Indian Growth Has Strengthened. Can It Do Better?

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1 Economics Group Special Commentary Jay H. Bryson, Global Economist (704) Michael Pugliese, Economic Analyst (704) Indian Growth Has Strengthened. Can It Do Better? Executive Summary Following a year or so of economic deceleration in India, the year-over-year rate of real GDP growth strengthened in Q Looking forward, we forecast that real GDP in India will grow roughly 7 percent per annum over the next few years. In our view, however, it would be premature to expect double-digit rates of economic growth in India on a sustained basis. On the one hand, continued strong growth in the working age population over the next few decades is positive for the country s long-term prospects for economic growth. In addition, the country has made progress in improving its notoriously poor infrastructure. But, for us to get really bullish on Indian growth prospects, we would need to see evidence of a sustained rise in the country s savings and investment rates. Indian Economic Growth Turns the Corner in Q3 Recently released data show that the year-over-year rate of real GDP growth in India strengthened in Q after five consecutive quarters of slowing (Figure 1). Real GDP rose 6.3 percent in the third quarter, with the largest demand side component, private consumption, advancing at roughly the same pace as the overall economy. India saw another quarter of solid import growth amid this steady demand, but exports grew just 1.2 percent year over year for the second consecutive quarter. As a result, net exports once again sliced more than a percentage point off of the topline growth rate. Perhaps most encouraging from the Q3 print was the fact that economic growth strengthened despite a sharp deceleration in government expenditures. On a year-over-year basis, government expenditures had grown 16 percent or faster for more than a year amid a fiscal stimulus pushed by the Indian government. In the third quarter, however, government expenditures were up only 4.1 percent year over year, a sharp slowdown from the 17.2 percent pace in Q2. The big decline in the contribution from government was largely offset by acceleration in fixed investment spending, a positive sign for the near-term economic outlook in India. A period of demonetization, rupee appreciation and slow economic growth brought inflation in India down to historically low rates over the past couple of years (Figure 2). Food prices, which account for nearly 40 percent of India s consumer price index and which were falling on a year-ago basis as recently as July, have turned higher recently and are up about 4.4 percent year over year. Inflation excluding food and fuel has also been firmer in recent months. That said, the Reserve Bank of India (RBI) targets consumer price inflation of 4 percent over the medium term within a band of +/- 2 percent, meaning even with the recent jump in prices, inflation is still in check at present. In addition, the slowdown in economic growth over the past year and a half has raised output gap concerns among monetary policymakers, which coupled with the slower inflation led the RBI to reduce its main policy rate about 200 bps over the past three years before leveling out at 6.00 percent this summer. Although both the growth and inflation outlook have improved, the RBI will likely need to see a sustained improvement beyond the recent short-term bumps in growth and inflation before considering a tighter monetary policy stance. Looking forward, we forecast that real GDP in India will grow roughly 7 percent per annum over the next few years. The RBI will likely need to see a sustained improvement in growth and inflation before considering a tighter monetary policy stance. This report is available on wellsfargo.com/economics and on Bloomberg WFRE.

2 Figure 1 Figure 2 1 Real GDP Growth: 6. Indian GDP Growth Year-over-Year Percent Change 1 21% 1 Indian Consumer Price Index Year-over-Year Percent Change CPI: 4. 21% 1 7% 7% % 1% Source: IHS Global Insight, CEIC and Wells Fargo Securities The working-age population in India has risen sharply over the past few decades. Indian Demographics Are Strong Turning to the longer run, there is both good news and not-so-good news regarding India s growth prospects. Let s start with the good news. First, India has already been growing at a decent clip over the past decade or so. Real GDP growth in India averaged roughly 5 percent per annum in the 1980s and early 1990s (Figure 3). However, there was a clear acceleration in the economy that began in the mid-1990s following the economic reforms that were enacted in the aftermath of the 1991 balance-of-payments crisis. Today, real GDP is currently growing roughly 7 percent per annum, and the International Monetary Fund (IMF) looks for growth to strengthen a bit further over the next few years. Although India remains a very poor country, strong GDP growth has lifted GDP per capita from about $400 in 1990 to approximately $1700 today. Second, India has strong demographic dynamics. As shown in Figure 4, the working-age population in India has risen sharply over the past few decades. Rising numbers in this economically important cohort means that an economy can potentially produce more goods and services, everything else equal. Although the number of individuals who are aged 15 to 64 years may have hit an inflection point recently, the World Bank projects that the working-age population in India will continue to grow at a solid clip in coming years and exceed 1 billion individuals by Moreover, the World Bank projects that India will surpass China as the world s most populous country sometime within the coming decade. Figure 3 Figure Indian Real GDP Growth Forecasted Values from the IMF Indian Real GDP Growth: 7.1% Indian Real GDP Growth: IMF Forecast Five-Year Moving Average M 1000M Working-Age Population in India Millions of People, Forecasted Values from the UN Working-Age Population: 860M Working-Age Population: United Nations Forecast 1200M 1000M M 800M 600M 600M 400M 400M 200M 200M M 0M Source: International Monetary Fund, United Nations and Wells Fargo Securities 2

3 But Long-Term Challenges Remain What s the not-so-good news? Unlike China, where real GDP grew at an annual average growth rate of 10 percent between 1980 and 2012, India has never experienced double-digit rates of economic growth on a sustained basis. 1 During its growth spurt in the 1950s and 1960s the Japanese economy routinely grew in excess of 10 percent per annum, and South Korea posted double-digit rates of growth during much of the 1970s and 1980s. One of the factors that set these previously high-flying economies apart from India was the relatively large size of their industrial sectors at the time of their economic take off. The industrial sector accounted for roughly 30 percent of the value added that was created in the Japanese economy during the 1970s, and a similar proportion was achieved in the Korean economy during the 1980s (Figure 5). 2 In China, the industrial sector accounts for roughly 40 percent of value added. In contrast, the comparable ratio in India today is only 20 percent or so. What is so important about the industrial sector? There are two factors that determine a country s potential economic growth rate: labor force growth and productivity growth. We have already discussed the first factor in the context of the Indian economy. Productivity growth tends to be stronger in the industrial sector than in other sectors of an economy. 3 Therefore, economies with relatively small industrial sectors tend to have slower productivity growth and, hence, slower potential rates of economic growth, everything else equal. Figure 5 Figure Value Added in the Industrial Sector As a Percent of Total Value Added Indian Infrastructure Spending As a Percent of GDP State Government: FY 2. Central Government: FY Unlike China, India has never experienced double-digit rates of economic growth on a sustained basis % 30.7% Japan (70-79) Korea (80-89) China (00-09) India (10-15) Source: United Nations, Reserve Bank of India, CEIC and Wells Fargo Securities So how could a country increase the relative size of its industrial sector? The industrial sector tends to be capital intensive relative to the service sector, so strong growth in the former requires a significant amount of capital investment. India obviously is a labor abundant country, and low wage rates are attractive to manufacturers, everything else equal, but low wages are not the only consideration for manufacturers. Infrastructure, which is a component of overall capital investment, is notoriously poor in India, and low wage rates are not attractive if producers cannot easily get inputs to their production facilities and finished goods to market. In 2014, just as Prime Minister Modi was taking office, survey respondents ranked India 87th out of 1 Real GDP growth in China has slowed over the past few years to roughly 7 percent at present and most forecasters, including us, look for the Chinese economy to decelerate further in coming years. 2 Data on sectoral value added in Japan in the 1950s and 1960s are not readily available. The UN series that we use start in Long-term time series on sectoral productivity in the Asian economies that are mentioned in this report are not readily available. However, productivity data from the United States are instructive. Between 1992 and 2007, productivity in the American manufacturing sector grew at an annual average rate of 4.2 percent. Productivity in the overall nonfarm business sector rose 2.4 percent per annum during that period. 3

4 India has made substantial progress on the infrastructure front over the past few years. 144 economies in terms of infrastructure. 4 China placed No. 46 that year in the infrastructure category. India has made substantial progress on the infrastructure front over the past few years, raising its manufacturing potential, everything else equal. Total public spending on infrastructure has risen from 3.5 percent of GDP in fiscal year 2015 to 4.5 percent over the past two fiscal years (Figure 6). Spending by the central government has edged higher, but most of the growth in infrastructure spending has occurred at the state level. According to the survey referenced above, India shot up to No. 66 in terms of infrastructure in just three years, although it still trails China, which remained at No. 46. India has made significant progress in the quality of its roads and ports and, to a lesser extent, in the quality of its electrical supply. That said, it remains quite weak in terms of its fixed telephony technology, both fixed lines and mobile subscriptions. As noted above, infrastructure is just one component in overall capital investment which includes spending on machinery, equipment and structures as well. As we have noted in previous reports, the investment-to-gdp ratio in India is not extraordinarily high, at least by the standards of some high-flying developing economies. 5 As shown in Figure 7, the national investment rate in India rose markedly around the turn of the century and briefly flirted with 40 percent of GDP. However, the investment rate has receded in recent years, and the IMF forecasts that it will remain around its current level over the next five years. Figure 7 4 Savings & Investment in India As a Percent of GDP, Forecasted Values from the IMF IMF Forecast Indian Investment/GDP: 29. Indian Savings/GDP: The savings rate in India has fallen a bit short of the investment rate for more than a decade. Source: International Monetary Fund and Wells Fargo Securities As Figure 7 also makes clear, the savings rate in India has fallen a bit short of the investment rate for more than a decade. Consequently, India has incurred modest chronic current account deficits over that period. 6 If the investment rate were to strengthen while the savings rate remains unchanged, then the current account deficit would widen. Although foreign creditors may be willing to underwrite more red ink in India s current account for a while, they probably would not be willing to finance large deficits indefinitely. If current account deficits were to get too large, India could be vulnerable to sudden episodes of panic by foreign investors that could lead to sharp declines in the value of the Indian rupee. The only sustainable way for India to increase its national investment rate is to lift its national savings rate as it did about a decade ago. The IMF forecasts that the national savings rate will remain essentially unchanged for the foreseeable future. 4 The Global Competitiveness Report , World Economic Forum, Geneva, See Is India Ready to Assume China s Mantle? (March 28, 2016), which is available upon request. The investment rate in China has consistently exceeded 40 percent of GDP for more than a decade. 6 Through algebraic manipulation of the national income and product accounting identities, one can show that a country s current account balance is more or less equal to its savings-investment mismatch. That is, countries that save more than they produce run current account surpluses, and vice versa. 4

5 Conclusion Following a year or so of economic deceleration in India, the year-over-year rate of real GDP growth strengthened in Q Looking forward, we forecast that real GDP growth in India will pick up from 6.7 percent in the fiscal year that will end in March (FY 2018) to 7.1 percent in FY 2019 to 7.3 percent in FY Could Indian real GDP growth exceed our forecasts over the next few years? Sure. However, we do not believe that India will be able to achieve double-digit rates of economic growth on a sustained basis, at least not in the foreseeable future. The good thing about the Indian economy is the strong growth in the working age population that should continue over the next few decades. The not-so-good thing about the Indian economy is its relatively small industrial sector. If India had a larger industrial sector, the economy may be able to realize significant productivity acceleration and stronger economic growth, but poor infrastructure and relatively low rates of capital investment hold back growth in the industrial sector and, thereby, the country s potential economic growth rate. The country is certainly making progress in terms of infrastructure, although it continues to lag behind China. And it has shown that it can raise its national rates of savings and investment, at least temporarily. We believe that the Indian economy will continue to grow at a solid rate in coming years. But for us to get really bullish on Indian growth prospects, we would need to see evidence of a sustained rise in the country s savings and investment rates. Stay tuned. We do not believe that India will achieve doubledigit rates of economic growth on a sustained basis anytime soon. 5

6 Wells Fargo Securities Economics Group Diane Schumaker-Krieg Global Head of Research, Economics & Strategy (704) (212) John E. Silvia, Ph.D. Chief Economist (704) Mark Vitner Senior Economist (704) Jay H. Bryson, Ph.D. Global Economist (704) Sam Bullard Senior Economist (704) Nick Bennenbroek Currency Strategist (212) Eugenio J. Alemán, Ph.D. Senior Economist (704) Azhar Iqbal Econometrician (704) Tim Quinlan Senior Economist (704) Eric Viloria, CFA Currency Strategist (212) Sarah House Economist (704) Michael A. Brown Economist (704) Jamie Feik Economist (704) Erik Nelson Currency Strategist (212) Michael Pugliese Economic Analyst (704) Harry Pershing Economic Analyst (704) Hank Carmichael Economic Analyst (704) Ariana Vaisey Economic Analyst (704) Abigail Kinnaman Economic Analyst (704) Shannon Seery Economic Analyst (704) Donna LaFleur Executive Assistant (704) Dawne Howes Administrative Assistant (704) Wells Fargo Securities Economics Group publications are produced by Wells Fargo Securities, LLC, a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority, and the Securities Investor Protection Corp. Wells Fargo Securities, LLC, distributes these publications directly and through subsidiaries including, but not limited to, Wells Fargo & Company, Wells Fargo Bank N.A., Wells Fargo Clearing Services, LLC, Wells Fargo Securities International Limited, Wells Fargo Securities Asia Limited and Wells Fargo Securities (Japan) Co. Limited. Wells Fargo Securities, LLC. is registered with the Commodities Futures Trading Commission as a futures commission merchant and is a member in good standing of the National Futures Association. Wells Fargo Bank, N.A. is registered with the Commodities Futures Trading Commission as a swap dealer and is a member in good standing of the National Futures Association. Wells Fargo Securities, LLC. and Wells Fargo Bank, N.A. are generally engaged in the trading of futures and derivative products, any of which may be discussed within this publication. Wells Fargo Securities, LLC does not compensate its research analysts based on specific investment banking transactions. Wells Fargo Securities, LLC s research analysts receive compensation that is based upon and impacted by the overall profitability and revenue of the firm which includes, but is not limited to investment banking revenue. The information and opinions herein are for general information use only. Wells Fargo Securities, LLC does not guarantee their accuracy or completeness, nor does Wells Fargo Securities, LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. Wells Fargo Securities, LLC is a separate legal entity and distinct from affiliated banks and is a wholly owned subsidiary of Wells Fargo & Company 2017 Wells Fargo Securities, LLC. Important Information for Non-U.S. Recipients For recipients in the EEA, this report is distributed by Wells Fargo Securities International Limited ("WFSIL"). WFSIL is a U.K. incorporated investment firm authorized and regulated by the Financial Conduct Authority. The content of this report has been approved by WFSIL a regulated person under the Act. For purposes of the U.K. Financial Conduct Authority s rules, this report constitutes impartial investment research. WFSIL does not deal with retail clients as defined in the Markets in Financial Instruments Directive The FCA rules made under the Financial Services and Markets Act 2000 for the protection of retail clients will therefore not apply, nor will the Financial Services Compensation Scheme be available. This report is not intended for, and should not be relied upon by, retail clients. This document and any other materials accompanying this document (collectively, the "Materials") are provided for general informational purposes only. SECURITIES: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE