Column : Reignite savings-investment cycle

Written by Rajeev Malik | Updated: Nov 20 2012, 08:05am hrs
Optimism about India is in the air, again. The ruling Congress-led coalition government of Prime Minister Manmohan Singh finally woke up recently to take some long-overdue remedial action to address the macro imbalances it has bred. The government has made a welcome start, and there are some signs of stabilisation and re-assembling of the growth drivers. But a lot more needs to be done if India is to get up and run again rather than just limp along. Expectations are again running high and history cautions that government actions have rarely exceeded high expectations.

The pieces of Indias macro puzzle are slowly, but unevenly, being put in place. Growth will improve slightly in 2013not bad given the still-sobering global outlook. Fast-tracking of projects could be incrementally positive for growth at a time when export-dependent Asia will be suffering more than India from the global downshift. However, Indias macro adjustment will be protracted and a 2003-like growth take-off remains wishful thinking. Our forecast of lower commodity prices next year will be positive for inflation and allow for limited monetary easing. It is often ignored that lasting low inflation and qualitative fiscal adjustment are pre-requisites for sustained growth acceleration. We reiterate our non-consensus view that the rupee will weaken next year as Indias inflation differential will remain high.

Talk on Indias macro has been more negative than investors positioning. Easy global liquidity and investors faith in Indias long-term story ensured that the equity market has been much better off than the weak real economy. As the government heals the self-inflicted economic wounds, dont ignore the risks. The on-going corruption-fest, high probability of early general elections, governments hardwiring to populism and adverse capital inflows could cause a setback. Unlike the last one year, the now-awake government will, hopefully, be more constructive.

For all the global economic problems and the fallout from the local corruption scandals and policy inaction, Indias GDP growth in FY13 will still likely be around 5.5%. This is a far cry from the peak outcome of 9.6% in FY07 but should be viewed in the context of severe global and local headwinds. Still, India, given its low per-capita GDP of a mere $1,500, needs to grow much faster to generate sufficient employment to avoid social tensions. Some of the structural tailwinds, such as Indias favourable demographic and increasing consumerism, remain in place. However, others, such as the virtuous savings-investment cycle, have been damaged and will take time to heal. Challenges to Indias growth also come from local politics becoming more inward-looking despite the economys increasing global integration.

There are encouraging signs that the government is now awake, and is also taking several long overdue decisions. Once again, Indian politicians and policymakers confirmed that they wait until their backs are against the wall to do some right things. But better late than never. Trend growth will gradually move up as long as the government doesnt go back to sleep. Indias five-year growth cycle shows that India is positioned for a leg up (see charts). For all the self-inflicted damage done in the last 1-2 years, Indias growth will still exceed that of emerging economies (see charts).

Apart from softening global demand, there were two additional factors which decelerated Indias GDP growth. First, rising inflationary pressures that prompted RBI to tighten monetary policy, and second, governments policy inaction and the fallout of the corruption scandals. 2Q12 GDP growth came in at 5.5% yoy, a touch better than the 5.3% in 1Q12 but well ahead of the feared sub-5% outcome. There are several moving parts in mapping the economic outlook, including the scope for disappointment over eurozone growth. High-frequency signals from Indias PMI surveys suggest stabilisation. Manufacturing activity remains on a weak footing but the service sector has been offsetting that weakness. The less reliable official industrial production also shows some low-level stabilisation.

GDP growth appears to be bottoming out. Growth in the second half of FY13 is forecast to be slightly better than in the first-half. The recent policy activism from the government strengthens this view. This was already built into our expectations as we did not subscribe to the fashionable inaction forever assessment. Admittedly, guessing the exact timing of policy actions is a mugs game. The most likely outcome is that growth will improve slightly, to around 6-6.5% (CLSA: 6%) in FY14 versus our forecast of 5.5% for FY13.

There are two key macro adjustments India needs to undertake. First, under-invested Indias GDP growth is driven more by consumption than investment. This is a perverse outcome of using fiscal measures to enhance consumption, and the governments (until recently) policy paralysis that hurt investment. What will make the re-balancing more challenging is that consumer spending is already softening and will have more headwinds because of the need to cut the subsidy bill. Second, the virtuous savings-investment cycle needs to be re-ignited. Investment, already in trouble, also has to deal with another headwind: the decline in domestic savings rate (see charts). Higher investment spending will have to be a key driver of a sustainable upturn in economic growth. To be sure, Indias investment upturn between FY04 and FY08 was financed largely via domestic savings, with the investment and savings ratios trending upwards. With the pressing need to limit the current account deficit to 2-2.5% of GDP, India has little choice but to boost domestic savings rates for facilitating a long-lasting upturn in investment.

The author is senior economist, CLSA. Krishna Goradia of CLSA contributed to this article

This article is extracted from CLSAs Growth Puzzle: Repositioning for Indias upturn