India Economic Update- September 2011

Overview

A Return to Trend Growth, but a Weakening Outlook

After a return to trend growth in fiscal year 2010-11, India’s economic growth is likely to slow to 7-8 percent in the next two years. The slowdown is a result of uncertainties weighing down investment, tighter macroeconomic policies intended to fight still-high inflation, and the base effect of the strong agricultural rebound in FY2010-11. Slow growth in core OECD countries means domestic drivers for growth will have to be strengthened. This would include progress on important structural reforms, and further measures to achieve fiscal consolidation and reorient government spending toward investment and growth. Even then, risks from the uncertain international environment are high. Policymakers would do well in reviewing crisis preparedness at this time. 

GDP growth is estimated to have reached 8.5 percent in fiscal year (FY) 2010-11, mainly  because of strong agricultural sector performance with 6.6 percent growth. GDP growth slowed to 7.7 percent in Q1 FY2011-12, and inflation remained high at around 9.5 percent, increasingly driven by core inflation (calculated by excluding food and energy prices).  

Growth was supported by an impressive recovery in exports, which relied on Asia and higher oil  prices. Capital flows slowed and foreign institutional investment was hit by the financial turmoil gripping global markets in August 2011. Nevertheless, the rupee remained quite stable against the U.S. dollar with very little RBI intervention, and the RBI’s foreign reserves increased to more than $319 billion.

Macroeconomic policies were tightened with fiscal consolidation and increases in policy rates. The general government budget deficit for FY2010-11 is estimated at 8.5 percent of GDP, of which 6 percent central government deficit, as compared with 10.1 percent and 6.8 percent deficits in FY2009-10. However, the tax-to-GDP ratio was still lower than before the global financial crisis. Since March 2010, the main policy rate was raised 12 times by a cumulative 350bps, but the growth in monetary aggregates continued to outpace the RBI’s targets.

The global economic environment has deteriorated significantly. Doubts about sovereign debt  sustainability in the US and Europe have led to a significant decline in investor sentiment and consumer confidence. Growth forecasts for the global economy have been revised downwards. However, as its baseline scenario, the World Bank forecasts a relatively benign resolution of the recent turmoil.

In India, GDP growth in FY2011-12 and FY2012-13 is forecast to reach 7-8 percent, a slowdown  from the trend before the global crisis. With the slow growth expected in core OECD countries, India’s GDP growth will have to rely on domestic growth drivers. The slowdown in investment, capital outflows, and decline in the stock market point to deeper structural problems. Investors are holding back in the face of regulatory uncertainty (environmental clearances, land acquisition laws, tax reforms), banks are highly exposed to power projects facing delays due to the lack of coal and gas feedstock, and mining (especially of iron ore) has been hit by recent scandals in Karnataka and Orissa, putting the future growth of the steel industry in doubt. Major
structural reforms aimed at improving the investment climate, in particular progress on current  legislative initiatives (land acquisition, tax reform, financial sector reform, FDI in retail) would strengthen domestic growth drivers. Further tightening of macroeconomic policies - fiscal  consolidation and higher real interest rates – will have a dampening effect on aggregate demand, but will strengthen policy credibility and the prospects for sustainable growth later on.  This will also require rationalizing government expenditure by expanding investment and cutting subsidies including for items controlled by state governments (most notably, state electricity boards). Investments in infrastructure could alleviate supply bottlenecks and allow low-inflation growth.

Capital inflows are likely to be sufficient to finance the current account deficit. Volatility of  portfolio flows remains high and poses risks in both directions: renewed shocks to the global financial system could lead to another “flight to safety”, while global liquidity remains unusually high and could lead to FII surges in emerging markets. 

The downside risks to growth are high because of the risks to global growth posed by the  precarious situation in Europe. A worst-case international scenario would lead to a collapse of demand for India’s exports, and strong contraction in private sector spending, as was observed after the Lehman collapse in 2008. At that time, higher public sector spending set in at exactly the right time largely because of the implementation of the recommendations of the 6th pay commission. The RBI was able to lower policy rates significantly when inflation fell rapidly in line with international commodity prices. However, in the immediate aftermath of the Lehman collapse, the interbank market froze, and short term liquidity became very expensive. Policymakers would do well to review their preparedness for another global shock and prepare contingency measures.

Prepared by Ulrich Bartsch, Monika Sharma, and Maria Mini Jos.