The Indian economy: Here comes the sun3 min read . Updated: 15 Jul 2018, 07:50 PM IST
Private sector activity is picking up. So is inflation. Policymakers should now stick to the basics
The Indian economy seems to be in the midst of a strong growth rebound, as the effects of the twin shocks of demonetisation followed by the messy transition to the new goods and services tax (GST) have finally dissipated. The macro worries cannot be ignored—rising inflation, a growing current account gap, fiscal pressures and a banking mess. These worries have dominated the discourse in recent weeks, and for good reason. However, the official estimates for economic growth in the first quarter of the financial year are likely to provide a pleasant surprise.
The latest high-frequency indicators tell a good story. The most recent data on the Nikkei Purchasing Managers’ Index (PMI) show very strong output expansion in the private sector for June. The composite PMI was at its highest level since October 2016, the last month before the shock demonetisation decision. The indices for manufacturing and services are also well into expansion zone.
More granular data also supports the case for optimism. Production of passenger cars, commercial vehicles, consumer durables, steel, cement—which are good proxies for overall economic activity—show strong momentum. Rail as well as air traffic numbers have also been good. Meanwhile, on the monetary front, growth in broad money has picked up while bank credit shows signs of recovery. However, the increase in bank credit is led by consumer rather than business borrowing. Credit to industry continues to be flat, though large firms now have access to other sources of funds such as the bond market. Smaller firms are more dependent on the banks for funding.
Corporate earnings for the first three months of the financial year 2019 will provide more evidence about the strength of the private sector recovery. Most brokerages have put out fairly strong earnings estimates for the first quarter. The earnings season began last week on a good note, though the early birds often provide incomplete information about the performance of the entire flock. There have been signs of an earnings recovery in previous quarters as well, and the total earnings of Indian companies have been weighed down by the effects of bad loans in the banking sector as well as the price war in the telecom sector. No earnings season is without its nasty shocks, and rising input prices are likely to eat into corporate margins in the three months to June, but equity market strategists feel that the corporate sector could have turned the corner.
This does not mean all is hunky dory. Here are three specific worries. First, higher inflation will lead to rising interest rates very early in the credit cycle. Core inflation in June was 6.4%.
Second, the latest data on rural wages shows that consumer demand in rural areas will continue to rest on weak foundations.
Third, the jury is still out on whether investment activity has picked up, though the latest data on capital goods imports combined with the higher capacity utilization numbers released by the Reserve Bank of India (RBI) provide reason for optimism. The first-quarter results of equipment makers need to be watched closely for signs of an investment recovery.
The strong demand rebound in the absence of capacity creation has already pushed up core inflation. It appears that excess capacity is being squeezed out in select sectors. Steel is a good example. The lavish bidding for steel assets in the new bankruptcy process is good reason to believe that Indian steel companies will soon hit capacity constraints. The need to fix the banking sector becomes even more important now—since the inability to build new capacity will lead to some combination of higher inflation and higher imports.
The Indian economy seems to be headed out of its recent funk. The private sector perhaps has a good run ahead of it—despite the inherited problem of excess leverage. Policymakers would do well to stick to the basics right now. They should try to maintain macroeconomic stability rather than artificially push economic growth above potential, which can only result in high inflation combined with balance of payment problems as excess demand spills over into imports. India neither needs fiscal nor monetary adventurism at this point. What this means in practice is that the fiscal deficit should be kept as close to target as possible while the RBI contains inflation before it gets out of hand.
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