Growth in the Indian economy has stabilized but at a rate well below the economy’s long-run potential. India is due to report its third quarter GDP numbers next week, and they are likely to show the economy expanded by a little more than 5.5% yoy, roughly the same as in the first two quarters but substantially below where GDP was 12 months ago. This underscores the economy’s challenges, and it will be awhile before GDP growth is back at its trend rate. Our outlook is for a steady upturn in growth across the coming quarters before growth finally hits potential by the second half of 2014.
Recent data unspectacular
Recent economic data have been broadly in line with expectations. The corporate sector remains the weakest pocket of the economy, with sentiment weighed down by external weakness and, more important, the Congress-led government’s cack-handed management and policymaking in its second term. Production of electrical machinery, which is tightly linked to the capital expenditure cycle, fell 29% yoy in the year to September. Both imports and local production of capital goods are declining, reflecting weak business confidence and flat corporate investment.
Consumer demand continues to tick over at a steady but unspectacular rate. Production of consumer goods fell 0.2% yoy across the September quarter, while imports of consumer products such as electronics and leather goods are in mild decline. Overall, industrial production was a little better in the three months to September. This, along with some slightly better trade figures, lifts our third quarter
GDP forecast above that from the June quarter, but not by much, and anything with a “5” at the front of it must be considered disappointing.
Reform bounce is fading
The initial bounce in investor sentiment following the announcement of Prime Minister Manmohan Singh’s Big Bang of economic reforms has faded, and the reality of India’s deep-seated structural problems has begun to set in. Financial markets surged in the two months to October as the reforms were announced and it became clear the prime minister would follow through, with the Sensex rising 15% and the rupee up 8% against the U.S. dollar. The Sensex has dipped in recent weeks, largely mirroring global markets, while the currency has given back most of the recent gains.
Singh faces a bruising battle at the winter session of parliament. The opposition Bharatiya Janata Party has planned a day of protest, while Trinamool Congress, which recently withdrew from the government’s coalition, has promised a vote of no confidence once parliament returns. This may turn out well for the government. If the motion succeeds, parliament will dissolve, triggering an early election and a new government probably led by the BJP. But if the motion fails, as seems likely, it could help to fortify the government’s position at the expense of Trinamool’s obstinate but effective leader, Mamata Banerjee. That could provide a platform for fruitful policymaking during the last two years of Singh’s tenure as prime minister.
Slightly lower risk
The low-probability risk of an early election notwithstanding, the biggest impact of the recent burst of government policy formation has been to lower two of the biggest risks facing the Indian economy. The reforms will have little near-term economic impact but are positive, as they help to mitigate risks around both the fiscal and external deficit and shore up the economy’s long-term prospects.
The government’s initial projection for the 2012-2013 fiscal year was for a budget deficit around 5.1% of GDP, but this was predicated on an unrealistic GDP growth projection of 7.5%, putting the shortfall in danger of blowing out to 7% or 8%. With the government’s recent moves to lift diesel subsidies and privatize state-owned industries, the final deficit will be close to 6% of GDP, still uncomfortably high but manageable, with improvement expected from 2013 to 2014.
The blowout in the government budget, along with the slowdown in export demand, has pushed the current account deficit to dangerous levels. Recent moves to curb the budget deficit should help to narrow the shortfall, but more important is the shift in rules around foreign investment and retroactively taxing mergers and acquisitions transactions—negative for investor sentiment—which will make it easier to finance the shortfall. The rising rupee reflects abating concerns over how to finance this external deficit.
A better long-term outlook
The government reforms have materially lowered risk but will do little to support economic growth over the next two years. Our mediumterm outlook remains unchanged. Growth will stabilize at 5.5% to 6% across the second half of 2012, and there is little on the horizon to lift growth from current rates.
The Reserve Bank of India is squeezed between weak economic growth and elevated inflation. Following an initial rate cut in April, the RBI held fire on rates over inflation concerns, although it has cut reserve ratios to ease liquidity. This is unlikely to change much in the near term.
Cuts to fuel subsidies lifted October consumer prices and have begun to show in the closely watched wholesale price measure. The government has been leaning on the RBI to ease borrowing costs. Eventually the bank will comply, but it probably won’t be until 2013, perhaps once wholesale price index inflation starts to fall again.
Like much of Asia, the Indian economy is near the bottom of the current cycle. We see a steady acceleration beginning in the first quarter of 2013 as rising business confidence and a stable global outlook drive a cyclical upswing in demand. This washes out to GDP growth of 5.2% this year and 6% in 2013 before returning to its long-run potential in 2014.
Our forecast has not changed, despite the government’s positive moves, but we are more confident in the outlook, particularly over the next five to 10 years. India’s long-run potential growth is 7% to 7.5%, driven by the country’s favourable demographics and productivity convergence. But this is not a fait accompli. It needs the right policies in place and a friendly environment in which to do business, both of which have eluded India recently.
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