India is experiencing interesting times. A year ago, the country was classified as one of the so-called ‘fragile five’, as weak fundamentals (including large external deficits) made it vulnerable to Fed tapering-related EM concerns. However, prudent monetary policies and gold import restrictions have helped sharply reduce the current account deficit. Moreover, the clear victory of Narendra Modi and his Bharatiya Janata Party (BJP) at the May elections has brought fresh hope for reducing the policy paralysis and implementing key reforms. And indeed, economic growth started to accelerate in Q2. All in all, India’s prospects have improved compared to a year ago and the country has maintained its investment grade status. Still, twin deficits leave it vulnerable to shifts in market sentiment. Hence, prudent macro-economic policies and real reforms remain key to mitigating the risks from, for instance, faster-than- expected Fed tightening.
Post-election optimism has spurred economic growth
In the slipstream of political dynamism, economic growth has gained momentum. Real GDP growth rose to 5.7% yoy in Q2, the highest pace since Q1 2012. The acceleration was broad-based, with exports, public spending and investment all firming. Exports also picked up in recent months. Although imports have also recovered reflecting a strengthening of domestic demand, the growth contribution from net exports has increased. Meanwhile, industrial production strengthened in Q2, expanding by 3.9% yoy compared to an average contraction by -0.5% yoy in Q1. The forward-looking Manufacturing PMI also points to improving growth dynamics. The index slipped somewhat in August (52.4), but remains much higher than the levels of late 2013, suggesting that the manufacturing sector has picked up steam driven by increasing (domestic and external) orders. We expect growth to remain at similar levels in the coming quarters, with full-year growth in 2014 estimated at 5% (fiscal year 2014-15: 5.5%).
Will the new government deliver on reforms?
The convincing victory of PM Narendra Modi’s BJP at the May elections (with the National Democratic Alliance currently holding 62% of the seats in parliament), has raised hopes that the policy paralysis of the past years will come to an end. However, despite the post-election euphoria, the new Modi-government still has to show how serious it is about reforms. Improving the labour market, fighting corruption, reducing the extensive bureaucracy and opening up sectors are key to making India more attractive to foreign investors. So far, the government has announced certain piecemeal measures, such as loosening FDI regulation in the insurance, defence and railway sectors. However, it has so far taken a more cautious approach to politically more sensitive issues such as cutting energy and railway subsidies further, as is also illustrated by its refusal to sign a WTO agreement in August. Moreover, within India’s federal system, state governments will continue to play an important role. Over the next six months, elections will be held in several important states. If the ruling coalition wins these elections too, it would further facilitate the decision- making process. Certainly in that case, we expect the government to cautiously introduce wider reforms, although we still have to see whether those will be comprehensive enough.
High inflation forces the RBI to remain prudent
In early 2014, the Indian central bank (RBI) decided to use consumer prices (CPI) instead of wholesale prices (WPI) as the key measure for inflation. After surging in late 2013 spurred by currency weakness, both measures have fallen since. However, at around 8% yoy, CPI remains high, while the effects of a dry monsoon season will likely keep headline inflation elevated in the coming months, forcing the RBI to remain prudent. In the summer of 2013, India – as one of the so-called fragile five – was severely hit by Fed tapering related market concerns, also reflecting its external vulnerabilities. The RBI, under the leadership of former chief IMF economist Rajan since September 2013, took decisive action by raising the main policy rate by 75 bps, to 8% in January 2014. Although market sentiment has improved and inflation has fallen somewhat compared to late 2013, the RBI has since remained on hold. This reflects its commitment to reducing CPI inflation to 8% by January 2015 and to 6% by January 2016. With inflation expected to hover around 8%, we expect the RBI to stay on hold until at least the end of this year and probably longer. However, should inflation increase further and/or should India be hit by market turmoil related to a faster-than-expected Fed exit, the RBI may probably hike rates further.
External deficit has fallen sharply
The fact that India was hard hit by market turmoil last year was largely due to its large current account deficit, peaking at 7% of GDP in late 2012. However, the current account deficit started to fall in the course of 2013. Moreover, between May 2013 and August 2014, FX reserves have increased significantly. The improvement of the external position has been driven by the introduction of import restrictions for gold in combination with monetary tightening. Gold is India’s second-most important import item, after energy and India is the world’s second-largest gold importer, after China. In mid-2013, import duties on gold were raised to 10%. The government also introduced a 20% re-export measure, transaction taxes and restrictions on ETF buying. Market participants initially expected the new government to ease gold import restrictions in the run-up to the autumn wedding season. However, at its July budget presentation the government left the restrictions in place. Although the current account deficit has come down significantly, it is still meaningful in GDP terms (we expect a 3% of GDP level in the current year and the next). Given also other external financing risks (see below), we expect the authorities to maintain the gold import restrictions in the coming year (see also ABN AMRO Gold Watch, Upcoming auspicious season, 1 September 2014).
India remains vulnerable to faster Fed exit
India is generally believed to have “graduated” from the fragile five as its vulnerabilities have fallen over the past year, which is also illustrated by financial market developments. During last year’s Fed-tapering related market stress, the Indian rupee faced heavy pressure, depreciating by around 25% versus the USD in the period May-August 2013. However, since then the rupee has regained more than 10%, being among the best performing EM currencies. This recovery was supported by India-specific factors (policy measures, falling external deficits), but also by a general improvement in market sentiment versus EMs. Meanwhile, the post-crisis correction of the 10 year government bond yield has been relatively modest, partly reflecting India’s large fiscal deficits (around 5% of GDP). All rating agencies have kept India in (the lowest) investment grade category during this period, although S&P has a negative outlook. All in all, India’s vulnerability to external shocks has fallen over the past year. Still, taking into account its twin deficits on the current account and the budget, we feel that India remains vulnerable to abrupt reversals in market sentiment triggered for instance by a faster-than-expected Fed tightening.
Adjustment of USD/INR forecasts
We have lowered our 2014 year end USD/INR forecasts from 63 to 62, as investment sentiment has improved and the RBI has rebuilt its FX reserves to defend potential volatility in the currency. However, given the prevailing external financing risks mentioned above, the INR remains vulnerable to tighter monetary policy in the US. Consequently, we maintain our view that the INR will continue to underperform the USD towards 64 in 2015.