Focus on India’s long term macroeconomic story
India has seen a sharp improvement in its inflation dynamic after Reserve Bank of India’s monetary policy committee adopted the flexible inflation-targeting framework
While high oil prices are definitely a net negative for the Indian economy, which is reflected in the rupee volatility, it is unwise to judge India’s macro strength only through the prism of the currency. In the last four years, India has improved its macro strength considerably through structural and institutional reforms, and, therefore, it is instructive in our view to analyse the Indian economy on a holistic basis by taking a wide array of macro indicators into consideration.
Growth: India is experiencing a cyclical upswing in growth, impacted last year due to temporary disruptions like demonetisation and the goods and services tax (GST). Production momentum remains strong, capacity utilization has started picking up, and channel checks suggest that some private sector capex activity is likely to come on stream over the next few quarters. The outlook related to earnings recovery has improved and India continues to be a key focus country for medium- to long-term investors. Higher oil prices and a premature rate hike cycle may slow down the pace of recovery to some extent but even then India’s real gross domestic product (GDP) growth will likely remain over 7% in FY19, making it the fastest growing major economy in the world. Even if oil prices remain elevated, India’s growth recovery will sustain through FY19 and beyond as the impact of previous reforms and a modest pickup in private sector capex activity will add incrementally to growth.
Inflation and inflation expectations: India has seen a sharp improvement in its inflation dynamic after the Reserve Bank of India (RBI) adopted the flexible inflation-targeting framework. Consumer price index (CPI) inflation has halved in the last four years. Recent concerns related to upside inflation risks arising from high oil prices, rupee depreciation, potentially larger increase in minimum support price (MSP) are justified, but even then the worst case for CPI inflation looks to be about 5-5.5% average for this and the next fiscal year. That a country used to double-digit CPI inflation is now considering 5-5.5% average inflation as the worst-case scenario speaks volumes about the ongoing change in inflation and inflation expectations dynamic, that too over a relatively short period of time.
Real interest rate: We expect the RBI to hike the repo rate in June by 25 basis points (bps) and cumulatively by 75 bps, which should help sustain 1.75% average real rates over the next 12 months, even if we assume CPI inflation to average 5%, building in some upside risks. This will help maintain macro stability and prevent repeat occurrences of episodes when negative real rates led to a sharp increase in macro imbalances, finally leading to a disorderly depreciation of the rupee. The RBI’s focus on keeping real rates positive should be seen as a boon for the medium term, as it will help preserve and strengthen macro stability, without which sustaining high growth can become challenging.
Centre and state fiscal deficit: With oil prices remaining elevated, the concerns on the fiscal front are legitimate. If excise duty on petroleum products is reduced, revenue will reduce by that amount, ceteris paribus, a risk which has increased in recent weeks. But it is still possible to meet the fiscal deficit target if the GST collection picks up after the implementation of the e-way bill and some expenditure compression is effected. The government has been conservative with its disinvestments and non-tax revenue target, which may also possibly provide an upside surprise, thereby helping offset some of the slippages due to higher crude prices. In our view, it is too early to take a definite view regarding the fiscal arithmetic, but we expect the government to remain committed to meet the FY19 fiscal target at any cost.
Our analysis of state budgets pertaining to 16 key Indian states revealed that on a cumulative basis, the fiscal deficit of the states is likely to reduce by 50 bps, to 2.7% of GDP in FY19. If both the Centre and state fiscal deficit targets are met in FY19, India’s general government deficit will reduce to 6% of GDP, which will be the lowest since FY08. The big picture story of fiscal consolidation remains very much in place, in our view, despite the near term concerns.
The external sector: With Brent crude prices hovering around $75 per barrel, the FY19 current account deficit (CAD) is likely to increase to 2.5% of GDP, which in absolute terms will be about $71 billion. This would imply about $9-10 billion balance of payment (BOP) deficit, as the total capital account surplus is expected to be about $61 billion in FY19. While the increase in current account deficit is negative for the rupee, it is worth noting that 2.5% of GDP worth CAD is sustainable for the Indian economy. With CAD increasing, we would expect the RBI to hike rates and ensure that the deficit does not rise beyond 3% of GDP on an annual average basis. The RBI had close to $445 billion in reserves by end-March 2018, including forwards, which implied an import cover of eleven-and-a-half months. Given the likely BOP deficit and ongoing RBI intervention, it is possible that the import cover could fall to about 10 months by the end of this fiscal year, which is still strong from a reserves adequacy perspective. India’s reserves adequacy strength remains far stronger today than in 2012-13, and, therefore, we do not expect any disorderly depreciation of the rupee. Also, a swift correction in global oil prices could improve the BOP outlook and sentiment, more so in India’s case, given the economy’s increased sensitivity to global oil prices.
Kaushik Das is India chief economist, Deutsche Bank.
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