In September 2009, India’s economic advisory committee lowered its GDP growth forecast for 2007-2011 from 9.0% to 7.8%. The government now expects growth to slow to 6.3% in 2009, from an average 9.0% growth in the recent years, due to the global recession. But it expects growth to return to 8% and 9% in 2010 and 2011, respectively. However, less benign global factors going forward and slow domestic reforms will make it challenging to achieve these growth targets.
The Indian economy grew 6.1% in Q2 2009 after slowing to 5.8% in both Q4 2008 and Q1 2009. Clearly, Q1 2009 was the bottom for economic activity. Starting in Q2, both domestic and global conditions somewhat improved and policy measures began to show impact. However, several domestic and external factors could constrain growth in the short to medium term, potentially undermining a V-shaped recovery scenario. Short-term risks to growth include dismal agriculture sector performance, fading impact of policy stimulus while private demand is still weak, and a slowdown in the global risk appetite. Risks over the next two to three years include a sluggish recovery in global credit conditions and domestic structural problems such as high fiscal deficit and public debt, inflationary pressures, slow reforms, and supply-side bottlenecks.
Data Source: Ministry of Statistics, India
The government and most analysts now forecast that despite the improvement in global conditions and the pickup in Indian economic growth in Q2 2009, GDP growth will slow again in Q3 and Q4 2009. This is because below-average rainfall will cause the agriculture sector to contract, potentially pulling down GDP growth to around 5.5% in 2009. However, there might be some mitigating factors. The agriculture sector accounts for less than 20% of GDP. Even though the rural sector employs over 65% of the labor force and accounts for over 55% of total income, a large share of the rural income is accounted for by non-agriculture related activities. Government welfare programs and recent measures to provide assistance to drought-hit farmers will partly offset the income loss for households that derive income from agriculture-related activities. However, rural consumption might be hit if the drought leads to higher food prices since rural households are net buyers of food.
Despite the fiscal and monetary stimulus, private demand is still under pressure. Slow recovery in private demand implies it will be unable to offset the negative impact of agriculture sector on economic growth during 2009. Private consumption growth is extremely sluggish led by the downturn in urban consumption. Policy measures have benefited consumer spending on durable goods but households are still weighed by the negative wealth effects from 2008 and tight lending standards. While job losses have slowed, it might take several quarters for the hiring spree and income growth to revert to their previous highs.
Investment is down significantly. Higher commodity prices and sluggish sales will continue to pinch companies despite aggressive labor cost cutting. The revival of capital inflows including Foreign Direct Investment (FDI) and the booming stock market have raised hopes that investment will revive. It will be interesting to see how long portfolio inflows will be sustained if foreign investors become increasingly concerned about the sustainability of economic growth and the risk of an equity bubble in both the domestic and global markets. FDI and foreign borrowings by Indian companies might pick up owing to improving external financial conditions. Yet, both will fall short of their past stellar performance and the cost of capital at home and abroad will remain far higher in comparison to recent years.
Crude oil correction in 2008 has been a blessing for India. Low oil prices along with low import demand have cushioned the trade deficit and the current account balance. But as oil prices strengthen with the global recovery, the trade deficit could come under pressure even while exports and the capital account are weak. Ongoing government efforts to reduce import dependence and source energy needs domestically will help reduce energy imports only in the medium-term.
Policy measures have played a pivotal role so far in sustaining private demand. But it will not be long before the policy space starts tightening. Rising food and asset inflation will prevent any further monetary easing. Due to the significance of rural votes, the government will continue churning out assistance to drought-affected areas via subsidies and rural welfare programs. This will accentuate investor concerns about the high fiscal deficit and government borrowing needs.
A point of optimism for medium-term growth is the high share of private consumption and investment in GDP (over 55% and 35% respectively) and low export dependence. With these advantages, India will avoid the pains that some Asian economies will bear in rebalancing their economies away from exports. India’s investment spending is less correlated with export performance and FDI and is largely financed by the high domestic savings (over 37% of GDP) including corporate retained earnings.
Data Source: Ministry of Statistics, India
A note of caution is that a large share of investment in recent years (over 30%, according to some estimates) was financed by foreign borrowings, including those from banks and capital markets. The surge in foreign institutional investment (FII) and FDI, including cross-border M&A and private equity deals, also fueled investment activity. Cheap and abundant global liquidity helped India’s investment-to-GDP ratio surge to a high of 39% in 2008—well above its domestic savings—boosting economic growth. There is little question that global economic recovery and risk appetite will continue to attract investments into India, given expanding opportunities, high returns and the liberalization of foreign investment. But given the less favorable outlook for the recovery in global credit conditions and leverage buildup, it is doubtful that the scale of capital inflows into India will revert to the pre-recession levels, especially in the next couple of years. Therefore, investment recovery is likely to lag.
Given the global economic climate, attaining a sustainable 9% GDP growth will likely depend on domestic conditions. With fiscal deficits exceeding 10% of GDP during 2008 and 2009, government borrowing has surged. The fiscal deficit in 2009 and 2010 will be higher than that projected by the government due to the drought, welfare related spending, and lower than expected tax revenu
es. The public debt of over 80% of GDP and higher interest rates in the future will keep the debt servicing costs elevated. Efforts to reform the fuel and farm subsidy regime are off to a slow start. The government will fail to raise substantial funds from the ‘partial’ disinvestment of some ‘less strategic’ public companies. As a result, government borrowings from the market will remain high and exceed government projections. This will further reduce the government’s productive investment. As companies revive investment plans during the recovery and the central bank starts tightening monetary policy, these government debt issues can crowd out private investment.
Since the public sector will be a drag on growth, economic growth will have to come from private sources—which means India must boost domestic consumption and investment. Structural reforms in agriculture, rather than fiscally expensive subsidy and welfare spending, can increase rural consumption. Boosting human capital development and job creation can raise consumer spending, especially for the lower and middle income groups. Liberalizing foreign investment caps, broadening and deepening the domestic capital markets, easing capital controls on companies to borrow from abroad, and improving financial intermediation of domestic savings can also buoy investment. However, government reforms including liberalization, fiscal adjustment, and the removal of supply-side bottlenecks will be rather slow despite current optimism among investors. The central bank’s foreign exchange intervention and ambiguous stance towards hot inflows will continue. Hence, as capital inflows and domestic demand pick up during the recovery, these constraints will result in economic overheating, asset bubbles and inflationary pressures—a rerun of 2007 and early 2008.