The efficacy of incremental rate cuts in rapidly instigating a turnaround in economic growth remains uncertain, given continuing structural constraints.
In an unexpected move, the Monetary Policy Committee (MPC) had reduced the repo rate by 35 basis points (bps) to 5.4% in the August 2019 policy review, while retaining the accommodative stance. The slowdown in economic growth was clearly the MPC’s primary concern, with the CPI inflation forecast to remain under its medium-term target of 4% up to Q1FY21. With the GDP growth in Q1FY20 printing sharply below expectations, we now expect a fifth consecutive rate cut in the MPC review in October 2019.
The year-on-year (y-o-y) CPI inflation inched up to 3.21% in August 2019 from 3.15% in July 2019, only marginally higher than the MPC’s forecast of 3.1% for Q2FY20. Flooding in various states has resulted in a spike in vegetable prices, and a y-o-y decline in the estimated kharif output of rice, pulses, and sugarcane pose modest risks to the inflation trajectory. Moreover, crude oil prices have remained volatile, subject to geopolitical, and trade tensions. A relatively subdued global growth outlook is likely to restrain commodity prices in the near term, which would contain the inflation in manufactured products. However, the demand for various services is likely to remain sticky even during a period of muted domestic economic growth. In our view, the CPI inflation would continue to inch up in the next few prints, led by food items, but average a modest 3.5% in FY20.
The MPC had mildly revised its GDP growth outlook for FY20 downwards to 6.9%, with risks somewhat tilted to the downside, from 7% in the June 2019 review. Subsequently, the GDP data for Q1FY20 was released, which revealed an unexpectedly sharp slowdown in growth to a 25-quarter low 5% from 8% in Q1 FY19.
While the IIP growth improved in July 2019, the early indicators for August 2019 have revealed a widespread deterioration in the industrial sector. The instances of flooding in Q2FY20 are also likely to subdue agricultural growth in this quarter. However, central government spending may pick up post the July 2019 Union Budget, supporting economic growth in Q2FY20.
The government has responded to the weakness in the growth momentum with various measures, including the lowering of the corporate tax rate. This is expected to provide a substantial and broad-based boost to business sentiment in the immediate term, and is a long-term structural positive, although it would increase fiscal stress in the short-term.
Domestic corporates may choose to use the tax savings to retire high cost debt, increase dividends, lower prices or make fresh investments. Given the moderate capacity utilisation in various sectors, we don’t expect a broad-based pick-up in capacity expansion by the private sector until there is greater visibility of a sustained uptick in domestic consumption demand. In our view, land and labour reforms, and regulatory clarity and consistency are areas where additional measures are required to complement the impact of the tax cut. Such measures would make India a more attractive investment destination and help attract fresh FDI over the medium-term.
The Government of India (GoI) has pegged the gross revenue loss related to the tax cut at Rs 1.45 trillion, approximately 42% of which would be borne by the state governments through lower tax devolution to them. Therefore, the net impact of this tax cut is likely to be around Rs 0.8-0.9 trillion, which, by itself, would translate to a fiscal slippage of around 0.4% of GDP in FY20. Expenditure cuts may still have to be undertaken to prevent the GoI’s fiscal deficit from rising too sharply in FY20.
Based on the shortfalls in central tax collections in FY19 and the estimated gap in FY20, the aggregate central tax devolution to the states may be a sharp Rs 1.5-2.0 trillion lower than what was budgeted by the GoI. Sizeable expenditure reduction or deferral would be required to avoid substantial fiscal slippage at the state government level, given that the borrowing limit set by the GoI acts as a soft constraint to the size of the states’ fiscal deficits. In our view, likely cuts to productive and/or capital expenditure at the state level pose a key risk to the economic growth outlook.
Based on our assessment that private sector investment activity would pick up over the medium-term whereas government expenditure restraint would be required in the remainder of this fiscal, particularly at the state level, we are not revising our FY20 GDP growth forecast upward from 6.2%. Moreover, a sizeable reduction in the MPC’s baseline growth forecast for FY20 may be in the offing.
Given that at least a portion of the tax cuts would have to be absorbed through lower state government expenditure, the impact on inflation may be modest. Additionally, some firms may choose to pass through a portion of their tax savings through lower prices of goods and services.
Based on our forecasts of the inflation and growth trajectory, the space for additional monetary easing appears to be 25 bps, which we anticipate would be undertaken in the October 2019 MPC review.
Nevertheless, the efficacy of incremental rate cuts in rapidly instigating a turnaround in economic growth remains uncertain, given continuing structural constraints, such as the cost of land acquisition, moderate capacity utilisation levels, relatively high debt levels of some corporate groups, and reluctance of banks to lend for project finance.
Principal economist, ICRA
Views are personal