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The attractiveness and strength of structural tailwinds boosting the medium- to
long-term prospects of an economy don’t eliminate the cyclical headwinds over the
course of business cycles. The same is true for the Indian economy, except that the
rise of these cross-currents also often raises doubts about the medium-term
economic outlook. Indian governments’ chronically poor policy coordination and
embarrassing execution record are legitimate impediments to the rapid unlocking of
India’s realisable growth potential. But there is nothing new here. India’s economic
rise so far has been despite the government, not because of it.
India is experiencing predominantly cyclical headwinds that are for now battling the
strong domestic structural tailwinds. Additionally, the fallout from the corruption
scandals that erupted late last year has taken a toll on business sentiment, and could
snowball to create further downside risk. It is crucial for Prime Minister Manmohan
Singh to salvage his reputation by correcting the current policy paralysis. The
shortest distance between two points in India is never a straight line and some
correct decisions are forced when a policymaker’s back is against the wall. The fear
of nothing at all being done by the government appears exaggerated, in our view.
Trend economic growth has been accelerating in recent decades (Figure 1), despite
the uninspiring reform agenda. In early 2000s, no one expected the Indian economy
to ever grow at twice the pace of 4.4% recorded in FY01, let alone close to 10%
(FY07: 9.6%). But it did. Most recently, the economy was relatively resilient in the
fallout of the global financial crisis (GFC). The “collapse” in growth to 6.8% in
FY09 was not as severe as most expected. And hardly anyone expected growth to
rebound to average 8.3% in FY10-FY11.
The cyclical headwinds are reflected in the policy-induced moderation in economic
growth as higher inflation has prompted an aggressive monetary tightening. Just as
the recovery following the global financial crisis (GFC) was uneven, the ongoing
deceleration is uneven as well. The rate-sensitive parts of the economy are likely to
be more affected by monetary tightening but a sizable portion of consumer demand,
especially rural spending, will be resilient owing to its favourable structural
underpinnings. The twin deficits will persist but the key will be to manage them to
ensure that there is no blowout.
A crucial point that is often overlooked is that part of India’s high inflation is an
outcome of government’s policy initiatives to improve the terms of trade for the
agriculture sector/rural economy via higher minimum crop prices (MSPs) and social
programmes. This represents an income transfer from the rest of India, especially
the urban middle-class. In the last five years, the pace of increase in food prices has
outstripped the increase in the prices of non-food manufactured goods by a wide
margin. However, the improvement in the rural/agriculture terms of trade is an
important political initiative that has also boosted incomes and consumer demand in
these areas.
The cyclical headwinds warrant close tracking, but it is important not to lose sight
of the essential building blocks of the India story, such as the ongoing unlocking
of the demographic transition, increasing global integration and fuller capital
account convertibility. As a recent IMF paper (discussed later in this note)
correctly points out, the demographic dividend has already been contributing to
growth in recent decades and will further boost it in the next two decades.
Further, poorer states, which have been left out, are likely to catch up faster
owing to a bigger expansion in their working-age population.
It is under-appreciated that India has convincingly stayed the course with
continued capital account liberalisation, despite several countries announcing
restrictions on capital inflows. India has substantially increased the ceilings for
overseas borrowing by its companies and for foreign investment in local
currency government and corporate bonds. The combined ceiling is now
USD80bn, larger than the anticipated current account (CA) deficit.
A key disappointment with the current government has been its tardy pace of
reforms to address the chronic and rampant supply constraints advertised by the
rickety infrastructure. This, in turn, limits the increase in the non-inflationary speed
limit for growth. There can be no India story if the government does not work to fix
infrastructure bottlenecks. A more pro-active government policy on reforms is
undoubtedly a must for accelerating sustainable growth to a 9-10% range. But even
with subdued reform vigour, growth should be around the 8% mark over the
medium-term, still positioning India as the second-fastest growing Asian economy.
Indian politicians are being forced gradually to change by the forces of globalisation
and by the rising aspirations of a young and growing working-age population. The
domestic political agenda does not need to be sacrificed for the sake of
globalisation, but the constraints imposed by globalisation can’t be ignored as
opting out is not an option. The favourable demographic transition, which is
boosting growth, will also force the governments to deliver more to meet the
aspirations of the people.
For all the pessimists over the emerging India story, ask yourself the following:
When was the last time Indians themselves put pressure on their government to
improve its delivery and to address issues such as corruption, even as economic
growth was around 8%? It has never happened in India’s history, but is happening
now. The future in India is never linear and barring a born again government,
people and investors will still have to live with politicians that deliver short of what
is possible. But governments don’t have a choice but to deliver more to meet the
rising aspirations. Or else, Indians will vote with their feet.
CYCLICAL HEADWINDS
India has not had many business cycles in the last two decades and thus an active
use of policy to manage the short-term fluctuations in aggregate demand is a
relatively new area for policymakers. We analyse four main cyclical headwinds
facing the Indian economy: (1) growth moderation; (2) higher inflation; (3)
monetary tightening; and (4) the twin deficits. These headwinds are partly related
but also have independent drivers.
Growth: Much needed moderation
GDP growth slowed to 6.8% YoY in FY09 (the fiscal year that captured the full
impact of the GFC) before recovering to average 8.3% in the subsequent two years.
The aggressive monetary-fiscal expansion cushioned the growth downturn and also
contributed to the subsequent strong recovery. However, policy normalisation from
early 2010 was needed to avoid over-stimulating the economy as growth became
more self sustaining. Growth has been moderating since hitting a post-GFC peak of
9.4% YoY in 1Q10, and touched 7.8% in 1Q11
Compared with the last cycle (2004-08), the current one has been imbalanced with
domestic demand weaker (Figure 3). The current economic cycle from FY10
onwards is different from the prior cycle in two main respects: (1) consumption is
a more important driver of growth; and (2) investment spending has been weaker
than expected. The rebound in private consumption has been much stronger owing
partly to the government’s pro-consumer approach for cushioning the economic
downturn following the Lehman bust. Also, consumer spending has been buoyant
due to the delayed and insufficient fiscal adjustment even after the recovery was
on a firmer footing.
Looking forward, private consumption will moderate due to higher interest rates
(vehicle sales have already been decelerating) but it will still be more resilient
owing to structural factors that are increasing the number of people in the work
force and contributing to higher incomes. Fuel price adjustments that shrink the
subsidy bill and the government’s fiscal deficit will be more effective than raising
rates in impacting consumer demand without hurting investment.
The near-term economic outlook will continue to be affected by the lack of positive
policy activism on reforms, paralysis in decision making, and the ongoing fear
about the unfolding corruption issues and investigations that have affected business
confidence. The investment upturn after the crisis has not been as strong as initially
expected and now higher interest rates will also make the upturn more challenging.
Subdued investment spending will be the key risk to growth.
The service sector’s significant contribution to headline GDP growth continues to
be resilient (Figure 4). On our forecast, GDP growth is poised to moderate to 7.5%
in FY12 from 8.5% in FY11, suggesting at least 1-2 quarters of near 7% growth. If
realised, that annual growth outcome of 7.5% would be the lowest in seven straight
years, except for the dramatic deceleration in FY09 caused by the GFC.
What is the medium-term outlook? India has averaged annual growth of 8.5% in the
seven years to FY11, and 7.3% from FY2000 onwards. The outcomes include the
unprecedented hit from the GFC and one of the worst droughts suffered by India in
FY10. Assuming 8.5% per annum from FY13 onwards, the current decade will
yield an average annual growth rate of 8.4%. Assumptions of 8% and 7.5% per
annum will yield annual averages of 8% and 7.7%, respectively.
Inflation: A multi-headed dragon
In Triple-A India Tracking the macro risks (30 March), we reiterated that India’s
inflationary pressures are a complex mix of demand- and supply-side factors, cover
food and non-food categories, and are structural and cyclical in nature.
Like the previous cycle, global commodity prices have been a key driver of
inflationary pressures in the current cycle
However, unlike the previous cycle, current inflation has not been due to excessive
pace of monetary expansion. Indeed, the pace of increase in M3 has lagged the
growth in nominal GDP (Figure 6), something unusual in India’s experience. But
the delay in reversing the successful counter-cyclical measures introduced to deal
with the GFC has undermined the effectiveness of the RBI’s tightening. Indeed, a
lax fiscal approach, especially the absence of an adequate reduction in subsidies,
has been a key impediment to checking inflation, which has also been aggravated
by supply bottlenecks. Higher subsidies limit the adjustment to consumer
spending from higher oil prices, which in turn keep consumer spending stronger
than it otherwise would be and contributes to demand-driven inflation pressures
Apart from the impact of government policy and domestic supply shocks, there is a
structural element to India’s inflation as higher incomes have increased the demand
for food, especially protein-rich items such as eggs, meat, milk and fish.
Importantly, food grains such as wheat, rice and pulses are not showing any
significant price increase. However, the pressures from protein-rich food items are
accentuated by the government’s inadequate supply response. After all, India is not
the first country to experience increased demand for food as the broader population,
especially at lower income levels, enhances its purchasing power. But there is no
country where protein-based food inflation became permanently entrenched.
It is often mistakenly assumed that inflation is driven only by cyclical demand
pressures that higher interest rates will be able to check. While the strength of
aggregate demand, especially in the absence of the much-needed fiscal
consolidation, is a relevant contributor, there are two other factors that are directly a
function of the government’s policy: (1) higher minimum support prices (MSPs) of
several crops; and (2) higher spending on social programmes, including the rural
employment guarantee initiative. Both these policy measures have enhanced the
spending power of rural India, which, along with structural factors resulting in
greater consumerism, have contributed to the strength of consumer demand
Including FY05, the first year of the current term of the Congress-led UPA coalition
government, the MSPs for wheat and rice have jumped by a whopping 75-80%
(Figure 7). In the six years to FY11, wheat and rice prices surged around 72% and
75%, respectively, compared to the increases of around 10% and 14%, respectively,
in the six years to FY05. Thus, a meaningful part of food inflation has been caused
by the government’s own policy of higher MSPs. And higher MSPs have also
contributed to the strength of rural consumer demand, which in turn has sustained
the growth momentum.
This important point is often overlooked: a part of the high inflation is an outcome
of policy initiatives designed to improve the terms of trade for the agriculture
sector/rural economy via higher minimum crop prices at the expense of the rest of
India, broadly the urban middle-class. Thus, it is striking that in the last five years,
the pace of increase in food prices has outstripped the increase in non-food
manufactured goods by a wide margin
The still-elevated WPI inflation will worsen in the next few months due to the
anticipated upward revision in local fuel prices, and will prompt further
monetary tightening (more below). Moreover, India continues to suffer from
“suppressed” inflation as several local prices do not fully reflect the changes in
international prices.
On our forecast, headline WPI inflation will be in the 9-10% YoY range for the next
few months before softening to 7.5% (RBI: 6%) by March 2012. While food
inflation has been softening and will be reduced by a good monsoon season, the key
focus should be on rising non-food manufactured goods (core) inflation (Figure 9).
As explained in Triple-A India Recalibration (11 May), the RBI’s focus on WPI
instead of CPI is misguided, in our view, and increases the risk of over-tightening
(more below).
Also, India (like most other countries in the region) is moving on to a new
higher inflation trajectory. Indeed, inflation will remain higher for longer for
two key reasons: (1) policymakers do not want to dramatically slow growth; and
(2) there is a new higher global normal for commodity prices. These factors
suggest that inflation in India (and in other economies) will be higher than what
we have been used to. Thus, a much higher loss in near-term growth will be
needed if the old inflation trend has to be achieved. This is an option that most
countries will shun. Consequently, policymakers will have to live with higher
inflation for longer.
The bottom line is that India’s inflation problems cannot be solved only by interest
rate hikes. Fiscal consolidation and real sector reforms, including higher investment
in agriculture and revamping the mechanism of setting agricultural prices have to be
key parts of the solution. Sole emphasis on raising rates will be counter-productive
beyond a point as it will hurt growth without much improvement in inflation. In
fact, a huge dividend can be extracted by implementing reforms that could
ultimately result in both higher growth and lower inflation
Monetary tightening: A bit more to go
The RBI began tightening gradually in late 2004 by hiking the cash reserve ratio (CRR)
and the reserve repo rate, and stayed on a tightening path until September 2008 (Figure
10). Thereafter, the policy was in reverse mode to cushion the hit from the GFC.
Following the post-GFC recovery, the RBI began monetary tightening in early 2010
During that last tightening (2004-08), the RBI also shifted its operational policy rate
to the repo rate from the reverse repo rate. The repo rate peaked at 9% in the last
cycle and the cumulative rate tightening was 450bp (including the shift in the
operational policy rate). Given the surge in capital inflows in 2007 and 2008, the
RBI also hiked CRR by 450bp as it attempted to sterilise the intervention needed to
limit the INR’s appreciation.
An important aspect of the 2004-08 tightening was that the RBI had maintained the
repo rate at 7.75% for a little over a year before an unexpected jump in inflation (driven
mainly by global commodity prices) prompted an additional tightening of 125bp packed
in June-July 2008. That pushed the repo rate to 9%. Then, the combination of capital
outflows, domestic liquidity squeeze and a disinflationary shock trigged by the GFC
forced the RBI to ease aggressively from October 2008 onwards.
The current monetary tightening cycle began in early 2010 by the RBI increasing
CRR 75bp in two steps to 5.75%. In April 2010, the RBI again hiked the CRR (to
6%), and also began raising the repo and the reverse repo rates that had bottomed at
4.75% and 3.25%, respectively.
At the most recent policy review in June, the RBI hiked the repo rate by 25bp to
7.5%, as widely expected. It maintained a hawkish tone but added that it was
keeping a close watch on the potential downside risk to growth from adverse global
developments. Cumulatively, the RBI has effectively increased rates by 425bp
(including the shift in the operational policy rate) since early 2010. At 7.5%, the
current repo rate is 150bp below the last peak of 9%, and the CRR is 300bp lower
than its previous peak. We expect the RBI to increase the repo rate to 8% later in
the year.
The lower reliance on CRR in the current cycle is simply because capital
inflows have not been overwhelming for monetary management. Also, the
domestic liquidity deficit has improved the transmission of monetary measures,
especially from 4Q10, as a result of which market rates are higher than the level
which the repo rate might imply (Figure 11). The RBI is unlikely to ignore this
point while deciding on future interest rate hikes.
The growth-inflation combination will continue to be affected by monetary
tightening, global commodity price movements and the upcoming monsoon season.
An earlier pause in policy rate hikes would be warranted by either sufficiently
positive news on inflation (especially core) or a dramatic deceleration in growth.
We maintain that the RBI’s focus on WPI-core inflation for setting its interest rate
policy is misguided and could result in accidental over-tightening. Non-agriculture GDP
growth has already been decelerating and there appears to be little connection between
it and WPI-core inflation (Figure 12), the latter being significantly affected by global
commodity prices. The same pattern was observed in the previous cycle, but the hit
from the global crisis masked the deceleration that was already under way. Further,
aggressive easing following the Lehman collapse cushioned the downside to growth.
Twin deficits: Here to stay but need managing
India has had chronic deficits on the fiscal and the current account (CA) balances
(Figure 13). Both need to be checked so as to avoid a blowout, owing to either cyclical
pressures or external shocks (e.g. higher crude oil) that worsen the terms of trade.
Enhancing the competitiveness of exports is one way for narrowing the CA deficit. On
the fiscal front, the government has its work cut out to be more disciplined in spending
and to broaden the tax base via improved compliance and further tax reforms.
The federal government’s fiscal deficit in FY11 is now pegged at 4.7% of GDP, much
lower than the 5.1% announced in the revised estimate when the budget for FY12 was
announced in February. However, we forecast the FY12 fiscal deficit at 5.2% of GDP,
higher than the government’s target of 4.6% of GDP. The deficit will be affected by
moderating economic activity, successful divestment and the size of the subsidy bill.
India’s federal budgets are typically underfunded for subsidies when they are announced,
and the government attempts to juggle the subsidy bill and the scope of local price hikes
for fuel and fertilizer over the course of the year. On our estimate, every USD10/bbl
increase in crude oil price widens the fiscal deficit by around 0.2ppt of GDP. The impact
on the subsidy bill is marginally more as the overall fiscal deficit also benefits from
higher customs and excise collections, if they are not spent elsewhere
India’s fiscal problems have always been much more on the revenue side than on
the spending side (Figure 14). Archaic tax laws, high tax rates and poor
implementation and compliance narrow the tax base. Fiscal reforms in recent years
have paid some dividends but further important reforms are needed to address some
of these issues. The important point is that the government realises that fixing the
fiscal health is a vital ingredient in India attaining higher annual GDP growth on a
sustained basis.
Improving public finances will have to be an integral part of ensuring the
sustainability of the growth upturn, as higher government borrowing risks crowding
out credit to the private sector. Improving the fiscal position is also important for
boosting the economy’s domestic savings rate, which in turn will facilitate higher
investment and growth.
The implementation of fiscal reforms for boosting revenues remains patchy at best.
The Direct Tax Code (DTC), which will overhaul personal and corporate tax
structure for the first time since 1961, appears to be on schedule to be implemented
from 1 April 2012. However, the path-breaking goods and services tax (GST) is
currently caught in a partisan political crossfire that will certainly delay its
implementation beyond the target date of 1 April 2012.
It is often overlooked that India runs a CA surplus if the net trade in crude oil
and petroleum products is excluded (Figure 15). That emphasises the significant
impact of crude oil on the balance of payments. Higher domestic production of
crude in FY11 was instrumental in checking the oil import bill, and hence the
CA deficit, but India remains heavily dependent on crude oil.
The impact of a USD10/bbl increase in crude oil price is to worsen the CA
deficit by USD9.5bn, or 0.5ppt of GDP. On our expectation, the CA deficit in
FY12 will widen to 3.2% of GDP from an estimated 2.7% in FY11. Apart from
higher crude oil prices, the CA deficit is also affected by the fact that the Indian
economy is growing faster than the majority of its trading partners.
Financing the wider CA deficit is always a concern, but India, unlike most other
Asian countries, continues gradually to liberalise the capital account of the
balance of payments. Still, shifts in global risk appetite could make capital
inflows more volatile and thus create greater volatility for INR, especially since
the RBI has not been intervening in the currency market.
The key issues with the CA deficit are its size and the nature of financing.
Since India is growing faster than the rest of the world, it will post a higher CA
deficit during this phase than would otherwise be the case. Indian policymakers’ preference for low volatility in GDP growth even as global dynamics
remain volatile also contributes to a higher CA deficit. But the growth
differential in India’s favour is also the reason why foreign savings are being
recycled into India. As and when the global economy recovers, India’s CA
deficit will narrow as exports will likely rebound more than imports. Capital
flows will also adjust, although the broader structural trend of asset allocation
towards EM should still persist.
Obviously, there is no guarantee that capital flows will always be smooth. A wider
CA deficit makes India vulnerable to a sudden shock of reversal in short-term
capital inflows. Hence, the widening of the CA deficit will need to be checked so
that it does not go significantly beyond 3% of GDP on a sustained basis. Nothing
can beat policy initiatives to enhance the competitiveness of the export sector.
Hopefully, the ongoing debate about the financing of the CA deficit will finally
push the government to announce measures to attract more FDI, so as to increase
the share of long-term stable investment in total capital inflows.
STRUCTURAL TAILWINDS
Cyclical economic pressures and crises – external and domestic – often raise doubts
of the robustness of the emerging India story. In the early 2000s, no one expected
the Indian economy to ever grow at twice the pace of 4.4% recorded in FY01, let
alone close to 10% growth (FY07: 9.6%). But it did, and without any big bang
reforms. Most recently, the economy was relatively resilient in the fallout of the
GFC. The collapse in growth to 6.8% in FY09 was not as severe as most people
were guessing, and the post-crisis recovery was stronger than expected.
Trend economic growth has been accelerating in recent decades, and the size of the
Indian economy will hit USD2 trillion in FY12, having doubled in a mere 5 years.
Per-capita GDP will hit around USD1,700 in FY12, up a handsome 3.6 times from
the FY01’s level (Figure 16). It would be a mistake to think that all the growth is
happening because of pro-active governments implementing aggressive reform
agendas. The real wonder is that the Indian economy is growing as rapidly as it has
been despite having to suffer the inactions of governments that excel in overpromising and under-delivering.
Capital account convertibility: Moving ahead
In recent years, India has been attracting higher market-driven private capital
inflows. This is in contrast to the pre-1991 reform period when there was a
significant reliance on official lending. This is also well reflected in the use of
external commercial borrowings (ECBs) by Indian companies in the investment
upturn from 2001-02 to 2007-08. This surge caused the Reserve Bank to
announce prudential restrictions to check the surge in ECBs. The restrictions,
which were widely criticised at the time, were actually effective in ensuring that
the adverse effect of the GFC did not cause an even greater economic and
financial downturn.
Absorbing foreign savings via different channels (e.g. portfolio, FDI, ECB,
private equity, non-resident Indians’ savings) will continue to be an important
input in India’s global rise (see India Country Report Attracting capital –
Financing India’s acceleration, November 2010). The growing financial
openness of India has been accompanied by a significant shift in the
composition of capital inflows, and the share of market-driven private inflows
has been steadily rising (Figure 22). The strong post-crisis recovery in India
ahead of the global recovery, coupled with positive sentiment of global investors
about India’s prospects, induced the revival in capital inflows. The
government’s divestment in FY11 also attracted FII portfolio inflows.
HALF-FULL OR HALF-EMPTY?
At the very outset, the attractiveness of a strong structural growth story does not
eliminate cyclical headwinds. There are three pieces that will affect India’s near-
and medium-term economic outlook: (1) cyclical headwinds; (2) structural
tailwinds; and (3) government policy. The lethargic approach of the government has
been a chronic issue, but has become more relevant in the last nine months owing to
the fallout from the corruption scandals. Ironically, the same policymakers and
politicians who admirably navigated India through the unprecedented GFC now
seem on the back foot as they tackle an assertive civil society pushing for
accountability and change.
The cyclical worries over high inflation, monetary tightening and slowing growth
are legitimate but have to be viewed as part and parcel of managing aggregate
demand, an approach that is new and still evolving for Indian policymakers.
Importantly, cyclical moderation in growth does not lower the medium-term growth
prospects. In fact, effective monetary tightening, by attempting a soft landing in the
near-term, often eliminates the need for a hard landing later on.
There is nothing pre-ordained about India’s economic rise, despite the scope for
unlocking of the structural tailwinds, which will also be affected by the pace of
reforms. Prime Minister Manmohan Singh has a choice before him: he can choose to
be remembered by posterity as the man who, as finance minister, announced pathbreaking reforms following the 1991 crisis and answered the calls for an encore this
year. Or as a shackled man now on whose watch India’s economic rise sputtered.
The eminent British economist Joan Robinson had said, “Whatever you can
rightly say about India, the opposite is also true”. That is surely the case now, as
investors once again debate the cross-currents affecting India. The fear of nothing
at all being done by the government appears exaggerated, in our view. Why?
Governments will not have a choice but to try to deliver to meet the rising
aspirations of the burgeoning size of the working-age population. Indians will be
happy to throw out governments that don’t deliver. India continues to be a glass
half-full story, in our view. Indeed, we will look back in a few years and probably
cite the current push-and-pull for playing a constructive role in the subsequent
unlocking of the India story.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
The attractiveness and strength of structural tailwinds boosting the medium- to
long-term prospects of an economy don’t eliminate the cyclical headwinds over the
course of business cycles. The same is true for the Indian economy, except that the
rise of these cross-currents also often raises doubts about the medium-term
economic outlook. Indian governments’ chronically poor policy coordination and
embarrassing execution record are legitimate impediments to the rapid unlocking of
India’s realisable growth potential. But there is nothing new here. India’s economic
rise so far has been despite the government, not because of it.
India is experiencing predominantly cyclical headwinds that are for now battling the
strong domestic structural tailwinds. Additionally, the fallout from the corruption
scandals that erupted late last year has taken a toll on business sentiment, and could
snowball to create further downside risk. It is crucial for Prime Minister Manmohan
Singh to salvage his reputation by correcting the current policy paralysis. The
shortest distance between two points in India is never a straight line and some
correct decisions are forced when a policymaker’s back is against the wall. The fear
of nothing at all being done by the government appears exaggerated, in our view.
Trend economic growth has been accelerating in recent decades (Figure 1), despite
the uninspiring reform agenda. In early 2000s, no one expected the Indian economy
to ever grow at twice the pace of 4.4% recorded in FY01, let alone close to 10%
(FY07: 9.6%). But it did. Most recently, the economy was relatively resilient in the
fallout of the global financial crisis (GFC). The “collapse” in growth to 6.8% in
FY09 was not as severe as most expected. And hardly anyone expected growth to
rebound to average 8.3% in FY10-FY11.
The cyclical headwinds are reflected in the policy-induced moderation in economic
growth as higher inflation has prompted an aggressive monetary tightening. Just as
the recovery following the global financial crisis (GFC) was uneven, the ongoing
deceleration is uneven as well. The rate-sensitive parts of the economy are likely to
be more affected by monetary tightening but a sizable portion of consumer demand,
especially rural spending, will be resilient owing to its favourable structural
underpinnings. The twin deficits will persist but the key will be to manage them to
ensure that there is no blowout.
A crucial point that is often overlooked is that part of India’s high inflation is an
outcome of government’s policy initiatives to improve the terms of trade for the
agriculture sector/rural economy via higher minimum crop prices (MSPs) and social
programmes. This represents an income transfer from the rest of India, especially
the urban middle-class. In the last five years, the pace of increase in food prices has
outstripped the increase in the prices of non-food manufactured goods by a wide
margin. However, the improvement in the rural/agriculture terms of trade is an
important political initiative that has also boosted incomes and consumer demand in
these areas.
The cyclical headwinds warrant close tracking, but it is important not to lose sight
of the essential building blocks of the India story, such as the ongoing unlocking
of the demographic transition, increasing global integration and fuller capital
account convertibility. As a recent IMF paper (discussed later in this note)
correctly points out, the demographic dividend has already been contributing to
growth in recent decades and will further boost it in the next two decades.
Further, poorer states, which have been left out, are likely to catch up faster
owing to a bigger expansion in their working-age population.
It is under-appreciated that India has convincingly stayed the course with
continued capital account liberalisation, despite several countries announcing
restrictions on capital inflows. India has substantially increased the ceilings for
overseas borrowing by its companies and for foreign investment in local
currency government and corporate bonds. The combined ceiling is now
USD80bn, larger than the anticipated current account (CA) deficit.
A key disappointment with the current government has been its tardy pace of
reforms to address the chronic and rampant supply constraints advertised by the
rickety infrastructure. This, in turn, limits the increase in the non-inflationary speed
limit for growth. There can be no India story if the government does not work to fix
infrastructure bottlenecks. A more pro-active government policy on reforms is
undoubtedly a must for accelerating sustainable growth to a 9-10% range. But even
with subdued reform vigour, growth should be around the 8% mark over the
medium-term, still positioning India as the second-fastest growing Asian economy.
Indian politicians are being forced gradually to change by the forces of globalisation
and by the rising aspirations of a young and growing working-age population. The
domestic political agenda does not need to be sacrificed for the sake of
globalisation, but the constraints imposed by globalisation can’t be ignored as
opting out is not an option. The favourable demographic transition, which is
boosting growth, will also force the governments to deliver more to meet the
aspirations of the people.
For all the pessimists over the emerging India story, ask yourself the following:
When was the last time Indians themselves put pressure on their government to
improve its delivery and to address issues such as corruption, even as economic
growth was around 8%? It has never happened in India’s history, but is happening
now. The future in India is never linear and barring a born again government,
people and investors will still have to live with politicians that deliver short of what
is possible. But governments don’t have a choice but to deliver more to meet the
rising aspirations. Or else, Indians will vote with their feet.
CYCLICAL HEADWINDS
India has not had many business cycles in the last two decades and thus an active
use of policy to manage the short-term fluctuations in aggregate demand is a
relatively new area for policymakers. We analyse four main cyclical headwinds
facing the Indian economy: (1) growth moderation; (2) higher inflation; (3)
monetary tightening; and (4) the twin deficits. These headwinds are partly related
but also have independent drivers.
Growth: Much needed moderation
GDP growth slowed to 6.8% YoY in FY09 (the fiscal year that captured the full
impact of the GFC) before recovering to average 8.3% in the subsequent two years.
The aggressive monetary-fiscal expansion cushioned the growth downturn and also
contributed to the subsequent strong recovery. However, policy normalisation from
early 2010 was needed to avoid over-stimulating the economy as growth became
more self sustaining. Growth has been moderating since hitting a post-GFC peak of
9.4% YoY in 1Q10, and touched 7.8% in 1Q11
Compared with the last cycle (2004-08), the current one has been imbalanced with
domestic demand weaker (Figure 3). The current economic cycle from FY10
onwards is different from the prior cycle in two main respects: (1) consumption is
a more important driver of growth; and (2) investment spending has been weaker
than expected. The rebound in private consumption has been much stronger owing
partly to the government’s pro-consumer approach for cushioning the economic
downturn following the Lehman bust. Also, consumer spending has been buoyant
due to the delayed and insufficient fiscal adjustment even after the recovery was
on a firmer footing.
Looking forward, private consumption will moderate due to higher interest rates
(vehicle sales have already been decelerating) but it will still be more resilient
owing to structural factors that are increasing the number of people in the work
force and contributing to higher incomes. Fuel price adjustments that shrink the
subsidy bill and the government’s fiscal deficit will be more effective than raising
rates in impacting consumer demand without hurting investment.
The near-term economic outlook will continue to be affected by the lack of positive
policy activism on reforms, paralysis in decision making, and the ongoing fear
about the unfolding corruption issues and investigations that have affected business
confidence. The investment upturn after the crisis has not been as strong as initially
expected and now higher interest rates will also make the upturn more challenging.
Subdued investment spending will be the key risk to growth.
The service sector’s significant contribution to headline GDP growth continues to
be resilient (Figure 4). On our forecast, GDP growth is poised to moderate to 7.5%
in FY12 from 8.5% in FY11, suggesting at least 1-2 quarters of near 7% growth. If
realised, that annual growth outcome of 7.5% would be the lowest in seven straight
years, except for the dramatic deceleration in FY09 caused by the GFC.
What is the medium-term outlook? India has averaged annual growth of 8.5% in the
seven years to FY11, and 7.3% from FY2000 onwards. The outcomes include the
unprecedented hit from the GFC and one of the worst droughts suffered by India in
FY10. Assuming 8.5% per annum from FY13 onwards, the current decade will
yield an average annual growth rate of 8.4%. Assumptions of 8% and 7.5% per
annum will yield annual averages of 8% and 7.7%, respectively.
Inflation: A multi-headed dragon
In Triple-A India Tracking the macro risks (30 March), we reiterated that India’s
inflationary pressures are a complex mix of demand- and supply-side factors, cover
food and non-food categories, and are structural and cyclical in nature.
Like the previous cycle, global commodity prices have been a key driver of
inflationary pressures in the current cycle
However, unlike the previous cycle, current inflation has not been due to excessive
pace of monetary expansion. Indeed, the pace of increase in M3 has lagged the
growth in nominal GDP (Figure 6), something unusual in India’s experience. But
the delay in reversing the successful counter-cyclical measures introduced to deal
with the GFC has undermined the effectiveness of the RBI’s tightening. Indeed, a
lax fiscal approach, especially the absence of an adequate reduction in subsidies,
has been a key impediment to checking inflation, which has also been aggravated
by supply bottlenecks. Higher subsidies limit the adjustment to consumer
spending from higher oil prices, which in turn keep consumer spending stronger
than it otherwise would be and contributes to demand-driven inflation pressures
Apart from the impact of government policy and domestic supply shocks, there is a
structural element to India’s inflation as higher incomes have increased the demand
for food, especially protein-rich items such as eggs, meat, milk and fish.
Importantly, food grains such as wheat, rice and pulses are not showing any
significant price increase. However, the pressures from protein-rich food items are
accentuated by the government’s inadequate supply response. After all, India is not
the first country to experience increased demand for food as the broader population,
especially at lower income levels, enhances its purchasing power. But there is no
country where protein-based food inflation became permanently entrenched.
It is often mistakenly assumed that inflation is driven only by cyclical demand
pressures that higher interest rates will be able to check. While the strength of
aggregate demand, especially in the absence of the much-needed fiscal
consolidation, is a relevant contributor, there are two other factors that are directly a
function of the government’s policy: (1) higher minimum support prices (MSPs) of
several crops; and (2) higher spending on social programmes, including the rural
employment guarantee initiative. Both these policy measures have enhanced the
spending power of rural India, which, along with structural factors resulting in
greater consumerism, have contributed to the strength of consumer demand
Including FY05, the first year of the current term of the Congress-led UPA coalition
government, the MSPs for wheat and rice have jumped by a whopping 75-80%
(Figure 7). In the six years to FY11, wheat and rice prices surged around 72% and
75%, respectively, compared to the increases of around 10% and 14%, respectively,
in the six years to FY05. Thus, a meaningful part of food inflation has been caused
by the government’s own policy of higher MSPs. And higher MSPs have also
contributed to the strength of rural consumer demand, which in turn has sustained
the growth momentum.
This important point is often overlooked: a part of the high inflation is an outcome
of policy initiatives designed to improve the terms of trade for the agriculture
sector/rural economy via higher minimum crop prices at the expense of the rest of
India, broadly the urban middle-class. Thus, it is striking that in the last five years,
the pace of increase in food prices has outstripped the increase in non-food
manufactured goods by a wide margin
The still-elevated WPI inflation will worsen in the next few months due to the
anticipated upward revision in local fuel prices, and will prompt further
monetary tightening (more below). Moreover, India continues to suffer from
“suppressed” inflation as several local prices do not fully reflect the changes in
international prices.
On our forecast, headline WPI inflation will be in the 9-10% YoY range for the next
few months before softening to 7.5% (RBI: 6%) by March 2012. While food
inflation has been softening and will be reduced by a good monsoon season, the key
focus should be on rising non-food manufactured goods (core) inflation (Figure 9).
As explained in Triple-A India Recalibration (11 May), the RBI’s focus on WPI
instead of CPI is misguided, in our view, and increases the risk of over-tightening
(more below).
Also, India (like most other countries in the region) is moving on to a new
higher inflation trajectory. Indeed, inflation will remain higher for longer for
two key reasons: (1) policymakers do not want to dramatically slow growth; and
(2) there is a new higher global normal for commodity prices. These factors
suggest that inflation in India (and in other economies) will be higher than what
we have been used to. Thus, a much higher loss in near-term growth will be
needed if the old inflation trend has to be achieved. This is an option that most
countries will shun. Consequently, policymakers will have to live with higher
inflation for longer.
The bottom line is that India’s inflation problems cannot be solved only by interest
rate hikes. Fiscal consolidation and real sector reforms, including higher investment
in agriculture and revamping the mechanism of setting agricultural prices have to be
key parts of the solution. Sole emphasis on raising rates will be counter-productive
beyond a point as it will hurt growth without much improvement in inflation. In
fact, a huge dividend can be extracted by implementing reforms that could
ultimately result in both higher growth and lower inflation
Monetary tightening: A bit more to go
The RBI began tightening gradually in late 2004 by hiking the cash reserve ratio (CRR)
and the reserve repo rate, and stayed on a tightening path until September 2008 (Figure
10). Thereafter, the policy was in reverse mode to cushion the hit from the GFC.
Following the post-GFC recovery, the RBI began monetary tightening in early 2010
During that last tightening (2004-08), the RBI also shifted its operational policy rate
to the repo rate from the reverse repo rate. The repo rate peaked at 9% in the last
cycle and the cumulative rate tightening was 450bp (including the shift in the
operational policy rate). Given the surge in capital inflows in 2007 and 2008, the
RBI also hiked CRR by 450bp as it attempted to sterilise the intervention needed to
limit the INR’s appreciation.
An important aspect of the 2004-08 tightening was that the RBI had maintained the
repo rate at 7.75% for a little over a year before an unexpected jump in inflation (driven
mainly by global commodity prices) prompted an additional tightening of 125bp packed
in June-July 2008. That pushed the repo rate to 9%. Then, the combination of capital
outflows, domestic liquidity squeeze and a disinflationary shock trigged by the GFC
forced the RBI to ease aggressively from October 2008 onwards.
The current monetary tightening cycle began in early 2010 by the RBI increasing
CRR 75bp in two steps to 5.75%. In April 2010, the RBI again hiked the CRR (to
6%), and also began raising the repo and the reverse repo rates that had bottomed at
4.75% and 3.25%, respectively.
At the most recent policy review in June, the RBI hiked the repo rate by 25bp to
7.5%, as widely expected. It maintained a hawkish tone but added that it was
keeping a close watch on the potential downside risk to growth from adverse global
developments. Cumulatively, the RBI has effectively increased rates by 425bp
(including the shift in the operational policy rate) since early 2010. At 7.5%, the
current repo rate is 150bp below the last peak of 9%, and the CRR is 300bp lower
than its previous peak. We expect the RBI to increase the repo rate to 8% later in
the year.
The lower reliance on CRR in the current cycle is simply because capital
inflows have not been overwhelming for monetary management. Also, the
domestic liquidity deficit has improved the transmission of monetary measures,
especially from 4Q10, as a result of which market rates are higher than the level
which the repo rate might imply (Figure 11). The RBI is unlikely to ignore this
point while deciding on future interest rate hikes.
The growth-inflation combination will continue to be affected by monetary
tightening, global commodity price movements and the upcoming monsoon season.
An earlier pause in policy rate hikes would be warranted by either sufficiently
positive news on inflation (especially core) or a dramatic deceleration in growth.
We maintain that the RBI’s focus on WPI-core inflation for setting its interest rate
policy is misguided and could result in accidental over-tightening. Non-agriculture GDP
growth has already been decelerating and there appears to be little connection between
it and WPI-core inflation (Figure 12), the latter being significantly affected by global
commodity prices. The same pattern was observed in the previous cycle, but the hit
from the global crisis masked the deceleration that was already under way. Further,
aggressive easing following the Lehman collapse cushioned the downside to growth.
Twin deficits: Here to stay but need managing
India has had chronic deficits on the fiscal and the current account (CA) balances
(Figure 13). Both need to be checked so as to avoid a blowout, owing to either cyclical
pressures or external shocks (e.g. higher crude oil) that worsen the terms of trade.
Enhancing the competitiveness of exports is one way for narrowing the CA deficit. On
the fiscal front, the government has its work cut out to be more disciplined in spending
and to broaden the tax base via improved compliance and further tax reforms.
The federal government’s fiscal deficit in FY11 is now pegged at 4.7% of GDP, much
lower than the 5.1% announced in the revised estimate when the budget for FY12 was
announced in February. However, we forecast the FY12 fiscal deficit at 5.2% of GDP,
higher than the government’s target of 4.6% of GDP. The deficit will be affected by
moderating economic activity, successful divestment and the size of the subsidy bill.
India’s federal budgets are typically underfunded for subsidies when they are announced,
and the government attempts to juggle the subsidy bill and the scope of local price hikes
for fuel and fertilizer over the course of the year. On our estimate, every USD10/bbl
increase in crude oil price widens the fiscal deficit by around 0.2ppt of GDP. The impact
on the subsidy bill is marginally more as the overall fiscal deficit also benefits from
higher customs and excise collections, if they are not spent elsewhere
India’s fiscal problems have always been much more on the revenue side than on
the spending side (Figure 14). Archaic tax laws, high tax rates and poor
implementation and compliance narrow the tax base. Fiscal reforms in recent years
have paid some dividends but further important reforms are needed to address some
of these issues. The important point is that the government realises that fixing the
fiscal health is a vital ingredient in India attaining higher annual GDP growth on a
sustained basis.
Improving public finances will have to be an integral part of ensuring the
sustainability of the growth upturn, as higher government borrowing risks crowding
out credit to the private sector. Improving the fiscal position is also important for
boosting the economy’s domestic savings rate, which in turn will facilitate higher
investment and growth.
The implementation of fiscal reforms for boosting revenues remains patchy at best.
The Direct Tax Code (DTC), which will overhaul personal and corporate tax
structure for the first time since 1961, appears to be on schedule to be implemented
from 1 April 2012. However, the path-breaking goods and services tax (GST) is
currently caught in a partisan political crossfire that will certainly delay its
implementation beyond the target date of 1 April 2012.
It is often overlooked that India runs a CA surplus if the net trade in crude oil
and petroleum products is excluded (Figure 15). That emphasises the significant
impact of crude oil on the balance of payments. Higher domestic production of
crude in FY11 was instrumental in checking the oil import bill, and hence the
CA deficit, but India remains heavily dependent on crude oil.
The impact of a USD10/bbl increase in crude oil price is to worsen the CA
deficit by USD9.5bn, or 0.5ppt of GDP. On our expectation, the CA deficit in
FY12 will widen to 3.2% of GDP from an estimated 2.7% in FY11. Apart from
higher crude oil prices, the CA deficit is also affected by the fact that the Indian
economy is growing faster than the majority of its trading partners.
Financing the wider CA deficit is always a concern, but India, unlike most other
Asian countries, continues gradually to liberalise the capital account of the
balance of payments. Still, shifts in global risk appetite could make capital
inflows more volatile and thus create greater volatility for INR, especially since
the RBI has not been intervening in the currency market.
The key issues with the CA deficit are its size and the nature of financing.
Since India is growing faster than the rest of the world, it will post a higher CA
deficit during this phase than would otherwise be the case. Indian policymakers’ preference for low volatility in GDP growth even as global dynamics
remain volatile also contributes to a higher CA deficit. But the growth
differential in India’s favour is also the reason why foreign savings are being
recycled into India. As and when the global economy recovers, India’s CA
deficit will narrow as exports will likely rebound more than imports. Capital
flows will also adjust, although the broader structural trend of asset allocation
towards EM should still persist.
Obviously, there is no guarantee that capital flows will always be smooth. A wider
CA deficit makes India vulnerable to a sudden shock of reversal in short-term
capital inflows. Hence, the widening of the CA deficit will need to be checked so
that it does not go significantly beyond 3% of GDP on a sustained basis. Nothing
can beat policy initiatives to enhance the competitiveness of the export sector.
Hopefully, the ongoing debate about the financing of the CA deficit will finally
push the government to announce measures to attract more FDI, so as to increase
the share of long-term stable investment in total capital inflows.
STRUCTURAL TAILWINDS
Cyclical economic pressures and crises – external and domestic – often raise doubts
of the robustness of the emerging India story. In the early 2000s, no one expected
the Indian economy to ever grow at twice the pace of 4.4% recorded in FY01, let
alone close to 10% growth (FY07: 9.6%). But it did, and without any big bang
reforms. Most recently, the economy was relatively resilient in the fallout of the
GFC. The collapse in growth to 6.8% in FY09 was not as severe as most people
were guessing, and the post-crisis recovery was stronger than expected.
Trend economic growth has been accelerating in recent decades, and the size of the
Indian economy will hit USD2 trillion in FY12, having doubled in a mere 5 years.
Per-capita GDP will hit around USD1,700 in FY12, up a handsome 3.6 times from
the FY01’s level (Figure 16). It would be a mistake to think that all the growth is
happening because of pro-active governments implementing aggressive reform
agendas. The real wonder is that the Indian economy is growing as rapidly as it has
been despite having to suffer the inactions of governments that excel in overpromising and under-delivering.
Capital account convertibility: Moving ahead
In recent years, India has been attracting higher market-driven private capital
inflows. This is in contrast to the pre-1991 reform period when there was a
significant reliance on official lending. This is also well reflected in the use of
external commercial borrowings (ECBs) by Indian companies in the investment
upturn from 2001-02 to 2007-08. This surge caused the Reserve Bank to
announce prudential restrictions to check the surge in ECBs. The restrictions,
which were widely criticised at the time, were actually effective in ensuring that
the adverse effect of the GFC did not cause an even greater economic and
financial downturn.
Absorbing foreign savings via different channels (e.g. portfolio, FDI, ECB,
private equity, non-resident Indians’ savings) will continue to be an important
input in India’s global rise (see India Country Report Attracting capital –
Financing India’s acceleration, November 2010). The growing financial
openness of India has been accompanied by a significant shift in the
composition of capital inflows, and the share of market-driven private inflows
has been steadily rising (Figure 22). The strong post-crisis recovery in India
ahead of the global recovery, coupled with positive sentiment of global investors
about India’s prospects, induced the revival in capital inflows. The
government’s divestment in FY11 also attracted FII portfolio inflows.
HALF-FULL OR HALF-EMPTY?
At the very outset, the attractiveness of a strong structural growth story does not
eliminate cyclical headwinds. There are three pieces that will affect India’s near-
and medium-term economic outlook: (1) cyclical headwinds; (2) structural
tailwinds; and (3) government policy. The lethargic approach of the government has
been a chronic issue, but has become more relevant in the last nine months owing to
the fallout from the corruption scandals. Ironically, the same policymakers and
politicians who admirably navigated India through the unprecedented GFC now
seem on the back foot as they tackle an assertive civil society pushing for
accountability and change.
The cyclical worries over high inflation, monetary tightening and slowing growth
are legitimate but have to be viewed as part and parcel of managing aggregate
demand, an approach that is new and still evolving for Indian policymakers.
Importantly, cyclical moderation in growth does not lower the medium-term growth
prospects. In fact, effective monetary tightening, by attempting a soft landing in the
near-term, often eliminates the need for a hard landing later on.
There is nothing pre-ordained about India’s economic rise, despite the scope for
unlocking of the structural tailwinds, which will also be affected by the pace of
reforms. Prime Minister Manmohan Singh has a choice before him: he can choose to
be remembered by posterity as the man who, as finance minister, announced pathbreaking reforms following the 1991 crisis and answered the calls for an encore this
year. Or as a shackled man now on whose watch India’s economic rise sputtered.
The eminent British economist Joan Robinson had said, “Whatever you can
rightly say about India, the opposite is also true”. That is surely the case now, as
investors once again debate the cross-currents affecting India. The fear of nothing
at all being done by the government appears exaggerated, in our view. Why?
Governments will not have a choice but to try to deliver to meet the rising
aspirations of the burgeoning size of the working-age population. Indians will be
happy to throw out governments that don’t deliver. India continues to be a glass
half-full story, in our view. Indeed, we will look back in a few years and probably
cite the current push-and-pull for playing a constructive role in the subsequent
unlocking of the India story.
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