India: A Changed Landscape

Jahangir Aziz and Gunjan Gulati, JP Morgan, Mumbai.
This article appeared in the June 2009 issue of Current Economics with permission of the author.

Key Concepts: GDP Growth | Growth Forecasts | Economic Recovery |
Key Economies: India |

About a month ago, with the market expecting a hung parliament following the May elections, investor diffidence was widespread. While some signs of recovery in the economy were emerging, they were seen as tentative and, without supportive reforms, unlikely to be sustained beyond the second half of 2009. Our view was less harsh. We held that regardless of the hue of the new government, economic reality would allow little room for policy bravado. Instead, some supportive policies and reforms would be implemented, even if halfheartedly. Growth then was expected to be around 5.2% in FY09/10 (fiscal year 2009/10) and 7% in FY10/11 with significant downside risks.

Belying pundits and polls, the Congress-led alliance won the elections easily. Equities rose sharply at the prospect of a stable government and return to reform. The return of confidence improved the investment outlook dramatically and was greeted with strong foreign inflows. Reinforcing this was the unveiling of the new government’s policy priorities, much in line with market expectations.

This improvement in market confidence has reinforced our long-held view of a recovery in the second half of 2009. The revival of the domestic investment cycle will likely be stronger such that GDP growth in FY09/10 could be around 6.2%, higher than our previous projection of 5.2%. We had factored in supportive policies and reforms in our previous projection of FY10/11 growth, thus the forecast has been raised marginally to 7.2% from 7%. However, the downside risks are now significantly lower. If reforms are implemented speedily and global environment is supportive, the upside to the FY10/11 forecast could be large. With a better investment outlook, portfolio and FDI inflows should be much stronger, as should domestic fund raising, setting in motion a virtuous feedback between market sentiment and growth.

Explaining the Upside Surprise in First Quarter GDP

The recently released first quarter 2009 GDP growth rate significantly surprised on the upside, at 5.8% (y-o-y) (measured from the supply side) against the market expectation of 5.0%. Growth in the fourth quarter of 2008 was also revised up to 5.8% (y-o-y) from 5.3%. On a sequential basis, growth momentum increased to 6.4% q-o-q seasonally adjusted annualised rate in the first quarter of 2009 from 2.3% in the fourth quarter of 2008. This brought full-year FY08/09 growth to 6.7% (y-o-y), from 9.0% in FY07/08.

A Tale of Two Economies?

From the supply side, growth was driven by construction, reflecting pre-election public works spending, and services supported by trade, and communications and financial services. Manufacturing contracted for the second consecutive quarter and agriculture grew modestly.

Measured from the demand side, GDP grew only 4.1% (y-o-y) in the first quarter of 2009, close to our estimate of 4.0%, slowing further from 4.8% in the fourth quarter of 2008. Continued strong government spending (21.5% y-o-y) was the main driver. Private consumption (2.7% y-o-y) and investment growth remained weak while exports contracted (0.8% y-o-y).

Real GDP Real GDP Growth
India real GDP Indian real GDP growth
   

The two estimates tell different tales about the economy. From the supply side, it would appear that India — in line with the regional trend — adjusted sharply in the fourth quarter of 2008 and recovered in the first quarter of 2009.

From the demand side, the economy appears to have behaved largely along the lines we have been describing previously. Breaking from the regional pattern, growth in the first quarter was lower than in the fourth quarter of 2008, as the economy adjusted to the global shock more slowly than the rest of the region, and will likely bottom out in the second quarter of 2009, beginning a recovery in the second half of 2009.

What Do We Make of This?

For the past few years, the constraint limiting growth in India has been supply factors; e.g., infrastructure shortages. So it made sense to focus on GDP measured from the supply side. But since the fourth quarter of 2008, demand has become the growth constraint as the global economy fell into recession.

Separately, India’s GDP estimates have been prone to significant revisions. The margin of such revisions tends to be largest when the economy either slows down sharply or picks up abruptly. For example, in the 2000-01 downturn, the official forecast overestimated GDP growth by 1.6% points, while in the 2005-06 upturn growth was underestimated by 1.3% points. For these reasons, we expect FY08/09 GDP growth to be eventually revised down closer to the demand-side estimate of 6.1%.

The disparate tales of the economy do not materially alter the economic outlook in the changed environment. What it could affect is the policy stance. If one has more faith in the supply side, then the case for continued large monetary and fiscal stimulus is much weaker, than if one believes the demand side estimates to be more accurate. We believe that policymakers will likely take the middle road, with stimulus forthcoming (more on this later) but less than expected earlier, especially given the much stronger growth outlook.

A Recovery Reinforced

Growth. India’s 9% average growth over 2003-07 was driven by investment; this pattern is likely to continue in the coming years. When and how the investment cycle turns up will also drive growth. The return of market confidence, an expected rise in infrastructure spending, much better fund-raising conditions, and further opening of sectors to foreign ownership will likely result in a stronger turnaround in investment. We still do not expect private consumption or exports to revive sharply, and believe that government consumption growth will be less because of a smaller fiscal stimulus. Taking these separate effects into account, we expect growth in the second half of FY08/09 to be up sharply sequentially, delivering FY09/10 growth of 6.2%.

Inflation. Despite the faster growth, the output gap will remain markedly negative at least through the first half of 2010. Thus, demand side pressure on inflation will be weak, and inflation will continue to be low. On the other hand, India is vulnerable to the global commodity cycle, through food, fertilizer, and energy prices. If the cycle turns up sharply, especially if oil prices spike, then supply side pressures on inflation could be large. That said, we do not expect oil prices to jump sharply in a sustained manner, so the rise in inflation, if it does take place, is likely be less than in the April-August 2008 episode. For FY09/10, we expect wholesale price index (WPI) inflation to average 1.5-2%, ending the year at around 5.5%.


Differences in supply and demand side GDP estimates Inflation in the current cycle
Supply and demand side GDP estimates for India Inflation cycle in India
   

Capital flows and Indian Rupee (INR). The largest impact of the changed economic landscape, we believe, will be on the balance of payments. Earlier we held the view that capital account dynamics would be subdued and exchange rate (INR) movements determined by current account dynamics. On the current account, exports were expected to remain weak, but lower oil prices and non-oil imports reflecting slower investment demand were expected to sharply shrink the deficit (CAD), providing modest support to the currency.

Now, the current account-capital account relative dynamics are likely to change markedly. The return of portfolio inflows is expected to continue as long as the reform agenda does not come to a sudden halt. Foreign direct investment (FDI) inflows should strengthen, reflecting improved investor confidence. As a result, the capital account balance should turn strongly positive. The CAD is still expected to shrink, but less sharply. Export growth is likely to be weaker, given the sustained contraction so far, while imports should pick up faster given the stronger revival in the investment cycle. Importantly, the upturn in the capital account is likely to take place earlier than the widening of the CAD, which is likely to be quite small, given the sharp decline in the trade deficit so far this year. Consequently, the INR will face upward pressure, especially in the next three to six months, before a higher CAD exerts offsetting downward pressures. We expect USD/INR to appreciate in the second half of 2009 and stabilize thereafter accounting for likely central bank interventions.


Balance of payments
Indian balance of payments
   


Bank Credit and Lending Rates. Bank credit has been slowing in the last few months from 31% (y-o-y) in October 2008 to 16% (y-o-y) in May 2009. Sequentially, credit offtake has turned negative since April. The slowdown has elicited a lot of hand wringing, especially in policymaking circles. In our view, the slowdown is consistent with weakening activity and guards against unwarranted increases in non-performing loans. However, the situation is likely to change, as the investment cycle picks up in the second half of FY08/09. Lending rates have softened and are likely to decline further, especially as alternative cheaper sources of funding open up for corporates (CP and AAA rates have fallen considerably more than bank prime lending rates). While deposit rates have also declined and continue to do so, the decline will likely be less than for lending rates, squeezing banks’ interest margins. The impact on profitability could be mitigated by a pickup in credit volume. We expect credit growth to increase as the economy recovers, nearing 20% (y-o-y) in the second half of FY08/09.

Reform Agenda and Policy Stance

The new government’s policy priorities, as laid out in the President’s recent address to the parliament, largely reflect its election promise to deliver “inclusive growth,” balancing growth and equity considerations. While specifics have not been laid out yet, the main areas of focus are maintaining fiscal prudence, divesting public sector units (PSUs), expanding infrastructure, encouraging foreign direct investment, and restructuring the health care and education systems. Financial sector reforms were not explicitly mentioned, but they will also likely form part of the agenda. In keeping with its election manifesto, the government also expanded a number of social programs, including making provisions to provide subsidized rice and wheat to those below the poverty line. Several measures are also planned to enhance transparency and accountability.


Commercial credit Nonbank borrowing rates for corporates
Commercial credit in India Corporate borrowing rates in India
   

Medium-Term Growth. Much of the impact of these reforms will be felt over the medium term. In particular, these should strengthen medium-term growth by better utilizing India’s demographic advantages of an increasing working age population, a growing middle class, and a high saving rate. It is difficult to ascertain the quantitative impact on headline growth in the absence of reform details. But if implemented efficiently, these reforms should reduce the downside risks to a medium-term growth path averaging 8%.

FY09/10 Budget and Rates. As its first order of business, the government will present the full-year FY09/10 budget in early July (since April public finances have run on an interim budget). The budget will likely balance further near-term fiscal support with medium-term consolidation. We expect the budget to target a deficit of 7% of GDP (including noncash subsidies) against the interim target of 6%, lower than our previous expectation of 8%, as the government is likely to consider providing a large stimulus less pressing.

The changed political landscape allows the government more financing options to limit market borrowing. Divestment now appears well established on the agenda. The government could also increase limits on foreign holdings of Treasury bonds. Despite these measures, the possibility of bond rates stabilizing at the long end are high, especially as government borrowing will likely coincide with a revival in private credit growth.

Two years of high deficit will raise concerns about debt sustainability, as total government debt could breach 85% of GDP by end-FY09/10. There is also the potential of a high price tag for the new and expanded social programs and a rise in defense spending, given geopolitical uncertainties. We continue to expect the government to put together a medium-term consolidation plan, including reforms to the fertilizer and fuel subsidy policies, a new fiscal responsibility act, a national goods tax and continued divestment. Of these the major bottleneck appears to be the lack of sufficient political support for subsidy reforms, especially for fertilizer.

Monetary Policy. We continue to believe that the Reserve Bank of India (RBI) will likely cut rates another 25bp in the near term. The continued contraction in non-oil imports and weak credit growth could prompt the cut. Beyond this, the central bank will likely take a breather, allowing fiscal policy and structural reforms to provide support to growth.

A marked pickup in capital inflows could complicate monetary policy. Interventions to smooth rupee appreciation will inject additional liquidity into an already flush system. This should be consistent with the RBI’s stated policy to keep monetary conditions easy for an extended period, unless inflation picks up markedly. As discussed earlier, demand side pressures on inflation appear unlikely given a recovering but still soft economy. But a sharp upturn in oil prices could exert supply side pressures that could induce a rise in generalized inflation. This could force the RBI to tighten policy prematurely exerting upward pressure on interest rates and complicating the management of the government borrowing program.

Risks to the Outlook. A premature increase in lending rates is the biggest near-term risk. India’s investment cycle over the past few years has been largely driven by the change in cost of capital. If this rises, investment could be held back, jeopardizing the recovery.

Over the medium term, a slowdown in the reform efforts remains the main risk. This could be forced by India’s electoral cycle; several key provinces face elections in 2012.

Yield curve Real interest and growth
Yield curve on Indian bonds Real interest rate in India
   
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