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India: heading for an accidental soft landing
· Headline inflation remains stubbornly high and now sequentially core inflation has
accelerated to double digits
· With private investment languishing, the high inflation is an unsurprising result of a
large fiscal and monetary stimulus pushing the economy to grow beyond its capacity
· As a supply response will take time, slowing demand is the only option to bring down
inflation; the only question is whether it will be a soft or hard landing
· The FY12 budget effectively targets a fiscal consolidation of 1.7% of GDP; if achieved it
will be the largest consolidation in several decades, slowing growth below 7.5%
· However, significant fiscal slippages are likely (0.7% of GDP) on account of an underbudgeting
of subsidies, resulting in a more modest consolidation
· As in the past year. monetary policy is expected to remain behind the curve, but
continued tight liquidity will keep lending rates high for most of 2011
· Such policy slippages could accidentally engineer a soft landing with growth slowing
to just below 8% and inflation moderating in the second half of the year
Headline inflation remains stubbornly high as core predictably rises …
It was exactly a year ago that inflationary concerns had become widespread. Feb10 inflation had
printed close to double digits (9.7 % oya) a sharp increase from a print of only 1 % in October the
previous year. While we had worried that inflation was about to turn sticky and growing capacity
constraints would pressure core inflation (see India: inflation turning sticky, March 26
2010), the conventional wisdom was still that the headline rate was being driven by food
inflation which, in turn, was on account of the bad monsoon of 2009. And so, the argument went
that a normal monsoon in 2010 would ensure that inflation quickly moderated ceasing to be a
concern by the end of the year. Even as late as November last year, the authorities and much of
the market believed that inflation would head down to 5-6% by end-March 2011.
This didn’t happen. Instead as we had feared, Dec10 inflation was recently revised up to 9.4%,
while the unrevised Feb11 print clocked 8.3%. The good monsoon has come and gone and yet
inflation continues to remain stubbornly high. While food inflation has moderated in recent
weeks, our fears that core inflation would accelerate over the course of 2010 have come to pass.
The sequential momentum of non-food manufacturing inflation (what the RBI uses as a proxy for
core inflation) has increased dramatically from less than 1 percent q/q, saar (annualized) in Sep10
to more than 9% q/q, saar (annualized) by Feb11.
This is worrying but not surprising. We have been arguing for a while (see, “India:
government consumption boosts 3Q GDP growth to 8.9%, November2010) that high
growth (boosted by a sustained fiscal and monetary stimulus) in conjunction with no material
private investment in the manufacturing sector is causing increasing capacity constraints across
multiple sectors. This, in conjunction with rising input costs (as global commodity prices have
soared over the last few months) and increasing wage pressures, has meant that it was just a
matter of time before output prices responded. That time has come.
…and future prospects are sobering
What’s more, the prospects for core inflation moderating soon are sobering. The PMI output price
index has been a reliable leading indicator of the direction and magnitude of non-food
manufacturing inflation, and the sharp increase in this index over the last few months suggests
that core inflation is likely to accelerate further. This is understandable given that raw material
prices continue to surge and output prices have not yet fully responded, wage pressures continue
to build and will likely be exacerbated by the indexation of NREGA wages to the CPI and the fact
that the dearness allowance of central government employees was recently predictably increased
again to compensate for higher inflation. All this is likely to exert upward pressure on private
sector wages as well. In sum, while food inflation could moderate further to the 7-8 % levels (its
average over the last few years) core inflation is expected to remain sticky and keep the headline
rate high for much of 2011.
\
What’s growth got to do with this?
GDP growth has accelerated sharply over the last few quarters staying above 8% for five of the
last 6 quarters and averaging almost 9 % in the first half of this fiscal year. And this has been
boosted in no small measure by a sustained fiscal and monetary stimulus. Net of asset sales, the
central government fiscal deficit rose from 3.1 % of GDP to 7.8% of GDP as a result of the large
fiscal stimulus injected in the crisis year of 2008-9. Since then, however, the consolidation has
been minimal and the fiscal deficit, net of asset sales, is expected to print at 6.7 % of GDP in
FY11. The effective fiscal consolidation (net of asset sales) has only been 0.2 % of GDP over the
last year at a time when growth has been printing close to 9%!
Monetary policy has been just as culpable. Despite the call rate rising by more than 350 bps over
the last year, real interest rates remained negative for most of 2010. The sharp rise in market rates
starting in December 2010 was more due to tight liquidity in the banking system (an upshot of
temporary slowdown in government spending and seasonal increases in currency in circulation)
than due to policy rate hikes. Ironically, market rates rose in December despite policy rates
remaining on hold that month.
Accelerating growth boosted by multiple policy stimuli is not the problem, per se. What is a
problem is that there has been no meaningful increase in private investment outside of
infrastructure during this period. With accelerating growth and no capacity addition since the
global financial crisis, it is unsurprising that capacity constraints are increasingly binding across
multiple sectors and output gaps are getting exacerbated. In effect, the policy stimuli has pushed
the economy to grow beyond its current potential and it is no wonder that core inflation has begun
to rise sharply in response.
Any supply response will take time. Based on several high-frequency indicators in the economy
(capital goods within the IP, non-oil imports) there is no evidence yet to suggest that a sharp pickup of the private capex cycle is at hand. And, even if the cycle were to turn on soon, it would take
at least 3 to 4 quarters before this new capacity comes online.
Therefore in the near term slowing aggregate demand appears to be the only real option to cool
inflation. To expect core inflation to moderate if the economy continues to grow at these rates
would be unrealistic. Moreover, as long as inflationary expectations remain high and with it the
likelihood of a hard landing, the capex cycle will remain tentative.
FY12 budget attempts the largest consolidation in decades …
In evaluating the injection or withdrawal of any fiscal stimulus it is important to net out asset
sales, as these constitute an exchange of a monetary for non-monetary assets between the public
and private sector and thereby do not have a contractionary or stimulatory impact on the
economy.
Viewed through this lens, the FY12 budget attempts to bring down the deficit from 6.7% of GDP
in FY11 to 5 % of GDP in FY12—a consolidation of 1.7% of GDP. This would constitute the
largest fiscal consolidation ever attempted in independent India. More importantly, with most of
the consolidation planned via expenditure compression (spending is targeted to shrink in real
terms) a consolidation of this magnitude would certainly slow growth. With most expenditure
multipliers ranging between 0.6-0.7 (taking into account the crowding in impacts of private
investment) if the fiscal consolidation is achieved, growth would slow to between 7 and 7.5 %.
While this would certainly help bring inflation down it would, by most accounts, hard land the
economy as neither the authorities nor the market is expecting this. Strangely, the budget
assumptions are based on real GDP growth of 9% and inflation of 5% for FY12! Again we expect
nominal GDP growth to be around 15%, such that the revenue estimates in the budget are
reasonable, but with lower real GDP growth and higher inflation than assumed by the government
(see, “FY12 budget surprises positively but beware of the fine print,” February 28, 2011)
…but don’t be alarmed, slippages are likely
It is unlikely though that the targeted fiscal consolidation will materialize as subsidies appear
grossly under funded. Oil subsidies are a case in point. The government will likely enter FY12
with arrears to oil marketing companies of about Rs200 billion (0.3 % of GDP). Even if crude
were to average $100 a barrel, the government’s share of the under-recoveries is expected to be
around Rs 830 billion for FY12, and it has only budgeted Rs 240 billion for this fiscal. Assuming
that a similar amount of arrears is rolled over to the next fiscal, the under-budgeting for this fiscal
is still about 0.7 % of GDP. If crude averages $110, for example, the under-budgeting rises to 1%
of GDP.
Only significant changes in the administered prices of petroleum products would meaningfully
reduce this liability; e.g., even if diesel prices are increased by Rs 2-3 per litre (about a quarter of
the under-recovery per litre at $ 100 a barrel), the government’s liability would only fall by about
0.1% of GDP.
Food subsidies, too, seem under budgeted. With FY10’s food subsidies itself likely to end up
closer to Rs 750 billion (Rs 150 billion higher than what was budgeted), and a Food Security Bill
likely to be in place for at least the second half of this fiscal (which could add about Rs 80
billion), an allocation of Rs 600 billion for FY12, seems at least 0.2 to 0.3 % of GDP short of
what may eventually be needed.
Even between the announcement of the budget speech and the tabling of the Finance Bill in
Parliament this week there have been other slippages, albeit small. The increase in the dearness
allowance for central government employees will add Rs 60 billion to FY 12 expenditures and
revocation of services tax to the healthcare industry will reduce projected tax collections, but by
less than 0.05% of GDP.
All told, the slippage on the fiscal deficit could be of the order of 0.6-0.7 % of GDP and the
deficit outturn could be closer to 5.3% of GDP than 4.6% as targeted. This would imply an
effective consolidation of about 1% of GDP slowing growth to a shade under 8%.
Monetary policy to remain behind the curve, but tight liquidity will keep
lending rates high
Even though policy rates have been hiked by 200bps over the last year, the fact that the
momentum of headline and core inflation has accelerated secularly over the last 6 months is
indication enough that monetary policy has been consistently behind the curve. This was evident
again when the RBI’s March inflation forecast was increased by 250 bps over the last two
meetings even as policy rates were only increased by 50 bps during those two meetings As it
turns out, we expect even the revised target of 8% for March to be breached.
As indicated above, though, market rates have been ahead of policy rates over the last few months
because banking system liquidity has remained consistently tight since June thereby rendering
monetary policy tightening more effective than the policy rate hikes would suggest.
We expect this phenomenon to continue for much of 2011. The RBI is likely to continue its
calibrated approach of hiking rates in 25 bps increments and hike rates another 2-3 times this
year, given their increasing concerns about slowing domestic and global growth. In and of itself,
we don’t believe this would be enough to curb inflationary pressures but banking system liquidity
is again expected to remain in deficit and relatively tight for much of 2011 (primarily for
structural reasons as currency in circulation is expected to rise sharply again as sticky inflation
keeps transactions demand for money high and continued government spending in the rural
economy result in ever-increasing leakages from the banking system ) thereby keeping the
pressure on market rates and rendering monetary policy more effective than it was necessarily
intended to be.
Heading for an accidental soft-landing
The planned fiscal consolidation of 1.7 % of GDP looks excessively tight and improbable. As
such, it appears more likely that fiscal slippages on account of subsidies will ensure that the fiscal
consolidation would be closer to 1% of GDP, inadvertently engineering a soft landing of growth
to just below 8% rather than the 7-7.5% implied by the budgeted consolidation.
Conversely, while policy rates will stay behind the curve, continued tight liquidity is expected to
keep market rates high and thereby have a greater impact on taming core inflation than was
perhaps planned.
In sum, even though fiscal and monetary policy are currently on course to be too tight and too
loose, respectively, we could end the year with the odd scenario that policy errors inadvertently
offset each other (for the reasons mentioned above) and the economy experiences a soft landing
with growth printing a shade below 8% and core and headline inflation peaking around
August/September and then gradually moderating.
FY12 growth a shade below 8%...
After printing close to 9% in the first half of the fiscal year, GDP growth has begun to slow, with
FY11Q3 growth printing at 8.2 % oya and a likely further slowing in Q4. Despite this, however,
FY11 growth is still expected to print around 8.5%, buoyed by strong agricultural and services
(mainly government). Industrial growth is expected to print close to 7.5% reflecting the
languishing capex cycle.
Taking into account the likely fiscal and monetary tightening and assuming global growth
remains fairly robust with crude oil prices remaining around $110/barrel, we expect FY12 growth
to slow to a shade below 8% (depending on how much fiscal consolidation is actually delivered
and how global growth – with its impact on India exports – pans out).
Even assuming a normal monsoon, agriculture is expected to grow around 3.5 % on account of
the high base from this year. With the investment cycle slated to pick-up only in the second half
of this fiscal (once inflationary concerns have bottomed out), industrial growth could accelerate to
about 8.2 %. In contrast, a sharp reduction in community and social services (proxy for
government spending) is likely to cause services growth to moderate to about 8.9% oya.
…and inflation to average around 8%
As alluded to above, with inflation increasingly being driven by core inflation on account of
rising output gaps, the headline rate is expected to remain sticky through much of 2011. In fact,
we expect inflation to accelerate further towards the 9-10% mark in Q2 of the fiscal year, before
moderating in the remaining quarters as the impact of the fiscal consolidation takes hold. On
average, inflation in FY12 is still expected to average 8%, about a 120 bps less than this fiscal.
CAD expected to widen to 3% of GDP, but expected to be financed
As we have been arguing for a while, (see, “Current account deficit concerns overstated,”
February, 2011), the current account deficit for FY11 is likely to print much below market
expectations. Specifically, we expect the CAD for this fiscal to print around 2.5 % of GDP, below
the 3-3.5 % of GDP that the RBI and market had expected for a while. This is largely on account
of a sharp narrowing of the trade deficit because both exports have surged in recent months (as
global growth has accelerated over the last quarter) and non-oil imports have languished in the
absence of a pick up in the capex cycle.
Going forward, however, we expect the FY12 CAD to about 3% of GDP. This is on account of
multiple factors: higher oil import values as crude prices stay high (JPM Forecast of Brent is $110
for FY12), a pick-up in non-oil imports in 2HFY12 as the investment cycle is finally slated to
pick-up, and a slight deceleration in exports as global growth potentially slows later in the year on
account of elevated crude prices. That said, we expect the current account to be financed as
external commercial borrowings (ECBs) and FDI are expected to rise in tandem with the
investment cycle, leaving a relatively smaller proportion of the current account to be financed by
the more volatile portfolio flows.
Yield curve expected to flatten further in the near term
As expected, authorities announced that the government’s borrowing calendar would be
frontloaded, with 60% (Rs 2.5 trillion) of the full-year gross borrowing requirement (Rs 4.17
trillion) to be conducted in the first half of the fiscal year (see, “India Borrowing calendar: bond
yields will not spike,” by Abhishek Panda and Bert Gochet, March 28.) The market was
expecting a greater degree of front-loading, and bonds have therefore rallied 5-6 bps since then.
The yield curve has bear-flattened significantly over the last 6 months, and we expect that this
dynamic will continue over the next quarter or so. Stubbornly high inflation, tight liquidity and
more rate hikes are expected to keep rates high at the short-end, whereas yields at the long end
are expected to stay in the 8% range as the borrowing program in the FY12 budget and the
proportion to be borrowed in the first half of the year has been lower than market expectations.
Things could change, however, as we approach the middle of the year as it becomes clear that
fiscal slippages could be significant and the borrowing program for the second half will likely
need to be revised up, and the market internalizes the fact that the RBI could be coming to the end
of its rate-tightening cycle as growth begins to slow. That said, we do not expect bond yields to
spike sharply at any point as the RBI is expected to support the bond-market through significant
open-market operations in 2H as a means to reaching its reserve money target for this year.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India: heading for an accidental soft landing
· Headline inflation remains stubbornly high and now sequentially core inflation has
accelerated to double digits
· With private investment languishing, the high inflation is an unsurprising result of a
large fiscal and monetary stimulus pushing the economy to grow beyond its capacity
· As a supply response will take time, slowing demand is the only option to bring down
inflation; the only question is whether it will be a soft or hard landing
· The FY12 budget effectively targets a fiscal consolidation of 1.7% of GDP; if achieved it
will be the largest consolidation in several decades, slowing growth below 7.5%
· However, significant fiscal slippages are likely (0.7% of GDP) on account of an underbudgeting
of subsidies, resulting in a more modest consolidation
· As in the past year. monetary policy is expected to remain behind the curve, but
continued tight liquidity will keep lending rates high for most of 2011
· Such policy slippages could accidentally engineer a soft landing with growth slowing
to just below 8% and inflation moderating in the second half of the year
Headline inflation remains stubbornly high as core predictably rises …
It was exactly a year ago that inflationary concerns had become widespread. Feb10 inflation had
printed close to double digits (9.7 % oya) a sharp increase from a print of only 1 % in October the
previous year. While we had worried that inflation was about to turn sticky and growing capacity
constraints would pressure core inflation (see India: inflation turning sticky, March 26
2010), the conventional wisdom was still that the headline rate was being driven by food
inflation which, in turn, was on account of the bad monsoon of 2009. And so, the argument went
that a normal monsoon in 2010 would ensure that inflation quickly moderated ceasing to be a
concern by the end of the year. Even as late as November last year, the authorities and much of
the market believed that inflation would head down to 5-6% by end-March 2011.
This didn’t happen. Instead as we had feared, Dec10 inflation was recently revised up to 9.4%,
while the unrevised Feb11 print clocked 8.3%. The good monsoon has come and gone and yet
inflation continues to remain stubbornly high. While food inflation has moderated in recent
weeks, our fears that core inflation would accelerate over the course of 2010 have come to pass.
The sequential momentum of non-food manufacturing inflation (what the RBI uses as a proxy for
core inflation) has increased dramatically from less than 1 percent q/q, saar (annualized) in Sep10
to more than 9% q/q, saar (annualized) by Feb11.
This is worrying but not surprising. We have been arguing for a while (see, “India:
government consumption boosts 3Q GDP growth to 8.9%, November2010) that high
growth (boosted by a sustained fiscal and monetary stimulus) in conjunction with no material
private investment in the manufacturing sector is causing increasing capacity constraints across
multiple sectors. This, in conjunction with rising input costs (as global commodity prices have
soared over the last few months) and increasing wage pressures, has meant that it was just a
matter of time before output prices responded. That time has come.
…and future prospects are sobering
What’s more, the prospects for core inflation moderating soon are sobering. The PMI output price
index has been a reliable leading indicator of the direction and magnitude of non-food
manufacturing inflation, and the sharp increase in this index over the last few months suggests
that core inflation is likely to accelerate further. This is understandable given that raw material
prices continue to surge and output prices have not yet fully responded, wage pressures continue
to build and will likely be exacerbated by the indexation of NREGA wages to the CPI and the fact
that the dearness allowance of central government employees was recently predictably increased
again to compensate for higher inflation. All this is likely to exert upward pressure on private
sector wages as well. In sum, while food inflation could moderate further to the 7-8 % levels (its
average over the last few years) core inflation is expected to remain sticky and keep the headline
rate high for much of 2011.
\
What’s growth got to do with this?
GDP growth has accelerated sharply over the last few quarters staying above 8% for five of the
last 6 quarters and averaging almost 9 % in the first half of this fiscal year. And this has been
boosted in no small measure by a sustained fiscal and monetary stimulus. Net of asset sales, the
central government fiscal deficit rose from 3.1 % of GDP to 7.8% of GDP as a result of the large
fiscal stimulus injected in the crisis year of 2008-9. Since then, however, the consolidation has
been minimal and the fiscal deficit, net of asset sales, is expected to print at 6.7 % of GDP in
FY11. The effective fiscal consolidation (net of asset sales) has only been 0.2 % of GDP over the
last year at a time when growth has been printing close to 9%!
Monetary policy has been just as culpable. Despite the call rate rising by more than 350 bps over
the last year, real interest rates remained negative for most of 2010. The sharp rise in market rates
starting in December 2010 was more due to tight liquidity in the banking system (an upshot of
temporary slowdown in government spending and seasonal increases in currency in circulation)
than due to policy rate hikes. Ironically, market rates rose in December despite policy rates
remaining on hold that month.
Accelerating growth boosted by multiple policy stimuli is not the problem, per se. What is a
problem is that there has been no meaningful increase in private investment outside of
infrastructure during this period. With accelerating growth and no capacity addition since the
global financial crisis, it is unsurprising that capacity constraints are increasingly binding across
multiple sectors and output gaps are getting exacerbated. In effect, the policy stimuli has pushed
the economy to grow beyond its current potential and it is no wonder that core inflation has begun
to rise sharply in response.
Any supply response will take time. Based on several high-frequency indicators in the economy
(capital goods within the IP, non-oil imports) there is no evidence yet to suggest that a sharp pickup of the private capex cycle is at hand. And, even if the cycle were to turn on soon, it would take
at least 3 to 4 quarters before this new capacity comes online.
Therefore in the near term slowing aggregate demand appears to be the only real option to cool
inflation. To expect core inflation to moderate if the economy continues to grow at these rates
would be unrealistic. Moreover, as long as inflationary expectations remain high and with it the
likelihood of a hard landing, the capex cycle will remain tentative.
FY12 budget attempts the largest consolidation in decades …
In evaluating the injection or withdrawal of any fiscal stimulus it is important to net out asset
sales, as these constitute an exchange of a monetary for non-monetary assets between the public
and private sector and thereby do not have a contractionary or stimulatory impact on the
economy.
Viewed through this lens, the FY12 budget attempts to bring down the deficit from 6.7% of GDP
in FY11 to 5 % of GDP in FY12—a consolidation of 1.7% of GDP. This would constitute the
largest fiscal consolidation ever attempted in independent India. More importantly, with most of
the consolidation planned via expenditure compression (spending is targeted to shrink in real
terms) a consolidation of this magnitude would certainly slow growth. With most expenditure
multipliers ranging between 0.6-0.7 (taking into account the crowding in impacts of private
investment) if the fiscal consolidation is achieved, growth would slow to between 7 and 7.5 %.
While this would certainly help bring inflation down it would, by most accounts, hard land the
economy as neither the authorities nor the market is expecting this. Strangely, the budget
assumptions are based on real GDP growth of 9% and inflation of 5% for FY12! Again we expect
nominal GDP growth to be around 15%, such that the revenue estimates in the budget are
reasonable, but with lower real GDP growth and higher inflation than assumed by the government
(see, “FY12 budget surprises positively but beware of the fine print,” February 28, 2011)
…but don’t be alarmed, slippages are likely
It is unlikely though that the targeted fiscal consolidation will materialize as subsidies appear
grossly under funded. Oil subsidies are a case in point. The government will likely enter FY12
with arrears to oil marketing companies of about Rs200 billion (0.3 % of GDP). Even if crude
were to average $100 a barrel, the government’s share of the under-recoveries is expected to be
around Rs 830 billion for FY12, and it has only budgeted Rs 240 billion for this fiscal. Assuming
that a similar amount of arrears is rolled over to the next fiscal, the under-budgeting for this fiscal
is still about 0.7 % of GDP. If crude averages $110, for example, the under-budgeting rises to 1%
of GDP.
Only significant changes in the administered prices of petroleum products would meaningfully
reduce this liability; e.g., even if diesel prices are increased by Rs 2-3 per litre (about a quarter of
the under-recovery per litre at $ 100 a barrel), the government’s liability would only fall by about
0.1% of GDP.
Food subsidies, too, seem under budgeted. With FY10’s food subsidies itself likely to end up
closer to Rs 750 billion (Rs 150 billion higher than what was budgeted), and a Food Security Bill
likely to be in place for at least the second half of this fiscal (which could add about Rs 80
billion), an allocation of Rs 600 billion for FY12, seems at least 0.2 to 0.3 % of GDP short of
what may eventually be needed.
Even between the announcement of the budget speech and the tabling of the Finance Bill in
Parliament this week there have been other slippages, albeit small. The increase in the dearness
allowance for central government employees will add Rs 60 billion to FY 12 expenditures and
revocation of services tax to the healthcare industry will reduce projected tax collections, but by
less than 0.05% of GDP.
All told, the slippage on the fiscal deficit could be of the order of 0.6-0.7 % of GDP and the
deficit outturn could be closer to 5.3% of GDP than 4.6% as targeted. This would imply an
effective consolidation of about 1% of GDP slowing growth to a shade under 8%.
Monetary policy to remain behind the curve, but tight liquidity will keep
lending rates high
Even though policy rates have been hiked by 200bps over the last year, the fact that the
momentum of headline and core inflation has accelerated secularly over the last 6 months is
indication enough that monetary policy has been consistently behind the curve. This was evident
again when the RBI’s March inflation forecast was increased by 250 bps over the last two
meetings even as policy rates were only increased by 50 bps during those two meetings As it
turns out, we expect even the revised target of 8% for March to be breached.
As indicated above, though, market rates have been ahead of policy rates over the last few months
because banking system liquidity has remained consistently tight since June thereby rendering
monetary policy tightening more effective than the policy rate hikes would suggest.
We expect this phenomenon to continue for much of 2011. The RBI is likely to continue its
calibrated approach of hiking rates in 25 bps increments and hike rates another 2-3 times this
year, given their increasing concerns about slowing domestic and global growth. In and of itself,
we don’t believe this would be enough to curb inflationary pressures but banking system liquidity
is again expected to remain in deficit and relatively tight for much of 2011 (primarily for
structural reasons as currency in circulation is expected to rise sharply again as sticky inflation
keeps transactions demand for money high and continued government spending in the rural
economy result in ever-increasing leakages from the banking system ) thereby keeping the
pressure on market rates and rendering monetary policy more effective than it was necessarily
intended to be.
Heading for an accidental soft-landing
The planned fiscal consolidation of 1.7 % of GDP looks excessively tight and improbable. As
such, it appears more likely that fiscal slippages on account of subsidies will ensure that the fiscal
consolidation would be closer to 1% of GDP, inadvertently engineering a soft landing of growth
to just below 8% rather than the 7-7.5% implied by the budgeted consolidation.
Conversely, while policy rates will stay behind the curve, continued tight liquidity is expected to
keep market rates high and thereby have a greater impact on taming core inflation than was
perhaps planned.
In sum, even though fiscal and monetary policy are currently on course to be too tight and too
loose, respectively, we could end the year with the odd scenario that policy errors inadvertently
offset each other (for the reasons mentioned above) and the economy experiences a soft landing
with growth printing a shade below 8% and core and headline inflation peaking around
August/September and then gradually moderating.
FY12 growth a shade below 8%...
After printing close to 9% in the first half of the fiscal year, GDP growth has begun to slow, with
FY11Q3 growth printing at 8.2 % oya and a likely further slowing in Q4. Despite this, however,
FY11 growth is still expected to print around 8.5%, buoyed by strong agricultural and services
(mainly government). Industrial growth is expected to print close to 7.5% reflecting the
languishing capex cycle.
Taking into account the likely fiscal and monetary tightening and assuming global growth
remains fairly robust with crude oil prices remaining around $110/barrel, we expect FY12 growth
to slow to a shade below 8% (depending on how much fiscal consolidation is actually delivered
and how global growth – with its impact on India exports – pans out).
Even assuming a normal monsoon, agriculture is expected to grow around 3.5 % on account of
the high base from this year. With the investment cycle slated to pick-up only in the second half
of this fiscal (once inflationary concerns have bottomed out), industrial growth could accelerate to
about 8.2 %. In contrast, a sharp reduction in community and social services (proxy for
government spending) is likely to cause services growth to moderate to about 8.9% oya.
…and inflation to average around 8%
As alluded to above, with inflation increasingly being driven by core inflation on account of
rising output gaps, the headline rate is expected to remain sticky through much of 2011. In fact,
we expect inflation to accelerate further towards the 9-10% mark in Q2 of the fiscal year, before
moderating in the remaining quarters as the impact of the fiscal consolidation takes hold. On
average, inflation in FY12 is still expected to average 8%, about a 120 bps less than this fiscal.
CAD expected to widen to 3% of GDP, but expected to be financed
As we have been arguing for a while, (see, “Current account deficit concerns overstated,”
February, 2011), the current account deficit for FY11 is likely to print much below market
expectations. Specifically, we expect the CAD for this fiscal to print around 2.5 % of GDP, below
the 3-3.5 % of GDP that the RBI and market had expected for a while. This is largely on account
of a sharp narrowing of the trade deficit because both exports have surged in recent months (as
global growth has accelerated over the last quarter) and non-oil imports have languished in the
absence of a pick up in the capex cycle.
Going forward, however, we expect the FY12 CAD to about 3% of GDP. This is on account of
multiple factors: higher oil import values as crude prices stay high (JPM Forecast of Brent is $110
for FY12), a pick-up in non-oil imports in 2HFY12 as the investment cycle is finally slated to
pick-up, and a slight deceleration in exports as global growth potentially slows later in the year on
account of elevated crude prices. That said, we expect the current account to be financed as
external commercial borrowings (ECBs) and FDI are expected to rise in tandem with the
investment cycle, leaving a relatively smaller proportion of the current account to be financed by
the more volatile portfolio flows.
Yield curve expected to flatten further in the near term
As expected, authorities announced that the government’s borrowing calendar would be
frontloaded, with 60% (Rs 2.5 trillion) of the full-year gross borrowing requirement (Rs 4.17
trillion) to be conducted in the first half of the fiscal year (see, “India Borrowing calendar: bond
yields will not spike,” by Abhishek Panda and Bert Gochet, March 28.) The market was
expecting a greater degree of front-loading, and bonds have therefore rallied 5-6 bps since then.
The yield curve has bear-flattened significantly over the last 6 months, and we expect that this
dynamic will continue over the next quarter or so. Stubbornly high inflation, tight liquidity and
more rate hikes are expected to keep rates high at the short-end, whereas yields at the long end
are expected to stay in the 8% range as the borrowing program in the FY12 budget and the
proportion to be borrowed in the first half of the year has been lower than market expectations.
Things could change, however, as we approach the middle of the year as it becomes clear that
fiscal slippages could be significant and the borrowing program for the second half will likely
need to be revised up, and the market internalizes the fact that the RBI could be coming to the end
of its rate-tightening cycle as growth begins to slow. That said, we do not expect bond yields to
spike sharply at any point as the RBI is expected to support the bond-market through significant
open-market operations in 2H as a means to reaching its reserve money target for this year.
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