its easy availability. The balance is accounted for by natural gas (10%) and nuclear & hydro power (5.9%).
Oil Intensity higher than the world average: India’s efficiency of oil usage, as measured by oil intensity (primary oil consumption per unit of GDP), is higher than the world average and marginally higher than other emerging countries.
….But share of world oil consumption is high: Despite oil having a low share in overall energy consumption, India is one of the leading consumers of oil in the emerging world owing to the relatively larger size of the economy. It has high share (3.8%) of world oil consumption.
India’s fiscal balance sheet most vulnerable: India’s headline deficit is the highest in the region. Indeed, if we include all off- budget expenditure items, the fiscal deficit will be 8.2% of GDP in F2011E. While Malaysia also has high deficit, its oil subsidy burden is largely an internal liability as it is a net oil exporter. China is also a net importer of oil but has a strong balance sheet with public debt to GDP of 35.5% compared to 68.5% for India.
The typical macro impact of oil price movements: The government’s involvement in domestic oil pricing means that movements in oil prices can have a less- or greater-than proportionate impact on key macro indicators such as inflation, consumption and growth. We estimate the typical macro impact would be as discussed in the table above.'
Oil subsidy sensitivity to crude oil prices: In our base case for F2012, we have assumed crude prices (Arab Light) average about US$110/bbl. In this case the overall oil subsidy burden will rise to 1.2% of GDP, with typically close to half being borneby the government in the form of direct subsidy and issuance of oil bonds. Our oil sensitivity analysis indicates that every US$10/bbl increase in oil prices increases fuel oil subsidy in India by US$6.3 bn (0.31% of GDP) if domestic fuel prices are unchanged.
Exchange rate movement: As international oil prices adjust, the initial impact on the domestic economy can be offset (or exacerbated) depending upon the strength of the exchange rate at that point in time. In the past, when commodity prices rose rapidly, we have observed that central banks were less hesitant to allow appreciation of the currency against the US dollar, particularly when the US dollar was weakening against all currencies.
Governments’ influence on domestic fuel prices: Domestic prices of oil products (other than industrial products such as naphtha and aviation turbine fuel) historically have been directly or indirectly controlled by the government. For a brief period between April 2002 and April 2004 (when crude oil prices were US$24-35/bbl) oil companies could independently determine the price of diesel and gasoline. In 2010, the gasoline prices in India were made market linked. The retail price of diesel, kerosene and LPG is currently regulated by the government.
Theme III: Structural Inflation Outlook
Theme III: Structural Inflation Outlook
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India, unlike other EMs, does not have a history of high inflation: Inflation WPI and CPI-Industrial Workers (CPI-IW) have averaged 5.4% and 6.8%, respectively, over the last 15 years compared with 9% average (CPI) for emerging markets. Double- digit inflation is not the norm. Typically, double-digit inflation makes policy makers respond as society at large has begun to expect inflation of around 5-6%.
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Structural inflation should be lower as savings, investments, and productivity growth rises: We believe that the combined effect of more favorable demographics and increased productive job opportunities should boost India’s savings-investments, lifting productivity growth and sustaining structural inflation at 5-6% in the medium term and even lower in the longer term.
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Key risk to our view: The key, we believe, from a cyclical and structural perspective will be the government's policies. If government and central bank attempt to boost growth through the support of loose fiscal and monetary policy instead of structural reforms, which help boost savings and investments, inflation will be higher than expectations.
Historically, India’s inflation has been lower compared with that in other emerging markets. Inflation WPI and CPI-Industrial Workers (CPI-IW) have averaged 5.3% and 6.8%, respectively, over the last 15 years compared with 11.2% average (CPI) for emerging markets. Double-digit inflation is not the norm. Indeed, over the last 10 years on an annual average basis, WPI inflation crossed 10% not once while CPI-IW crossed 10% only one time. On a monthly basis, the two recent spikes in WPI inflation numbers to double-digit levels have been caused by oil prices spiking above US$140/bbl (in 2008) and severe drought affecting farm output, leading to a sharp rise in food inflation (2009) and other cyclical factors. Typically, double-digit inflation prompts policy maker responses as society at large has begun to expect inflation of around 5-6%.
Recall the trend in 2003-07: Strong growth and manageable inflation: We highlight that during 2003-07, India’s GDP growth averaged 8.9% and WPI inflation averaged 5.5%. In other words, India has been able to transition to higher growth without significant acceleration in inflation, but for the recent cyclical spikes in inflation as discussed above. However, one could argue that in the initial part of the strong period, the country was operating with excess capacity, as measured by the usual trend in current account, which was in surplus of 2.3% of GDP in F2004 (12 months ended March 2004). However, there was no major inflation pressure in this period. Inflation pressures picked up only in 2008, when oil prices shot up and summer crop/food grain output suffered a decline of 2.3% YoY. Current account deficit also remained in the manageable range during this period with peak levels of just 1.3% of GDP in 2008.
Inflation will be managed even as growth accelerates: Over the past 10 years, India's headline WPI inflation has averaged 5.3%. The combined effect of more favorable demographics and increased productive job opportunities should boost India’s private-savings level and push aggregate savings to 37-40% of GDP over the next 10 years, allowing the country to maintain an investment-to-GDP ratio of 39-42%, we estimate. The increase in capacity through higher investments should ensure a shift in India’s growth to a sustained rate of 9-10% in this period without overheating concerns.
Productivity growth is rising: Recall that over the past five years, India’s average GDP growth was 8.5% with infrastructure spending at 6.4% of GDP and inflation (WPI) averaging 5.5%. In that context, we believe that in the coming three years, India’s infrastructure spending to GDP will rise to 9-10%, ensuring that productivity growth remains strong. We expect the structural inflation trend to remain in the 5-6% range with GDP growth likely closer to 8.5-9%.
Structural outlook: The structural component in food inflation is all about protein. Over the last few years, the acceleration in the pace of per capita income growth, particularly in the lower income groups, is reflected in higher protein-related food items. Moreover, a similar trend in other developing nations has meant that the government cannot rely on imports to reduce the pressure on domestic food prices. While structural demand growth has risen, particularly for protein-related food items, the supply side continues to be affected by structural problems. Productivity growth has remained lackluster.
We believe that in the medium-term food inflation could average higher at 6-7%assuming there is no major crop failure. We are also assuming the government’s efforts to improve productivity in the farm sector and the inventory management as well as public distribution systems will take some time to improve. However, with continued rise in non-farm investments, we expect productivity growth in that segment to ensure that overall inflation is maintained in the 5-6% range over the medium term.
Similar trend in other Asian economies during initial phase of take off: In the initial period of growth take off, some parts of the economy tend to lag, and capacity creation in those areas is not anchored to high GDP growth. Moreover, investments in the economy tend to be higher than savings. During the initial phase of high growth, other Asian economies also faced slightly higher inflation trends and saw current account in deficit or in very small surplus. For instance, in China the current account balance remained in small deficit or negligible surplus until the mid-1990s. China moved into high growth of 9%-plus on a sustained basis for the first time in the early 1980s from an average of 6.3% in the 1970s. Urban CPI in China averaged 8.1% in the 1980s compared with an average of 1.4% in the 1970s. We have seen a similar trend in other Asian economies such as Korea and Malaysia, when they moved to a high growth trend. Indeed, India appears to have managed the transition to higher growth trajectory with minimal inflation pressures compared with the other Asian Tigers
Theme IV: Fetish for Gold
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India’s gold consumption has picked up again: After a short weak trend in 2009 due to the global credit crisis, India’s spending on gold bounced back sharply in 2010. India’s gold consumption (in US$ terms) rose by almost 106% YoY in 2010 after declining 7.3% YoY in 2009.
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India remains the world’s largest consumer of gold: On an annual basis, India is the world’s largest consumer of gold in tonnage terms, followed by China. During 2010, India accounted for 31.5% of global gold demand.
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A shift away from gold into financial savings is unlikely to happen in a hurry: We believe there is a complex set of drivers behind Indian households’ fetish for gold. While the government is continuing its efforts to channel these savings into more productive financial assets, we believe this shift is unlikely to materialize in the short term.
Gold consumption is rising sharply again: After a short weak trend in 2009 due to the global credit crisis, India’s spending on gold bounced back sharply in 2010. India’s gold consumption (in US$ terms) rose by almost 106% YoY in 2010 after declining 7.3% YoY in 2009. Cumulatively, India now holds over 18,000 tons of above-ground gold stocks worth approximately US$800bn at the current gold price – nearly 50% of the country’s GDP. This represents 11% of the world’s stock, according to World Gold Council (WGC) estimates. On an annual basis, India is the world’s largest consumer of gold in tonnage terms, followed by China. In 2010, India’s gold demand accounted for 31.5% of global gold demand.
Gold is one of the key assets in household balance sheets: Gold holdings among Indian households at current market value are about 2.8x the current equity stock holding of US$290 billion. Bank deposits by households are currently valued at US$675bn, according to our estimates. While the share of gold in household savings declined to 5.7% in F2008, we estimate that this has risen back to 9-10% currently. On an annual basis, household savings in gold and bank deposits stood at US$38bn and US$120bn, respectively; in equities it was US$0.8bn as of the four quarters ended December 2010. The share of gold in household savings appears to have risen again in F2010. Our analysis based on stake holdings trend of around 1,200 NSE-listed companies and purchase of mutual funds indicates that Indian households’ allocation to equity has fallen sharply following the credit crisis. On the other hand, their investment in gold has been trending upward
Share of financial savings remains low: After rising to an average of 60% in the mid-1990s, over the last 10 years, the share of financial savings in total household savings has remained largely stagnant at an average of 48%. Indeed, low real interest rates have provided little incentive to increase allocation from physical savings (which include gold, property and household investments in small businesses). The share of financial savings in total decreased to 46% in F2009 from 64% in F1997 as real interest rates fell to -0.5% from 9.1% over the same period. Indeed, this decline in real interest rates has only encouraged households to increase the allocation to physical savings (including gold, property and household investments in small businesses). However the share of financial savings increased to 50% in F2010 as real interest rates increased to 3.6%. Yet the penetration of financial savings in India still remains low. Apart from this, incidence of unaccounted money (black money) is also a reason for the low share of financial savings.
Financial sector reforms needed to increase the share of financial savings: To increase the share of financial savings, deepening of financial sector reforms would be the key. Apart from increased easy access to banking and financial services facilities, one of the most important areas that need attention in this context is reforms related to long-term savings schemes. Although the government has initiated some reforms recently, the desired results are still not reflected in the share of long-term savings.
A shift away from gold into financial savings is unlikely to happen in hurry: We believe there are a complex set of drivers behind Indian households’ fetish for gold. While the government is continuing its efforts to channel these savings into more productive financial assets, we believe this shift is unlikely to materialize in the short term.
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