Key reforms such as GST, land Act changes and labour reforms will be more effective than a 50 basis point reduction in the repo rate
In a short period of six months, the new government has introduced several initiatives to improve the ease of doing business, such as simplification in labour compliance, launching of online clearances for environmental and forest approvals. Moreover, it has made various announcements that would boost domestic production, albeit with a lag, including Make in India, defence project approvals, FDI norms in various sectors, early coal block auctions, etc. Such early measures have maintained the revival in business sentiment, with a perceptible improvement in new projects announcements in the just-concluded quarter.
Simultaneously, falling wholesale and retail inflation has lifted sentiments. The new inflation targeting regime of RBI has designated CPI as the nominal anchor of monetary policy with clearly defined medium-term goals for the inflation trajectory. CPI inflation moderated to 5.5% in October 2014, from an average of 10% each in 2012-13 and 2013-14. This has been led by a favourable base effect, slower growth of rural wages and prudent decisions such as modest increases in MSP.
The decline in inflation has also benefited from the benign global price scenario, albeit engendered by weak growth dynamics. The rapid and sizeable fall in the price of the Indian crude oil basket enabled diesel pricing to be deregulated in October 2014 and led to a considerable reduction in domestic retail fuel prices. But if crude oil prices strengthen, the transmission to output prices in India would be relatively faster, now that prices of major fuels including diesel are market-linked. Notably, lower commodity prices transmit speedily into wholesale inflation, but have a limited and slow impact on the Indian CPI that is dominated by food and services such as education and health.
Systemic liquidity has improved in recent months, partly on account of low credit offtake. A continuing robust equity market is expected to enable divestment by corporates, helping to deleverage their balance sheets. Guidelines issued by RBI covering incentives for issuance of long-term bonds by banks for financing of infrastructure and affordable housing and those by Sebi for REITS and InvITs are expected to improve the availability and reduce the cost of funding for many sectors.
Notwithstanding the positive environment, falling commodity prices and improving liquidity scenario, a broad-based revival in investment activity remains elusive. A weak monsoon has predictably dulled output and consumer demand related to India’s farm sector. The deteriorating outlook for several important trading partners is expected to dampen growth of Indian exports in the remainder of this fiscal, arresting a key engine of India’s growth for the previous four quarters. Such factors are expected to dampen Indian economic growth to about 5% in H2CY14 from a healthy 5.7% in Q1FY15.
Calls for an early repo rate cut have gained momentum with the decline in growth of bank credit offtake as well as the expected further fall in CPI inflation in November 2014. However, the latter is likely to be a temporary respite, with a subsequent rise in this metric to about 7% in February-March 2015 as the favourable base effect wanes. With RBI having indicated that it would look through such base effects, we expect a low likelihood of repo rate cuts in the next two policy meetings, as the central bank would seek to ensure that the economy adjusts towards the medium-term inflation target of CPI inflation at 4+/-2%.
MSP revisions are expected to remain modest in 2015-16. Moreover, state governments have been discouraged from offering bonuses above the MSP, which is expected to contain the extent of price rise for cereals. While it is too early to predict the timing and magnitude of monsoon rainfall in 2015, the recurrence of spikes in prices of perishables following short-lived demand-supply mismatches cannot be ruled out.
Broad-based measures to reduce wastage and improve the agricultural supply chain are imperative to reduce the persistence of food inflation in India. The importance of such reforms cannot be overstated, given that food items comprise 50% of the CPI Index. Considerable electricity tariff increases remain a risk factor for 2015-16, particularly if pass-through of prices of pooled coal/gas imports is permitted. Nevertheless, the expectation that commodity prices would remain low in the near term, thereby absorbing inflationary pressures brought on by a revival in demand conditions, has improved the likelihood of CPI inflation moderating in line with the target of 6% in January 2016. The central bank is likely to embark on a rate easing cycle in the beginning of next fiscal, with repo rate cuts of up to 50 basis points, if the monsoon forecast for 2015 is normal, crude oil prices average sub-$95/barrel and exchange rate volatility remains contained.
In ICRA’s view, a number of additional measures need to be introduced to ensure an early pick-up in growth, which would be far more potent than a 50bps reduction in the repo rate. Key reforms and events that are awaited in the near term include clarifications related to land acquisition; broader labour reforms; resolution of Centre-state differences related to GST to ensure implementation by April 1, 2016; successful resolution of coal block auctions paving the way for wider energy sector reforms; fleshing out of proposals announced by the government such as Smart Cities, investment in rail and highways, etc; as well as adequate allocations for the same in the 2015-16 Budget. Such factors would critically impact the strength and sustainability of a capex revival in India as well as the pace of GDP growth in FY16, which we currently expect to be in the range of 6-6.5%.
By Naresh Takkar
The author is MD & CEO, ICRA Ltd