Going down: Revising our economic forecasts for India

We have revised our economic forecasts for the Indian economy downward to -10.7% for fiscal 2020/21 and expect the economy to grow by 8.9% in fiscal 2021/22 (see Figure 1 and Table 1). For Q3 2020, we have penciled in -15.4% y/y, with private consumption contributing -8.6ppts and capital formation -7.4ppts. The relief from additional government spending is marginal at best. Moreover, the economy is set to contract (on a y/y basis) up to the second quarter in 2021.

Although we were relatively accurate in predicting the impact of the hard lockdown phase in Q2 (-19.8% y/y versus Consensus: -18.1% y/y), monthly data on important economic indicators show that we have probably been too bullish on the pace of the recovery after the hard lockdown phase. Oil consumption and steel production in July and August were still showing double-digit contractions, industrial production in July registered -11% (y/y), services sector PMIs are looking bleak, and consumer confidence is at a rock bottom low (Table 2).

The weak pace of the recovery is directly linked to continuing local lockdown measures which are heavily restricting economic activity. Given India’s relatively young population (28 is the median age), the relatively low mortality rate, and a large share of people with low incomes (for whom the restricting measures have been particularly devastating), we assumed that policymakers in India would phase out restricting measures at a much faster pace than we are currently seeing. In fact, India’s stringency index even rose from 75 in early June to 81 currently (Figure 2).

Over the last couple of months, the INR has been appreciating against the USD. This is due to lighter interventions by the RBI and to the fact that large inflows of portfolio investment (directly related to the massive amount of liquidity that central banks have pumped into the global system) are sloshing around searching for yield.

Going forward however, we expect the INR to slide due to a serious strengthening of the USD after the US elections in November (Figure 3). Geopolitical risk is set to increase further, which increases risk-off sentiment towards emerging markets. In a nutshell we see that both China and the US are actively working on a decoupling strategy and we expect this development to speed up considerably after the elections. It does not even matter much which of the US presidential candidates is elected, as both Trump and Biden are actively pursuing an equal course as far as foreign strategy on China is concerned. And there is a high risk of more potential geopolitical fallout: Iran and the US, India and China, etc.

Compared to other EM currencies, we think the INR is especially vulnerable in the short term (Figure 4). In Q2 India experienced one of the most severe GDP crunches among the G20 and is showing a weak recovery in the high-frequency data. Not to mention stubbornly high inflation (i.e. stagflation), rapidly sliding fiscal metrics and ongoing high stringency to contain the corona virus.

Against the backdrop of a struggling economy, the question is: what can policymakers do? India has a weak external and fiscal position, which seriously limits its policy options (Figure 5). Although we expect a current account surplus of 0.1% for fiscal 20/21, we argue that this surplus is merely incidental in nature. We anticipate an exceptionally positive surplus of 2.6% in Q2, caused by a severe crunch in imports in Q2 in combination with large portfolio inflows on the back of excessive global liquidity searching for yield. Indeed, we saw the trade balance tip into deficit territory again in July and August.

Fiscal policy

We expect the budget deficit to deteriorate to -8.1% (of GDP) in FY2020/21 and -6.5% in FY2021/22 (Figure 6). High debt to GDP has kept central government spending tight with minimal additional spending. Instead, the central government has put the onus on state governments and given them space for spending (see here). This also leads to a rise in the cost of funding in the domestic market., There is also a sentiment that, additional spending, if any, will be “people-centric” (see also this article). If the government were to introduce additional fiscal measures, there would be a serious risk that rating agencies would further downgrade the sovereign credit rating. Ratings of Moody’s and Fitch stand one notch above junk status and any slide here would create an extra burden: it could trigger severe capital outflows and further increase the cost of funding. So there’s probably no relief from the fiscal side. What about monetary policy?

Monetary policy postponed

The Monetary Policy Committee (MPC) was supposed to meet on 29 September until 1 October, but the meeting has been postponed unexpectedly and no reason was mentioned. The RBI said that the new dates will be announced shortly.

The task of the MPC has become a very complicated one. Although the economy is in desperate need of further stimulus, inflation remains stubbornly high in India (Figure 6). Since December 2019, inflation has been hovering above the RBI’s upper band target range (of 6%), except for April. Going forward, we expect food inflation to decline, as the impact of unfavorable base effects is expected to wear off and because the monsoon brought 25% more precipitation in 2020 than the long-term average. Core inflation, on the other hand, is likely to be elevated, as supply chain disruptions due to local lockdowns have resulted in supply bottlenecks, pushing up costs for manufacturers and retailers. Further down the road, inflationary pressure may start to build up due to a sharp increase in Brent oil prices towards 50 USD/bbl. We also foresee global inflation picking up next year due to a recovery of global economic activity, resulting in higher import prices. Given the high inflationary regime and these risks, we think the MPC will be reluctant to cut its policy rates any time soon. For an extensive analysis on India’s inflation dynamics, see this article.

Other options?

Given the fiscal and monetary policy gridlock, Indian policymakers should especially focus on improving the fundamentals of the Indian economy. When announcing the 20 lakh crore stimulus package, PM Modi already mentioned that policy changes will be the path ahead. And we have seen the first steps in the right direction: new agricultural and trade bills as well as reforms of labor market laws were passed in Parliament in September. The F&A bills promote electronic trading, lower barriers for inter and intra-state trading, and enable farmers to sell directly to buyers, thereby clipping the middlemen and boosting farmer income. The labor reforms provide more flexibility to employers (with up to 300 employees) to hire and fire workers without government permission and offer social security to workers in the informal sector. These are hopeful developments, but there is always a big question mark about proper implementation.

There is still much to be done: for instance on land reforms, formalizing the economy and broadening the tax base. Currently, only 7.4% of Indian adults pay income tax (see here), which is much lower than in EM peers, such as the Philippines (26%) and Vietnam (58%). As long as India’s tax base remains small, the government will lack the financial means to conduct proper fiscal policymaking. Moreover, the banking sector continues to struggle: after the landmark Insolvency and Bankruptcy Act we have not seen much action by the government and RBI to clean up the sector.

Co-authored by Murtuza Abidini