India: Weak recovery after disappointing year
- In fiscal year 2012-13, economic growth in India fell to the lowest rate in a decade.
- Inflation has been easing recently, which has allowed the central bank to loosen monetary policy.
- However, the large and growing current account deficit and a sizeable fiscal deficit constrain the possibilities to apply (further) monetary and fiscal stimulus.
- Recovery will therefore have to come from improving investor sentiment.
- Overall, we expect a modest recovery going forward. A favorable monsoon is likely to boost growth somewhat in the short run.
Source: EIU, MOSPI & Rabobank
Slowest growth in a decade
While the OECD recently stated that India has probably surpassed Japan to become the world's third largest economy in purchasing power parity (PPP) terms, India's recent growth performance does not give much reason for cheer. Fiscal year 2012-13, which ran until 31 March 2013, has been the worst year in terms of growth in a decade. The economy grew by 5%, which is far below the average of the past decade (roughly 8%). This was partially due to a lack of rainfall, which slowed down growth in the agricultural sector to 1.9%. However, more important were that structural flaws, such as poor infrastructure and the slow pace of reforms, resulted in capital investment growth falling to an 8-year low.
Monetary policy responding to falling inflation
Looking ahead, lower interest rates may boost growth somewhat, as lower inflation has allowed the central bank (RBI) to loosen monetary policy in the past months. Wholesale price inflation, India’s main inflation gauge, fell to 4.9% in April, the lowest rate in 41 months, thanks to falling food and manufacturing prices. Core inflation dropped to 2.8% in April, down from 3.5% in March. Consumer price inflation also went down, although at 9.4% it was still relatively high. In response to lower inflation, the RBI has reduced its policy rate in three steps by 75 basis points since January. Earlier it also lowered the amount of cash that banks have to park at the RBI.
Source: Reuters EcoWin, Reserve Bank of India
Twin deficits constrain room for stimulus
In the meantime, the RBI warned last month that the widening current account (CA) deficit constrains its ability to further loosen monetary policy. The Bank stated that the CA has become the biggest risk for India, especially because a tapering of the ultra-loose monetary policies in the US may make it more difficult for the country to attract foreign capital. Unfortunately, India also has a sizeable budget deficit, which makes it difficult for the government to spur growth through fiscal stimulus. Although the fiscal deficit fell to 4.9% of GDP in FY2012-13, down from 5.8% in FY2011-12, it remains sizeable enough to act as a deterrant for fiscal expansion.
And reform progress likely to be slow
Given the limited possibilities to implement fiscal and monetary stimulus and a not extremely favorable external environment, an improvement of investor sentiment seems the most logical road to economic recovery. Regrettably, recent data show that investor sentiment remains relatively weak. A number of reforms the government implemented in the second half of 2012, such as a liberalization of the retail and aviation sectors, may boost investment somewhat in the second half of calendar year 2013. All in all, not too many new reforms should be expected, as politicians are unlikely to take important decisions in the run up to the national elections held in May 2014.
Economy likely to recover only gradually
As a result, we only expect a gradual recovery of investment growth, which is likely to be supported by more accommodative monetary policy. In the short run, the weather is thereby likely to help the economy somewhat, because the 2013 monsoon is expected to be a favorable one, which is likely to boost agricultural output and consumption while containing inflationary pressures. Overall, a quick return to the years of > 8% growth seems unlikely though. Instead, we expect economic growth to recover gradually to about 6% in fiscal year 2013-14. Due to the sizeable twin deficits, risks to this outlook are tilted to the downside.