India’s growing pains: marking down FY12 GDP growth ::JPMorgan

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India’s growing pains: marking down FY12 GDP growth

RBI’s newfound aggressiveness in combating inflation is likely to result in more monetary tightening than was originally anticipated This, in conjunction with policymakers’ stated resolve to ensure the targeted fiscal consolidation is achieved, suggests the tolerance of inflation among policy-makers is lower than was presumed in some quarters A more aggressive domestic policy response to combat inflation and ever-increasing downside risks to global growth have led us to mark down India’s FY12 GDP growth forecast A slow-down of activity was evident in 2Q11 and growth is likely to decelerate further below trend for the remaining quarters of 2011 However, high capacity utilization rates and resulting capacity constraints across several sectors of the economy, could lead to an up-tick in investment and growth in 2012 Marking down FY12 growth as downside risks intensify   For a while now our GDP growth forecast for the coming fiscal year (FY12) has been lower than that of policymakers and many market participants. With the FY12 budget effectively proposing a very large withdrawal of fiscal stimulus (not apparent in the headline numbers), inflation remaining more stubborn that most thought, and risks to global growth tilted to the downside, we had been forecasting growth to print a shade below 8% oya. Equally important, however, we had highlighted that the risks to that forecast were tilted firmly to the downside.   These risks have intensified over the last few weeks. While inflation has remained stubbornly elevated, as was expected, the RBI -- in a marked departure from its calibrated approach of the past – has adopted a more aggressive stance, raising rates by 50bp twice in the last three meetings and indicating that it will keep acting until inflation moderates on a sustainable basis, even if near-term growth were to suffer as a consequence.   This, in conjunction with rising global risks and the stated resolve of policy-makers to ensure that the domestic fiscal slippage is minimal, has induced us to mark down our FY12 GDP growth forecast to 7.6%oya from 7.9%, an appreciable slowing from the 8.5% levels witnessed last year. We believe growth will have to slow to about these levels if the economy is to let off enough steam and inflation is to moderate to about 7% by March 2012 – a trajectory that policy-makers are targeting.   Sequentially, we expect growth to moderate significantly for the first three quarters of this fiscal year as the impact of the fiscal and monetary tightening increasingly takes hold. However, with capacity constraints continuing to bind across various sectors, we expect investment demand could tick up in 2012 once inflation abates, growth has bottomed out, the rate cycle has peaked and macroeconomic stability returns.       RBI changes course: shocks markets again to signal it means business   We have long been pointing out that inflation is likely to remain more elevated and sticky than many policymakers and market participants had expected. This was essentially because the drivers of Indian inflation were misread with most assuming that this was the consequence of an unfortunate series of supply shocks, which would reverse.   Instead, as we have repeatedly emphasized, it has been the consequence of loose fiscal and monetary policy post the 2008 global financial crisis pushing the economy to grow beyond its capacity. This is reflected in the fact that inflation has remained above 8% for 19 consecutive months, with core inflation replacing food as a key driver of the headline rate.   Furthermore, inflation is likely to accelerate further for the next few months as the full impact of the recent increase in energy prices flows through, expectations remain high leading to a wages-price spiral, and generous increases in minimum support prices for key agricultural commodities put a floor on food inflation even in the event of a normal monsoon this year.   All this was well known. What is new, however, is the RBI’s aggressiveness. The central bank first changed course and raised rates by 50bp in its May policy review, but markets still viewed this as an aberration rather than a mid-course correction. As a result, when June inflation accelerated to 9.4% from 9.1% the previous month, short rates actually rallied as the market increasingly convinced itself that monetary tightening was coming to a close even as inflation continued to accelerate!   It therefore took another 50 bps hike in July by the RBI to shock markets and signal it meant business. Further, it explicitly indicated that its stance would only be changed by a “sustained” moderation of inflation. More importantly, the RBI has repeatedly acknowledged in recent months that growth will need to slow, and slow enough to significantly reduce producer pricing power, for inflation to asymptote to more acceptable levels.   Viewed from this standpoint, more needs to be done. While the PMI, for example, fell sharply for a second successive month in July, what was revealing in that survey was that output prices continued to rise and producers still retained pricing power.   Given all this, we have increased our policy rate forecast to 8.5% from 8% by the end of 2011. The risk, if any, is to the upside with more rate hikes if inflation remains above the RBI’s comfort zone.     Fiscal consolidation broadly on track   Often missed in the growth discussion is the fact that fiscal policy is programmed to result in a significant withdrawal of stimulus this year, and will serve as a non-trivial drag on growth. The headline numbers are misleading: the fiscal deficit is budgeted to fall marginally to 4.6% of GDP in FY12 from 4.7% last year. Net of asset sales, however, this will result in an effective fiscal consolidation of 1.3% of GDP—the largest tightening in two decades.   Most in the market are expecting significant fiscal slippage – to the tune of 1% of GDP. We believe otherwise. Tax revenues are expected to exceed budget targets as inflation remains stubbornly high and nominal GDP therefore again exceeds budget targets. This, in conjunction with the fact that policymakers seem determined to keep the slippage small (offsetting some subsidy slippages with cuts in other areas), makes us believe that the aggregate fiscal slippage will be limited to 0.3%-0.4% of GDP. This along with the fact that the bulk of the consolidation occurs through expenditure compression (the multiplier effect of which could be large) should serve as a significant drag on growth. However, this was built into our original forecasts, and the fact that the consolidation is on track does not bias our revisions in any direction.   Over-estimating policymakers’ tolerance of inflation   While many in the market rationalized the elevated inflation over the last 19 months as a series of supply shocks over which monetary policy had no influence, some others interpreted it to mean that perhaps policymaker’s tolerance of inflation had risen in recent years as growth remained strong and a number of safety nets (e.g. the rural unemployment guarantee scheme) came into place.   That thesis has been significantly undermined by the policy response in recent months. The RBI turning more hawkish and policymakers seemingly determined to ensure that any fiscal slippage is small suggests that the tolerance of inflation is far less than markets had presumed. The implication is that unless inflation begins to approach more acceptable levels, the tightening will continue.   What is encouraging to note is the increasing acceptance that growth will need to slow to reverse inflationary pressures and expectations, and that a moderation of short-term growth to restore macroeconomic stability is a key prerequisite to safeguarding medium term growth. This is an important departure from policymakers’ approach last year and underpins our lower growth forecast for this year.   Global growth softens and uncertainty rises markedly   Unsurprisingly, another reason for downgrading India’s growth forecast has been a significant reduction in global growth forecasts for 2011. Specifically, global growth is now expected to print at 2.8%, significantly below the 3.3% projected a few months ago. More worrisome, global uncertainty has risen markedly in the last few days, and growth risks are firmly to the downside.   To be sure, the global slowing has not dampened India’s surging exports just yet. But a sustained slowing of new export orders within the PMI, for example, suggest that global weaknesses are eventually likely to restrain export growth.   It is important to note that the policy response to growth disappointments in DMs are also crucial to policy and activity in India. If, for example, slow growth induces more monetary accommodation in DMs causing commodity prices to rise further, inflation in India could remain even stickier and necessitate correspondingly more rate hikes and demand destruction domestically.         Growth to slow sequentially in 2011...   Signs of a slowdown were already clear in the first quarter of this fiscal year (2Q11) with a variety of high-frequency indicators including IP, motor vehicle sales, credit growth, and PMI beginning to moderate. We expect this moderation will become even sharper as the year goes on and the previous rate hikes begin to bite further and the RBI perseveres with more monetary tightening. Furthermore, the impact of the fiscal tightening is expected to be felt only in the latter half of 2011 as government spending slows sharply in the coming months. Finally, exports likely propped up growth in the first quarter of the fiscal, but are expected to moderate as the year goes on. For these reasons, we expect growth to fall-off to about 7% in 4Q2011. Sub-trend growth for the first three quarters of the fiscal year should let off sufficient steam such that inflation peaks in 3Q11 and then gradually begins to moderate.     As regards the components of demand, we expect private consumption growth to moderate to 7.3% from 8.6% last year. Consumer durables have fallen off sharply in response to the monetary tightening and are expected to slow further. In contrast, however, rural consumption – much less sensitive to interest rate changes – is expected to remain buoyant as the transfer of purchasing power to the rural economy will continue through wage indexation in the government’s unemployment insurance program (NREGA) and generous increases in minimum support prices promised to farmers. Domestic consumption therefore is not likely to abate by as much as the quantum of rate hikes would suggest         …but investment could tick up in 2012   In contrast to buoyant consumption over the last year, gross capital formation slowed appreciably last year as stubbornly high inflation, heightened policy uncertainty, and the prospect of a hard landing deterred investors. More generally, relatively anemic investment levels since the global financial crisis meant that by 1Q2011 capacity utilization levels climbed to their highest level in three years and capacity constraints are increasingly binding across sectors.   It is, therefore, likely that once inflation peaks later in 2011, growth troughs, the rate cycle peaks and macroeconomic stability returns, these capacity constraints could induce a meaningful pickup in fixed investment and growth in 2012.