India Watch – New GST should support long-term growth

by: Arjen van Dijkhuizen , Georgette Boele

  • Economic growth has slowed post demonetisation …,
  • … but we expect India to remain fastest growing emerging giant
  • Flagship GST reform per 1 July should be beneficial for long-term growth
  • With inflation dropping to record low, we now expect 25-50 bp of rate cuts
  • We change our end-2017/18 USD-INR forecasts to 64.5 and 64.0


170704-India-Watch.pdf (508 KB)

Economic growth fell to 6.1% yoy in Q1, lowest level since Q4-2014

Over the past quarters, economic growth has been on a declining trend. Real GDP growth fell to 7.0% yoy in Q4-2016 and dropped to a 2.5 year low of 6.1% yoy in Q1-2017. That also meant that Indian growth in Q1 was lower than Chinese growth for the first time since Q4-2014. The slowdown was accelerated by the ‘demonetisation’ that took place at the end of 2016. In an aim to fight the informal economy, the authorities replaced the two biggest denomination banknotes. Almost 90% of cash was taken out of circulation. The cash crunch was aggravated by the fact that the injection of new banknotes was constrained by some technical and infrastructural bottlenecks.


… as the effects of demonetisation have kicked in, investment particularly weak

Still, the slowdown in Q1 to 6.1% yoy was more severe than expected, suggesting that it has taken some time before the demonetisation showed its full impact on the economy. The impact of demonetisation may not have been accurately measured though, given ongoing GDP revisions. Looking at the composition of GDP, private demand was under pressure in Q1. That is particularly true for fixed investment, which fell into contraction territory (-2.1% yoy). Note that due to weak investment growth in recent years, India’s investment to GDP ratio has fallen and is significantly below the level of key Asian peers. Private consumption moderated as well (to 7.3% yoy), but remained strong. Meanwhile, net exports also contributed negatively to growth, as the acceleration of exports (+10.3% yoy) was compensated by an even stronger pick-up of imports (+11.9% yoy). The cooling of private demand was partially offset by a surge in public consumption, which was up by 32% yoy. On the supply side, construction did particularly weak in Q1 (contracting by 3.7% yoy), being hit relatively hard by demonetisation. Financial (including real estate) services growth dropped to a six-year low of 2.2% yoy in Q1.

We expect growth to improve, India to become fastest growing giant again

The development of the manufacturing PMI was not very promising either. The index collapsed immediately after the currency clean-up, recovered in subsequent months but has started to fall again in the past two months (to 50.9 in June). Other recent indicators have been a bit more hopeful. Growth of car sales has been solid in recent months. Industrial production has picked up to 3.1% yoy in April. Although the pick-up in global trade and growth is bringing more dynamism in the trade-related sectors, import growth has outpaced export growth by a wide margin in recent months. All in all, despite the stronger than expected slowdown in Q1, we are still of the view that the impact of the currency-clean up will fade. After dropping to 7.1% in FY 2016/17, we expect Indian growth to return to 7.5% in FY 2017/18 and FY 2018/19. As we project China’s gradual slowdown to resume (with growth falling to around 6.5% in 2017 and around 6% in 2018), we expect Indian to regain its status as fastest growing giant.

Introduction of flagship uniform Goods and Services Tax …

The government’s flagship reform, the uniform Goods and Services Tax (GST) was rolled out on 1 July. The new GST replaces all indirect taxes on goods and services levied by central and state governments. This should create a single indirect tax system, supporting a common Indian market. The new GST should also strengthen the tax administration, broaden the government’s revenue base and improve tax enforcement. It should bring a reduction in the overall tax burden on goods, currently estimated at 25-30%. Another advantage is that the GST should reduce paperwork and support the free movement of goods from one state to another (currently transporters of goods lose hours at state borders to pay taxes).

… could create short-term problems, but should be beneficial for long-term growth

That said, the new system is still complex with a large number of different tax groups remaining. On the short term, the change-over to a new tax system could prove to be problematic, particularly for smaller, not so well organised firms. The ‘anti-profiteering clause’ and the set-up of an ‘anti-profiteering agency’ presented by Finance Minister Jaitley aims to force companies to pass on benefits of lower taxes to consumers. These plans help limit inflationary effects from GST, but could also create more bureaucracy. Still, in our view, over the longer term the GST reform should contribute to a more efficient and transparent tax system, supporting economic growth. It could help improve India’s business climate further and support domestic and foreign investment.

Tackling the NPL burden could help support investment growth as well

The NPL burden in the Indian banking system is a key factor behind weak lending and investment growth. The bulk from these NPLs stems from the credit boom that originated before the Modi-government came into office in 2014. The sheer size of the problem was not really recognised before the RBI started an Asset Quality Review (AQR) in 2015. The NPL ratio has risen to around 10% currently, about three times as high as in early 2013. The government has started various initiatives to tackle the problem, but these were not really successful as the state-owned banks concerned could not take haircuts or sell assets at a loss. More recently, the government has granted the RBI more powers to deal with the bad loan problem. The RBI is now entitled to enforce insolvency proceedings for stressed corporates. This makes it more difficult for minority stakeholders to block a restructuring deal. As the RBI is now in the driver’s seat, the prospects for resolution of the NPL problems have improved, although such resolutions will bring fiscal costs as well.

… although this comes with risks of fiscal slippage

Public finances have been on a slowly improving trend. The central government’s budget deficit has been reduced from almost 6% of GDP in 2011 to 3.5% of GDP in 2016. As a result, the debt ratio of the central government has stabilised around 52% of GDP. However, there are contingent liabilities related to the NPL clean-up. According to rating agency Fitch, total capital injections needed to get Indian banks Basel compliant by 2019 is around USD 90bn. That is a much higher than the government is prepared to allocate so far. In addition, farm-loan waivers granted by several states to ease the post-demonetisation pain also pose risks to state government finances and could undermine efforts to reduce overall government debt over time, according to Fitch.

Inflation has fallen sharply in recent years, reaching a record low in May …

After fluctuating at high levels (between 8-12%) from mid 2008 until mid 2014, Indian inflation has fallen sharply in recent years reaching a record low of 2.2% yoy in May 2017. The improved inflation backdrop stems from a couple of factors. An important factor has been the drop in energy prices, as India is one of the largest net oil importers. A second factor is the strengthening of the monetary policy framework initiated by former Governer Rajan. In June 2016, the Reserve Bank of India (RBI) formally adopted flexible inflation targeting, defining price stability (in terms of a CPI target) as the primary objective of monetary policy. The current target is 4% (plus or minus 2%). The third factor, partially related to the second one, has been the strong performance of the Indian rupee compared to the US dollar and other key EM currencies. Previously, during the taper tantrum, a depreciating rupee had contributed to a pick-up in inflation. Finally, a drop in food price inflation (driven down post demonetisation, also reflecting the expectation of a normal monsoon this year) has also helped to bring inflation down to the current lows. Although we expect inflation to start rising again in the second half of this year, we have lowered our annual inflation forecasts for 2017/2018 by 0.5 %-point, to 4% and 4.5%, respectively.


… creating room for more monetary easing

The Reserve Bank of India (RBI) has operated quite cautiously for a while now, with its guiding comments at the April meeting being relatively hawkish. This cautiousness reflected the expected rate hike path by the US Federal Reserve and uncertainty regarding the duration of low inflation, as for instance food prices can be notoriously volatile being partially driven by weather conditions. Potential inflationary pressures stemming from scheduled public servants’ pay rises also played a role. However, with inflation at a record low in May and the benchmark interest rate unchanged at 6.25% since October 2016, the real policy rate has surged to 4.1%, the highest level since November 2014. Hence, the RBI has shifted its tone a bit recently, with the minutes of the June meeting showing that one of the MPC members opted for a 50 bp rate cut. All in all, we now expect the RBI to cut its main policy rate by 25-50 bps in the remainder of this year.

External financial risks have diminished …

Compared to the taper tantrum in 2013, when India was classified as one of the fragile five EMs, external vulnerabilities have fallen. The current account deficit is expected to rise somewhat this year, to around 1% of GDP (2016: 0.5% GDP), but remains far below the level of 5% GDP seen in 2012. FX reserves have continued to rise and now cover around 7.5 months of imports and four times external short-term debt. Still, although India has graduated from the fragile five, a (sharper than expected) rise in policy and other interest rates in the US could lead to a tightening of financial conditions for India and other EMs.

… and risks from protectionism are limited

India’s direct trade exposure to the US is limited in GDP terms (around 2%). A more restrictive US immigration regime could also affect flows of workers remittances. In 2015, India was the third-largest recipient country of remittances from the US (after Mexico and China), with the amount involved  being USD 11.7 bn or 0.6% of GDP. All in all, we think risks from (US) protectionism is limited for India, partly because we believe India will be seen by the Trump-administration as a strategic partner counterbalancing China.

Upgrade to our INR forecast, but the upside is limited

So far this year, the Indian rupee has rallied by close to 5% versus the US dollar, which partly reflects general dollar weakness and partly investor interest in the rupee because of attractive yields and optimism about economic growth and Modi’s policies. The rupee has a tendency to do well in an environment of positive investor sentiment, which is also reflected in a positive relationship with Indian stock market performance and the rupee. Going forward, we expect investor sentiment to remain rather positive and this should support the rupee. Moreover, we expect general US dollar weakness which should also have an upward effect on the rupee. However, it is likely that monetary policy easing by the RBI will reduce its attractiveness. Also taking in mind our view of higher US Treasury yields, we think that the upside in the rupee is limited. To reflect these dynamics, our new year-end 2017 and 2018 forecasts are 64.5 (was 67.5) and 64.0 (was 66.5), respectively.