Why India GDP growth will remain subdued in 2017-18
Possible disruption due to GST implementation could temporarily have an impact on tax revenue, curtailing government spending and thus India GDP growth
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After a dip from almost 8% in FY16 to an estimated 6.7% in FY17, the Reserve Bank of India (RBI) projects real gross domestic product (GDP) growth to pick up to 7.4% in FY18, similar to the market consensus of about 7.5%. I, however, believe that real GDP growth is likely to remain unchanged at 6.8% in FY18 (my estimate for FY17 is also 6.8%), with downside risks.
Lower government spending and wider—though not concerning—current account deficit (CAD) could entirely offset the expected pick-up in private spending. Possible disruption due to implementation of goods and services tax (GST) could temporarily have an impact on tax revenue, further curtailing government spending, and thus, GDP growth.
In any economy, there are three sectors that drive economic activity—private sector (households and private corporate), government sector, and external sector (or net exports).
A look at the drivers of real GDP growth in the past few years reveals that, knowingly or unknowingly, Indian policy makers have followed Keynesian economics. When the private sector is weak, the general government (Centre + states) has supported economic activity. The contribution of government spending (consumption + investment) to real GDP growth has risen consistently over the last five years from as low as 0.5 percentage points (pp) in FY13 (when the new series began) to 1.2pp in FY16 and as high as 2.3pp in FY17. In other words, though the government sector accounts for about 15% of real GDP, the government contributed about 35% to real GDP growth in FY17. In contrast, the contribution of the private sector to real GDP growth has fallen from 6.1pp in FY15 to 3.5pp in FY17.
In a recent study, Motilal Oswal Securities Ltd analysed the 2017-18 budgets for 17 states (which accounted for about 85% of national GDP) and combined them with the Union budget to understand fiscal policy. This study revealed that the general government has budgeted to increase its total spending by 8.7% in FY18 against 15.7% in FY17. It means that government spending growth will be the lowest in 12 years and the third-lowest in the past three decades. The only other years when it was lower than budgeted in FY18 were FY05 (7.6%) and FY06 (5.8%). The key difference, however, is in the private sector, which was roaring during the previous years but is subdued today.
Based on the government’s budget estimates, government’s contribution to economic activity will be lower than in FY17. While real government spending is budgeted to have increased by 16% in FY17, I expect it to grow about 11% in FY18. This implies that while the government sector will continue to support economic activity, it will not be as robust as in FY17.
Additionally, though net exports added to real GDP growth during the past four years, with current account deficit (CAD) narrowing from a high of 4.8% of GDP in FY13 to 1.1% in FY16 and further to 0.6% (estimated) in FY17, I expect it to widen to 1.1% of GDP in FY18. While CAD will remain comfortable, the reversal in trend will act as a drag on real GDP growth. There are two key reasons why I expect CAD to widen. First, I have assumed crude oil price of $55 per barrel for FY18, about 15% higher than FY17. Second, since private spending is import-intensive, an expected pick-up in the private sector is likely to push imports higher.
Lower government spending and wider CAD will act as a drag on real GDP growth in FY18. However, I expect some revival in the private sector. Private spending (consumption + investment) is likely to grow by 6.1% in FY18—higher than 4.1% in FY17 and the highest growth in three years. The revival in private spending will be entirely driven by better private investment, which I expect to grow by about 3% in FY18 against an estimated decline of 2.5% in FY17. Private consumption, on the other hand, is expected to grow 7.7% in FY18—only slightly better than 7.6% in FY17, but the highest growth in six years.
Overall, the expected pick-up in private spending will entirely offset the adverse impact of lower government spending and wider CAD. This is why the real GDP growth is likely to be around 6.8% in FY18—unchanged from FY17. Besides, as noted earlier, there are downside risks to my already lower-than-market expectations. This is primarily because the implementation of goods and services tax (GST) adds another element of uncertainty on the tax receipts front.
Both the Centre and the states have ignored the impact of GST in their budgets. Even in the best case scenario, the GST is likely to be disruptive at least in the first few months, which raises doubts over the tax receipts for FY18. For instance, although the biggest indirect tax reform since independence is expected to bring efficiency, the GST in its current form—with many exemptions and several rates—is likely to wipe out some of those gains. While the disruption in FY18 may largely be discounted by the markets, the improvement in forthcoming years would be entirely dependent on the swiftness with which the issues/concerns are addressed by the government.
On the other hand, while private spending and CAD are linked with each other, if crude oil remains soft at $45-50 per barrel, CAD could be lower than my expectation, without necessarily hurting investments. This could push real GDP growth higher than my estimate.
The silver lining: whether real GDP grows at 7.5% or 6.8% in FY18, India will remain the fastest growing major economy in the world.
Nikhil Gupta is chief economist at Motilal Oswal Securities Ltd.