Economic developments in India: A mixed bag of ups and downs

India’s National Statistical Office (NSO) will release the GDP print for Q3 on 30 November. In this report we already revised our Q3 GDP forecast upwards from -15.4% to -11.0%.

Based on the latest monthly data on economic indicators, we are making a further upward revision: -8.9% y/y (see Figure 1). Domestic vehicle sales, vehicle exports, PMIs, electricity production and industrial production all pushed into positive territory in September (see Table 1).

These positive economic developments are taking place against the backdrop of an Indian economy that has been reopening slowly but steadily (see Figure 2). Currently, India’s stringency index stands at 61.6, in line with most other large countries, such as the US, Germany, and Brazil. Reopening has been possible on the back of a significant decline in the number of COVID-19 cases (per 100,000 persons) and a downward-trending mortality rate (see Figure 3).

Vaccine 95% effective

There has also been more positive news in the fight against the corona virus. Pharmaceutical companies Pfizer and BioNTech on the one hand and Moderna on the other hand claim that the vaccines they have developed are 95% effective. European Commission President Ursula von der Leyen has already stated that both vaccines could be given European approval by mid-December. As the US, Japan, Europe and Canada have pre-ordered millions of doses of vaccines from these pharmaceutical companies, expectations are that large-scale vaccination outside the trial group could even start before Christmas in these regions.

The vaccine of interest for India, though, is the Oxford-AstraZeneca vaccine which has shown to be 70% effective on average, but there is a has been study which shows that an effective inoculation strategy can improve the effectiveness to up to 90%. This vaccine has been developed in collaboration with the Serum Institute of India, the world's largest manufacturer of vaccines by volume. An additional advantage is that, unlike other vaccines, it is easier to make, store and transport, which will be very important given that India lacks a sophisticated healthcare system outside urban regions.

Risk of a second wave

Health Minister Harsh Vardhan is confident a vaccine will be available within months, and the Serum Institute has already promised 100 million doses by the end of January 2021 for local use. Despite these developments, there is a real risk that India could face a nation-wide second wave of infections before the vaccine arrives, which also implies that the Indian economy might be in for a tough first quarter of 2021. In fact, Delhi is already struggling with a third wave, which is directly related to the dangerously high air pollution levels in the capital, which act a super spreader. To contain a further spread of the virus, Maharashtra and Goa have already imposed measures restricting the entry of people from other states, Delhi in particular.

The second wave in many European countries (such as France, Spain and the Netherlands) and in the US has forced policymakers to re-impose (local) lockdown measures, hurting the economy (see Figure 4). There is no saying whether India might go down the same route. But keep in mind that India experienced the peak of the first wave at a much later stage than these countries and might be in for an unpleasant surprise in the next few months, a risk that is currently boiling in, for instance, Brazil. Ultimately, we have lowered our economic forecasts for 2020Q1 from -0.2% to -0.9%.

With such elevated risks, the government has been working round the clock to engineer support packages for the ailing Indian economy. On 12 November, Finance Minister Sitharaman unveiled the Modi government’s fifth stimulus package since the start of the corona pandemic (see Table 2). The newly announced package, known as Atmanirbhar Bharat Abhiyaan 3.0, consists of INR 2.6 lakh crore (USD 34bn) of policy measures. It raises total direct support by the government to 17.2 lakh crore, which is almost 8.5% of GDP. Taken together with monetary policy measures of almost 12.7 lakh crore by the Reserve Bank of India (RBI), total government support currently stands at 14.7% of GDP.

Measures in detail

The Atmanirbhar Bharat Abhiyaan 3.0 package consists of several measures aimed at strengthening employment, the housing market, construction and infrastructure, and exports (see Table 3). Specific measures include a fertilizer subsidy and labor market subsidy for firms hiring new employees on or after October 2020. The government has also increased the outlays for Garib Kalyan Rojgar Abhiyaan, a scheme launched in June 2020 to support migrant workers hit by the COVID-19 crisis. Finally, the government has extended the emergency credit line guarantee scheme until 31 March 2021.

There are also a number of measures that will support the Indian economy in the medium term. For instance, the government has extended the list of sectors which will be covered by the production linked incentives (PLI) scheme to boost competitiveness and stimulate India as a manufacturing location. The scheme provides subsidies up to 6% on incremental sales on products made in India. It runs for five years and the total incentive per applicant is capped for each year. Mobiles manufacturing and electronics, key starting materials and medical devices were already subject to this scheme. Ten sectors have been added, such as pharmaceutical drugs, automobiles, textiles, food, solar modules and telecom and network products. The government is also providing an equity infusion to National Infrastructure Investment Fund (NIIF) and will allocate INR 10bn to capital and industrial investment on domestic defense, green energy and infrastructure.

Impact on GDP and fiscal deficit

We expect that the new package will support economic growth by an additional 0.1ppts this fiscal year, by 0.4ppts in FY2021/22 and by 0.2ppts in FY2022/23. Taken together, government support will push up GDP growth by 1.9ppts in FY2020/21, 1.6ppts in FY2021/22 and 0.7ppts in FY2022/23. As we already factored in additional government stimulus in our fiscal deficit forecast, and as we expect GDP growth to be slightly better than previously anticipated, we expect the fiscal deficit will amount to -7.9% of GDP for FY2020/21 (up from -8.1%) and -6.3% for FY2021/22 (up from -6.5%).

After Finance Minister FM Sitharaman announced the new stimulus package, there was no change in yields on government treasuries: the markets had already factored in the additional spending which is within the threshold of INR 12,000bn (a self-imposed threshold for FY2020/21 by the central government). The additional spending is also too small to seriously prop up the risk that rating agencies will downgrade government sovereign bond ratings, which stand just above the junk level (Moody’s and Fitch). Such an event would certainly result in foreign investors pulling out of Indian assets on a large scale. We feel that the downgrade risk is low as long as the fiscal deficit projection remains below the psychological double-digit threshold of -10%, and the government is being prudent with its borrowing decisions. Additionally, India benefits from its high economic growth potential: if economic growth rates quickly return to levels seen earlier this decade, the risk of a downgrade can be completely averted.

Considering all the above, we expect GDP in fiscal 2020/21 to contract by -8.8% (up from -9.4% earlier) and a recovery in fiscal 2021/22 of 9.5% (up from 9.1% earlier). The government especially will be doing the heavy lifting in the upcoming quarters (see Figure 5 and Table 4), but we think this will not be enough to prevent the Indian economy from contracting for at least three consecutive quarters (on a y/y basis).

MPC decision on 4 December

The Monetary Policy Committee (MPC) will meet on 4 December to decide what to do with its policy rates. The GDP print for Q3 will definitely shape their decision. It is no secret that the RBI has been looking for a window to cut rates, but as long as inflation is moving in the wrong direction we believe that the MPC can do no more than sit and wait until price increases level off. The headline inflation print for October came in at 7.6% y/y, and especially worrying is rising core inflation of 5.8% y/y. Inflation expectations have been elevated since the outbreak of COVID-19 (see Figure 6). We are also seeing that prices for services (such as barbers and maintenance charges for household equipment) have started to trend higher as well.

Against this backdrop and the risk of new local lockdowns resulting in renewed supply-chain disruptions, we expect monthly inflation to continue to hover above the 6.0% upper band target range of the RBI, which means the RBI will be forced to maintain the status quo.

Looking beyond the upcoming months, a vaccine would significantly improve mobility in India and solve the problem of disrupted supply chains. Moreover, a good monsoon and lower base effects will result in lower food price inflation going forward. However, we expect that higher oil prices and abundant liquidity (see Figure 7) in combination with a normalization of economic activity in H2 of 2021 could provide a substantial counterbalance and keep headline inflation elevated for at least four quarters.[1]

[1] Figure 8 is only illustrative to show how the increase in real money supply at this moment could push up future inflation. Our inflation model contains not only real money supply (with fewer lags) as explanatory variable, but also includes the FX rate, the output gap, the policy rate, global prices (including oil) and rainfall.

The Regional Comprehensive Economic Partnership (RCEP) is a free trade agreement signed in November, 2020 between fifteen countries: all ten ASEAN[2] countries, Australia, China, Japan, South Korea and New Zealand. India was a member of the drafting committee from its inception in 2011, but in November 2019 decided to opt out, saying that some of its main concerns were not being addressed. This is generally considered to be both an economic and geopolitical loss for India. Analysts believe that India’s departure means China will have complete control over one of the biggest trading blocks in the world. But below we argue that India’s choice not to join RCEP is not irrational.

India’s deteriorating external position

India’s main argument not to join RCEP is its large trade deficit with many RCEP countries. Over the last 5 years, RCEP members were on average responsible for almost 70% of India’s trade deficit (Figure 8). This trade deficit has resulted in weakness of India’s external position. This has implications for India’s financial conditions and creditworthiness. What’s more, India’s weak external position prevents it from adopting unconventional monetary policy. India’s worsening trade balance explains why it is still among one of the most protectionist countries in terms of tariffs (Figure 9). And Indian policymakers have been backtracking on free trade the last couple of years (see this report).

[2] ASEAN stands for Assocation of Southeast Asian Countries. Members are Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand and Vietnam.

Non-tariff barriers to trade

So from the perspective of external weakness, India opting out of RCEP makes sense. But reality is even more nuanced. Trade barriers are not only about tariff levels. Non-tariff barriers (NTBs) to trade, ranging from administrative burdens to outright quantitative restrictions, have become increasingly important. Looking at OECD data on NTBs, India is not the most protectionist country by an arm’s length, being outflanked by RCEP members Australia, Japan and China (see Figure 10). RCEP has not made any arrangements on lowering NTBs.

Enhance domestic competitiveness

Finally, a free-trade agreement (FTA) with industrialized countries, such as Japan and Australia, has drawn criticism from across the political party spectrum in India because it is said to be killing lower-end manufacturing jobs and innovation. Especially with the "Make in India" and "Atmanirbhar" campaigns trying to push more local manufacturing, a free trade deal with countries like China, Japan and South Korea is not seen as the best move.

The door is still open

It is easy to see why signing members have still left the door open for India to join and have even included some chapters safeguarding India’s interests in the final version. India joining RCEP would have resulted in a substantial decrease of India’s tariffs, which will enable RCEP members to more easily access it’s large market of 1.4 billion potential consumers. India is currently insistent that it will not join the partnership. But a few agreements on import exclusion in sensitive sectors and a phased-out liberalization might push India to rethink, as RCEP is currently one of the easiest large FTAs which concentrates solely on trade. There is no emphasis on issues like environment, labor or state-owned enterprises, which are contentious in getting a trade deal with the likes of EU and US.

Co-authored by Murtuza Abidini