Growth momentum shows recovery is on

Industrial production (IP) growth in India for the past two months has decelerated significantly to 0.4% year-on-year (y-o-y) in both July and August compared with an average growth of 4.4% in three months ending June 2014. This has led to concerns whether the growth momentum has faltered since the recovery in quarter ending June. While headline IP growth has decelerated recently, underlying growth momentum continues to imply that the recovery is holding up.

There are two key aspects of IP growth data that need to be taken on board.

Data volatility due to incomplete responses: The quality of the IP data is affected by lack of response from a good number of firms in the first release in which the Central Statistical Organization typically gets feedback from around 70% of the respondents. This can increase the risk of volatility in growth implied.

Issue of shutdown of a large mobile manufacturing plant: IP growth is being depressed by radio, television and communication equipment sub-component, partly due to the shutdown of the mobile manufacturing plant (of Nokia) in Chennai due to factors other than demand. Indeed, IP after excluding this component grew 3.3% y-o-y in the July-August 2014 period versus overall IP growth of 0.4% y-o-y.

To better understand the trend in underlying economic activity, a closer look was taken at other corroborative data for both external demand and domestic demand indicators.

External demand: Headline export growth has indeed slowed sharply from near double-digit level in the May-July period to a range of 2.5-2.7% y-o-y over the past two months. However, for exports excluding oil (which has been hit by sharp decline in prices), the trend is less concerning. Non-oil export growth has indeed accelerated from 0.8% in July to 6.3% in August and 8% in September (compared with an average of 6% in the quarter ending June).

Rural wages: Rural wage growth has moderated to around 8-9% y-o-y from an average growth of 18% between April 2009 and March 2013.

Fiscal deficit: Monthly public finance data indicates that the central government is likely to achieve budgeted fiscal deficit target of 4.1% of gross domestic product (GDP) in 2015. Taken together with the state government deficit, consolidated fiscal deficit is expected to decline to 6.5% of GDP in 2015 from 7.1% in 2014 and a peak of 9.9% of GDP in 2009.

Real deposit rates: One-year real bank deposit rates have moved into the positive territory since January 2014 after largely remaining in the negative territory for the past five years. Based on the latest Consumer Price Index (CPI) inflation data, real deposit rates have increased to 2.3%.

Price stability: Headline CPI inflation decelerated to 6.5% in September from 7.7% y-o-y in August, due to moderating food and non-food inflation. Core inflation moderated to a new low of 5.9% in September from 6.8% in the previous month exhibiting broad-based moderation in prices. Wholesale Price Index (WPI) decelerated to 2.4% in September from 3.7% in August, mainly due to the high base effect and deceleration in food prices.

External stability: The trade deficit for September widened to 8.5% of GDP annualized from 6.5% of GDP in August. The monthly annualized trade deficit at 8.5% of GDP in September has risen to the highest since June 2013. Increase in gold and commodity imports (indicate some front-loading of imports to capitalize on the lower commodity prices) led to a widening of the deficit.

Financial stability: This is improving, though at a slow pace. Loan-deposit ratio is gradually declining from somewhat stretched levels, property prices are gradually moderating and new impaired loans appear to have peaked. The rating upgrade to downgrade ratio has improved to above 1 for the first time since April-September 2011.

Faster improvement

The outlook is that there will be faster transition from stagflation to a position of higher growth and slower inflation.

Sustained deceleration in CPI inflation is expected, supported by these factors such as moderation in rural wage growth closer to nominal GDP growth, further reduction in the fiscal deficit, a sustained trend in positive real deposit rates, lower global commodity prices y-o-y in rupee terms and moderation in housing costs in line with the weak trend in property prices.

CPI inflation is expected to touch 6% by July 2015, which is earlier than the Reserve Bank of India (RBI) and consensus expectations of reaching the 6% mark by January 2016 and April-June 2016, respectively.

As inflation moves to 6% in a sustained manner, external stability indicators are expected to be within the central bank’s comfort zone.

Apart from this, build-up of real deposit rates and continued policy action from the government to improve the investment approval process and address the specific problems of the infrastructure sector will steadily help correct the asset quality issues facing the banking sector.

There is a high chance that RBI will take up a rate cut of 25 basis points (bps) in February or April 2015, if the actual inflation trajectory indicates high probability of reaching 6% sustainably from July 2015. (One basis point is one-hundredth of a percentage.)

From the underlying cost of capital perspective, there will be more focus on the trend in underlying bank deposit rates (one-year rates), which has been running significantly higher than the current policy rates. Considering the inflation forecast, the one-year deposit rates may decline by 125 bps over the next 12-15 months.

In the first stage of recovery, the government’s policy reforms will help revive the productivity dynamic, bring down the capital-output ratio and improve returns on investment. Hence, this initial phase of recovery in growth may be less capital-input-intensive.

As returns on investment improve, the corporate sector will be incentivized to lift capex, thereby leading to the second stage of the recovery. This will place India on a transition path from stagflation to higher growth and lower inflation. The GDP growth on a quarterly basis is expected to increase from the current pace of 5.7% (quarter ending June-14) to 7.2% for March 2017.

Edited excerpts from India Economics—Macro Indicators Chartbook: Is Growth Momentum Faltering? by Morgan Stanley.