India Watch – Modi blues

by: Arjen van Dijkhuizen

  • Growth has fallen sharply since mid-2018 and the slowdown is broad-based
  • We have cut our growth forecasts further, but do expect some recovery
  • … reflecting filtering through of monetary and fiscal support and base effects
  • Moody’s puts India on negative outlook, pointing to fiscal and other risks
  • More reforms under Modi 2.0 would support India’s growth potential …
  • … but RCEP exclusion not helpful in profiting from shifting supply chains
191113-India-Watch.pdf (256 KB)

A broad-based slowdown

Economic growth in India has cooled sharply since mid 2018. After hovering around 8% yoy in 1H18, real GDP growth has continued to slow, reaching a six-year low of 5.0% yoy in Q219. This slowdown is broad based. Next to domestic factors, the deterioration in the external environment plays a role as well. India is less directly exposed to the global business cycle than China and other east Asian countries, but it is not immune to the global slowdown in GDP growth and trade. Growth of fixed investment dropped from double digit levels last year to 3.5-4% yoy in the first half of this year, as business confidence has weakened (partly reflecting election uncertainty) and lending growth has slowed. India’s manufacturing PMI has dropped by more than three full points since the start of the year, to 50.6 in October. Private consumption has also slowed materially, from 7-8% yoy during 2018 to 3.1% yoy in Q219, partly reflecting weaker consumer sentiment and the impact of higher taxes. The drop in car sales (around -30% yoy in July-September) is illustrative for the fact that the Indian consumer has become much more cautious, although some bottoming out is visible recently. Weakness in the car sector is a global phenomenon too.


We have cut our growth forecasts further, but do expect an economic recovery

With India’s economy rapidly cooling and China’s slowdown remaining gradual thanks to piecemeal fiscal and monetary stimulus offsetting the drags from the US-China conflict, India has lost the status of fastest growing giant to China again. Over the past half year, we have cut our Indian growth forecasts for FY 2019-20 (April 2019-March 2020) in a few steps from 7.5% to 6.0% and our growth forecast for FY 2020-21 from 7.5% to 6.5%. These forecasts imply that we expect economic growth to recover in the coming quarters from the 5% level seen in Q2-2019. That view is based on the assumption that the stepping up of monetary and fiscal stimulus will start to filter through, while India will profit from positive base effects from Q3-2020 onwards.


We see limited room for further monetary easing

Until 2013, it was quite common that headline inflation showed double digit numbers, but that has changed over the past years. The structural drop in inflation partly reflects improvements in the monetary policy framework, but also better policies to contain food price inflation (food prices make up almost half of the CPI basket). That said, this year monsoon-related supply disruptions have led to higher food prices and these have driven up CPI inflation, from 2% yoy in January 2019 to a 16-month high of 4.6% yoy in October. Meanwhile, core CPI – in which volatile food and energy components are excluded – has fallen from over 6% yoy mid 2018 to around 4% yoy. As CPI inflation has remained within the target zone (4% +/- 2 ppt) and core inflation has come down, the Reserve Bank of India (RBI) has used the monetary policy space available to support growth. Since Shaktikanta Das took over the RBI chairmanship from Urjit Patel in December 2018, the RBI has cut its main policy rate by 135 bp, to 5.15%. Meanwhile, despite the easing steps taken by the central bank, credit growth has slowed in the course of this year, reaching a two-year low of 8.8% yoy in October. Although the gap between CPI inflation and the policy rate has narrowed sharply throughout 2019, we see limited room for further monetary easing and have pencilled in one more 25 bp rate cut in the current easing cycle.

Government steps up fiscal support

In late September, India’s Finance Minister Nirmala Shitharaman announced a reduction in corporate taxes with special preferences for new manufacturing companies established between 1 October 2019 and 31 March 2023. The aim of these tax cuts is to support economic growth and to create a level playing field in manufacturing with other Asian countries. The tax cuts will drive India’s effective corporate tax rate down to around 25%, which is more in line with other Asian countries. The government estimates the total spending related to these tax cuts at USD 21 bn.  More fiscal measures (focused at the automotive and export sectors) are expected to follow. As the fiscal deficit over Q2-2019 reached almost 93% of the full-year target for FY 2019-20, it is likely that the full-year target (3.3% of GDP) will be breached and the budget deficit may well slide towards 4% for the current fiscal year.

Moody’s puts India on negative outlook, pointing to fiscal and other risks

Although India’s public debt ratio has come down over the past years (2018: 48% of GDP), this could change if the budget deficit would widen too much and growth would continue to disappoint. Back in 2017, the improvement of fiscal dynamics was a key driver of Moody’s rating upgrade to Baa2. However, last week Moody’s put India’s rating on a negative outlook due to fiscal concerns combined with growth risks and institutional weaknesses. One of these institutional weaknesses relates to the perceived independence of the central bank. In August, the RBI announced a capital transfer of around USD 25bn to the Indian government. That amount was substantially higher than in previous years, higher than the government had budgeted for and also much higher than financial markets had expected. The unusually large transfer has fed criticism regarding the independence of the RBI; a loss of central bank credibility may backfire over the longer term.

More reforms under Modi 2.0 are needed …

Prime Minister Narendra Modi and his government coalition (National Democratic Alliance, NDA) did well in the elections held in April/May earlier this year, profiting from a flaring-up of tensions with Pakistan. Modi’s hindu nationalistic BJP secured a single majority in parliament and the broader NDA now holds more than 60% of the seats in parliament (largest majority since 1984). The coalition also controls governments in most states, but it lacks a majority in the Senate. In principle, this should bode well for policy continuity and further reforms, which are highly needed given challenges in the physical and institutional infrastructure and the financial sector. In his first term (2014-2019), Modi started with low hanging fruit such as improving the business climate, but also succeeded in pushing through controversial reforms, such as a new bankruptcy code, a uniform tax for goods and services and a currency clean-up. These moves were illustrated by a jump in the Doing Business ranking (from 142/189 in 2015 to 63/190 now). Still, India’s slide by ten places in the latest Global Competitiveness ranking (to 68/141) illustrates that many structural challenges remain (also see our recent BRICS report here).

… although exclusion from RCEP does not help India to profit from shifting supply chains

At the recent East Asia Summit held in Bangkok, the ten Southeast Asian countries unified in ASEAN combined with China, Japan, South Korea, Australia and New Zealand agreed to support the so-called Regional Comprehensive Economic Partnership (RCEP) to be signed in early 2020. The RCEP, an initiative that started in 2012, is a treaty covering the areas of a.o. goods and services trade, investment, economic and technical cooperation, intellectual property, competition and dispute settlement. India, however, decided to withdraw from RCEP. India does not want to give up its quite protectionist stance aimed at protecting vulnerable sectors (including agriculture) and certain manufacturing sectors deemed not competitive enough to survive in a world with less trade barriers. Moreover, India also has concerns over ‘equitable market access’ versus China; it already has a large bilateral trade deficit with that country. While in the short-term exclusion from RECP might be politically necessary given that India is less competitive than China, over the longer term this will not help India in positioning itself as a manufacturing hub at a time that the US-China conflict has already led to an acceleration in the shift of global supply chains.

To conclude: India has potential, but risks remain

Over the past year, India has lost some of its shine. Growth has fallen back to a six year low of 5.0% in Q2-2019 and recent economic data are not promising either. That said, we expect economic growth to recover in the coming years, as the government has embarked on fiscal and monetary stimulus while we assume some stabilisation in the external environment following a difficult 2019. One of the most important risks that could derail this outlook stem from the weaknesses in India’s financial sector, with challenges related to the areas of shadow  banking (illustrated by failures of several nonbank lenders) and weak asset quality at public banks (concentrated in the power sector). Another risk stems from tensions with arch enemy Pakistan, which have flared up in the course of this year due to developments in Kashmir. Domestic political risks remain as well, partly reflecting tensions between different religious groups. Fortunately, India’s external position has improved over the past years, as the current account deficit has fallen back to an expected 1.5% of GDP this year. Moreover, FX reserves have continued to rise and are now covering seven months of imports and almost four times short-term external debt.