Depending on the global environment, potential growth could rise meaningfully from 2020, led by higher investment and growth dividends from recent reforms.
GDP growth fell during the demonetisation and the GST implementation period of 2016-17, undershooting potential growth of 7.1%. The start of 2018 marked a period of overshooting, thanks to a low base and inventory re-stocking. We expect growth to remain elevated at 7.8% in H12018 and gradually return to trend by end-2018. Looking across sectors, higher government spending and gradually improving rural demand (triggered by non-agricultural activity), could lift growth. Investment has improved, but it is unlikely to accelerate immediately (with election uncertainties and tighter financial conditions). ‘Net exports’ will impart a sizeable drag (due to the likely impact of ‘trade wars’ and India’s rising growth differential with the world). We expect FY19 and FY20 CAD to be higher and GDP to be a shade lower than projected earlier. RBI raised rates over two consecutive policy meetings. We expect another rate hike at the December meeting (when the impact of higher minimum support prices (MSPs) shows up). With growth returning to trend by end-2018, core inflation momentum is likely to moderate. We have already begun to see indications of this in recent inflation readings. 2019 is likely to start off with weak (sub-7%) growth.
An ANOVA model suggests that the quarter right before national elections (which we assume will take place in the second quarter of 2019) is marked by slower growth. Thereafter, GDP growth is likely to rise to 7.5% by year-end, and quality is likely to improve, with investment outpacing consumption, and private sector participation beating government spending. We see risks of moderate rate hikes in the second half of 2019.
Depending on the global environment, potential growth could rise meaningfully from 2020, led by higher investment and growth dividends from recent reforms. This could start off a period of higher growth co-existing with low inflation, which is a rare occurrence for India. However, this will neither be easy, nor guaranteed. The authorities will need to strictly avoid fiscal and monetary policy excesses. Oil prices will need to stabilise and current global uncertainties will need to ease.
We find that a low base , and higher government spending and rural demand, could lift growth in 2018 (7.4% y-o-y vs 6.2% in 2017). Some believe that growth accelerates in pre-election years while others believe that growth slows, because the private sector postpones investment plans due to election-related uncertainties. An ANOVA analysis of growth data around elections for the last two decades suggests that while growth can be high in pre-election years, the momentum falls significantly in the quarter right before the national elections. Understandable, because by then, the government is already done with most of its spending, and many expenditure restrictions creep in. There are already signs of increased government-led infrastructure activity in the transport and rural sectors. Fiscal deficit targets may not be a binding constraint. There has also been an increase in ‘off-budget’ government spending in recent times, which could continue to support government projects.
With government spending remaining elevated, growth will remain high for much of 2018. In line with our expectations, rural wage growth has bottomed out in sequential terms, with significant contribution from non-agricultural wages. Other high frequency data on rural sentiments and unemployment also point to a gradual revival. Gently improving rural demand is expected to buoy overall GDP growth for the remainder of 2018.
Most drivers are currently supportive of strong growth in urban consumption. However, real wages, which we find to be the most important determinant of all (i.e., with the highest explanatory power), could grow at a lower clip, due to both slower nominal wage growth and higher inflation.
This could dampen the positive impact of other factors. All considered, urban consumption is expected to grow steadily in the range of 6.5-7% in FY19, same as in the previous year.
After falling for four years, India’s investment rate bottomed in early 2017 and has risen gently since. And yet, any sustained acceleration in investment growth is still some distance away. The recent improvements only seem to be closing the gap with the five-year average. Real credit growth to industry is ticking up but only marginally. Earlier work found that world growth, expected excess domestic future returns (growth – interest rates), economic policy uncertainty, and corporate indebtedness, together, can explain India’s investment growth rather well. Currently, these ‘explanatory variables’ are painting a mixed picture. The world’s growth outlook is better than before, but uncertainties are mounting; and domestic corporate indebtedness is falling, although ever so gradually. While these could support an investment revival, other drivers, such as increased policy uncertainty as we near the general elections in 2019, tighter financial conditions, and the overhang of India’s banking sector problems, could blunt any meaningful acceleration in private capex growth before 2020. We expect the investment rate to remain stable over 2018-19 and to only accelerate meaningfully in 2019-20, once private sector participation rises sustainably.
Earlier work highlighted that domestic supply bottlenecks, world growth and rupee (in that order) are the most important drivers of exports. And, encouragingly, each of these three drivers are looking supportive. Yet, for now, exports continue to look weak. On a sequential basis, exports contracted for a second month in July. Furthermore, uncertainties around global growth due to a rising wave of protectionism are casting a cloud over any meaningful revival.
India does not stand to lose much from the ongoing US and China trade dispute. While it may be too early to ascribe hard numbers to such an impact, a 2017 IMF model estimates that for every 10% effective increase in import tariffs levied by the US, world trade will fall by 1%, and the world’s GDP by half a percent. This, in turn, is likely to adversely impact both investment and export growth in India.
Higher imports could play ‘spoilsport’ for India’s trade balance and economic growth. India’s rising growth differential with its major trading partners could worsen the trade deficit. Indeed, we find that domestic demand is the strongest driver of India’s import growth and can offset any softening of imports due to the 6% YTD rupee depreciation. High crude prices could also keep the oil import bill elevated. We believe that the current account deficit for 2018-19 could be wider than we had previously anticipated (2.7% of GDP versus 2.4% estimated earlier). And net exports could remain a drag on India’s GDP growth, shaving off c1.5ppt from the annual growth number, as it did last year. With elections out of the way, the focus may turn again to fiscal consolidation and the new FRBM debt targets. A likely contractionary fiscal stance is expected to open up space, and throw up resources, for the private sector to begin to grow. As new investment projects get completed, and efficiency gains from structural reforms, such as the GST and Bankruptcy Code flow in, potential growth may begin to rise from 2020 onwards.
Indeed, our estimates suggest that potential growth could cross 7.3%, printing its highest figure in about a decade. Higher potential growth also means that the output gap will not rise and become inflationary as quickly as it has over the last few years. Coupled with indications of a structural element in the current bout of food disinflation, expectations of some stability in oil prices, and more hinged inflation expectations (thanks to the inflation targeting reform), our inflation model suggests that headline CPI inflation could rest at the c4.5% range. True, that this would still be a tad higher than RBI’s target of 4%, but it will be much lower than where inflation tends to stand during high-growth phases. In fact, over the last decade, inflation has averaged 8%.
If this works out, 2020 could mark a new and desirable period of higher potential growth alongside low inflation. This is a luxury that India has not enjoyed sustainably in the past. Oil prices will need to stabilise, and ongoing global uncertainties will need to ease. India’s dream could become a reality, but it is not certain.
Edited excerpts from HSBC’s Global Research, India: The Shape of Growth
The report was contributed to by Aayushi Chaudhary and Dhiraj Nim
-The author is Chief Economist, India, HSBC Securities and Capital Markets