India: On the right path

by: Maritza Cabezas

131209 - India Watch - On the right path ()

There have been some upward surprises in India lately. Third quarter GDP data was better than expected at 4.8% up from 4.4% the previous quarter. We expect a modest lift in growth to 5% in 2014 up from 4.5% in 2013. Stronger external demand and private investment under a strict fiscal consolidation should support the recovery. As for the impact on India of the Fed starting to taper, markets have largely priced in this adjustment, while the fiscal and current account deficits have improved. It may be, however, too soon to claim victory as upcoming May general elections could cause some volatility.

After a rollercoaster ride in the summer, India has lately been showing signs of recovery. Policymakers’ action to reduce the impact of the summer’s turmoil went a long way, including rising-long term yields, but monetary authorities have started unwinding these measures, while nevertheless continuing to keep a close eye on inflation. At the same time, sturdy steps have been taken to reduce the current account deficit and improve the fiscal balance. It may still be too soon, however, to claim victory on these fronts, while India is also not yet free of external pressures. As the US economy shows signs of gaining strength and the tapering debate resurfaces, India will remain vulnerable to investors’ mood swings.

India’s plus points

One of the sources of vulnerability, the current account deficit, is moving in the right direction. The deficit for the quarter ending in September narrowed to 1.2% of GDP, from 5% the previous quarter. Stronger export growth accounted for part of the improvement in the trade balance, while gold restrictions also helped to suppress imports significantly. The slowdown in economic activity also contributed to lower oil imports, with the result that the trade deficit fell to a 20-month low in September. Further improvements in the current account will depend on the pass-through effect of the currency depreciation (11% since January 2013) and the strength of the global recovery. We expect these potential improvements to materialize, given our positive outlook on global trade. Capital outflows have meanwhile been stabilizing. Although bond investments by foreigners, for instance, fell substantially during the turmoil in the summer, foreign direct investment held up relatively well, and strong inflows of foreign currency deposits held by non-residents partly offset the outflow of short term capital. As a result of this and the general improvement in sentiment the Indian Rupee has recovered and has outperformed other emerging market countries that were affected during the summer.

As for GDP, India’s third-quarter growth came in at 4.8% yoy, compared with 4.4% the previous quarter. Growth in manufacturing and agriculture rose, while export growth gained strength. Services growth weakened, however, due to lower consumption. Private investment will be key to supporting the recovery. There are several large-scale projects in the pipeline, and funding them with foreign direct investment would be preferable. India’s PMI, a forward-looking indicator, improved significantly, rising to 51.3 in November from 49.6 the previous month. India’s manufacturing sector contributes with more than a quarter to total GDP. This together with higher rural wages and stronger consumption are supportive for economic activity in the coming quarters.

Challenges ahead

Inflation is one of the main concerns in the Indian economy. October’s wholesale price inflation increased to 7% from 6.5%, while consumer price inflation came out at just above 10% (was 9.8% previously). The Reserve Bank of India (RBI) has shown that combating inflation remains a priority. Even though growth remains weak, inflation has been rising and is now at a level considered dangerous by most central banks. Food price inflation has been the main driver, and tackling this component will not be easy. Monetary authorities have the difficult task of reversing. As a result, and irrespective of any action taken by the RBI in upcoming monetary policy meeting in December, we expect monetary conditions to remain tight as the central bank seems keen on reinforcing its inflation-fighting credibility. We do not, however, expect a rate hike this year. In 2014, we think that monetary tightening will continue and that this will only be effective if accompanied by fiscal tightening.

The government’s fiscal deficit of 4.8% of GDP is another point needing attention, particularly since India is facing elections in May 2014 and a large share of projected expenditure has already been spent up until the month of October. Moreover, in a context of weak economic activity lower fiscal revenues are not unlikely. Although the government remains committed to fiscal consolidation, this will be a test of its resolve since the Indian electoral cycle is usually accompanied by higher than usual levels of fiscal spending. The clearest sign of commitment will probably be if the government is able to strengthen its fiscal accounts for a second year in a row.

Finally, we expect the Fed to start to taper its asset purchases by March. India is, however, moving in the right direction in reducing its current account and fiscal imbalances and its stocks are soaring, while US Treasury yields have largely adjusted to tapering. As a result we don’t expect the impact to be as large as in the summer of 2013. It is also true that uncertainty surrounding the general elections in May 2014 could harm investor sentiment. The ruling United Progressive Alliance coalition has been hurt by multiple corruption scandals. Mr. Gandhi, the front runner to lead the party, has limited accomplishments as vice-president of Congress and many claim that he lacks a clear vision for his party. In contrast Mr. Modi who was named the candidate for the Bharatiya Janta party in September, representing India’s Hindu nationalist opposition, has gained significant popularity in the past months and is perceived as a reform-minded leader. Indeed, Sunday’s state elections provided a boost to Mr. Modi. His success, as chief minister of the state of Gujarat for more than a decade is seen as positive for India’s political future. If Mr. Modi’s strategy implemented in Gujarat, with strong industrial and agricultural sectors, could be exported across India then this would be a success.