India Economic Outlook 2021: The only certainty is uncertainty

Best wishes for 2021! Many people will be more than happy to close the book on 2020. For the Indian economy (see Figure 1), we expect the corona crisis to go down in history as the worst economic crisis since 1900 (disregarding the economic fallout after both World Wars). We expect Indian GDP to contract by -8.4% (y/y) in fiscal 20/21 and grow by 9.7% (y/y) in fiscal 21/22. See Table 1 for an overview of our forecasts.

The availability of effective vaccines has brought hope that economies can return to normality somewhere later this year, something we expect will happen in Q3. A significant risk to that scenario, however, is that COVID-19 has been mutating. Two variants of the virus have emerged in the UK (202012/01) and South Africa (501.V2). Pharmaceutical companies are confident that their vaccines only need tweaking and will be effective against these mutated versions of the virus, but new testing will have to confirm these claims. These new strains only have raised the pressure on governments to contain the spread of the virus and to roll out vaccines as quickly as possible.

India faces the arduous task in 2021 to vaccinate 30 billion frontline workers (i.e. healthcare workers, policemen and soldiers) as well as 270 billion vulnerable people. Two vaccines have been approved so far. The first one is the AstraZeneca-Oxford University vaccine, which is produced by the Serum Institute of India. The second one is developed locally by Bharat Biotech, but its approval has received heated criticism, as only limited results have been published on the vaccine’s efficacy. Those rolling out a large-scale vaccination program might benefit from looking at India’s Universal Immunisation Program, which vaccinates more than 50 million people per year. So India has the proper infrastructure in place to facilitate this monster operation.

On 5 February, the Reserve Bank of India (RBI) will have to decide what to do with its policy rates. Inflation in December levelled off significantly to 4.6%, which might be the window the RBI has been looking for to cut rates after its first meeting in 2021. We expect the RBI to cut policy rates by 25bps in February, but have some doubts whether this would be the best strategy. While food inflation dropped markedly in December, supply chains will continue to face problems as long as lockdown measures are in place. Moreover, a fast increase in commodity prices and large amount of liquidity in combination with a pickup of economic activity across sectors might push up inflation in the upcoming months. High inflation risk is clearly visible in ongoing elevated core inflation (Figure 2). It also explains why the RBI has signalled to return to normal liquidity when the economy stabilizes.

Indian rupee
Going forward, we expect the INR to appreciate to bullish levels of 71.5 by year-end, in tandem with the expected global economic recovery and boosted by optimistic global investor sentiment (Figure 3 and Table 2). We are pleased to note that we came second in the Bloomberg FX forecast accuracy rankings for 2020Q4, which puts our forecast accuracy in the top 5 for 6 consecutive quarters.

Flexible inflation targeting (FIT) up for review
2021 is also the year that the Flexible Inflation Targeting (FIT) framework of the RBI will be up for its first five-year review. The framework is increasingly being questioned and critics urge to widen the inflation targeting band, which would provide the RBI with more headroom to stimulate growth. However, abandoning the framework or watering it down would, in our opinion, result in even more CPI volatility.

Central banks that use FIT as a framework have a clear goal in adopting a nominal anchor rather than targeting intermediate variables (such as money supply and credit growth), which at best have an indirect relationship with price stability. Policy transparency enhances central bank credibility to such an extent that it leads to lower inflation expectations, which ultimately are anchored at lower levels than without FIT. New Zealand pioneered the introduction of inflation targeting in the 1990s and has shown that this policy worked to lower inflation structurally, and there are many more countries that set an excellent example. From a theoretical perspective it is also logical why the focus on price stability as primary objective works better than a multi-indicator approach. It is impossible - the so-called impossible trinity - for a central bank to maintain exchange rate stability, price stability and foster economic growth at the same time, especially within a context of open capital markets (see also this report).

The million dollar question is: has FIT worked in India? At first glance: yes. Inflation in the post-GFC period (2009-2015) was on average 9%, whereas it has been 4.6% since the introduction of FIT (Figure 4). But if one takes into account the development of other determinants of inflation (e.g. the output gap, real money growth, global prices, the exchange rate, rainfall), our models show that the monetary regime change to FIT only contributed to lower inflation by -0.9ppts on average. So this is perhaps not the result policymakers hoped for. Moreover, the RBI must tread carefully to avoid squandering its credibility in the aftermath of the crisis. Inflation expectation have already been edging higher (Figure 5). If the RBI fails to act on inflation picking up later in 2021, it would easily waste all the effort put into setting up FIT in the first place.

Meanwhile, the Indian government continues to face several structural challenges, which were already present prior to the COVID-19 pandemic. The Modi government did use the sense of urgency of the crisis to push key reforms on agriculture and the labor market. But more needs to be done: improving labor market institutions and the education system, reform of land acquisition laws, push back on pollution and broadening the tax base. The expected deterioration of banks’ balance sheets might also have important implications in the short term, as this puts a brake on credit growth to corporates and, consequently, weighs on private investment going forward. Before COVID-19, the share of non-performing loans (NPLs) was on a downward trajectory (from 10.9% in 2018Q1 to 8.2% in 2020Q2), but the pandemic likely reversed that trend. What is puzzling, though, is that there was not much appetite among banks to participate in a one-time restructuring scheme set up by the RBI, which ended on 31 December. Under this scheme, banks can allow borrowers who have been facing financial woes due to COVID-19 to extend their repayment period by up to two years. Bloomberg shows that only INR 2,000bn of loans were submitted to the scheme, which is less than 2% of total outstanding lending by banks. This could indicate that bank assets quality is proving better than expected, but it is more likely that the criteria of the restructuring scheme prevent banks from participating and that we will see NPLs increasing at a rapid pace over the coming year.