India. Country Economic Forecast. Highlights. Forecast for India * 12 Jun 2014

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1 Country Economic Forecast Highlights s electorate delivered a clear verdict in the general elections. The Bharatiya Janata Party (BJP) won 282 seats of 543 in the lower house of parliament, comfortably above the 272 required for a simple majority. The unexpectedly clear mandate provides a stable platform for governance, and should facilitate quicker decision-making at the centre, reduce uncertainty and political risk. This has led to considerable optimism in financial markets, with share prices scaling record highs and the rupee appreciating. However, in our view, given the very stubborn nature of some of the fundamental problems facing, it is too early to assume any marked improvement in the country s economic outlook. Indeed, GDP growth in Q1 disappointed. The economy expanded by just 4.% year-on-year, below our expectation of 5.2% growth. Manufacturing output fell for the fourth consecutive quarter, while services growth slowed from.4% in Q to 5.8%. In view of the sluggish data, we have revised down our GDP growth forecast for from 4.7% to 4.5%. Although the risks to s economy have tempered considerably since last year, with the current account deficit narrowing sharply and the fiscal deficit also improving, the outlook is still weak. High inflation, relatively tight monetary and fiscal policy and high corporate debt levels will continue to exert a drag on domestic demand. And while net exports will continue to contribute positively to growth, this will largely reflect weak imports rather than strong exports. With headline CPI inflation still stubbornly high, the central bank (RBI) maintained its policy rate at 8% in June. Moreover the likelihood of a disappointing monsoon raising food inflation remains high, suggesting that interest rates will not be cut in the near future. Instead, the RBI has lowered the Statutory Liquidity Ratio (SLR) banks mandatory investment in government bonds by 50 basis points to 22.5% to ensure that banks have the scope to lend more when credit demand picks up. But, on its own, the move will not have any visible impact on growth. (Annual percentage changes unless specified) Domestic Demand Private Consumption Fixed Investment Stockbuilding & discrep (% of GDP) Government Consumption Exports of Goods and Services Imports of Goods and Services GDP Industrial Production Consumer Prices Current Balance (% of GDP) Government Budget (% of GDP) Current Account ($bn) Trade Balance ($bn) Short-Term Interest Rate (%) Exchange Rate (Rupee per US$) * Refers to Calendar year Forecast for * Economist: Nida Ali Tel: nali@oxfordeconomics.com 1

2 Research Briefing The end of an era enough reason to be optimistic? There was a dramatic end to the general elections last week, with the country s electorate delivering a clear verdict. The Bharatiya Janata Party (BJP) won 282 seats of 543 in the lower house of parliament (Lok Sabha), comfortably above the 272 seats required for a simple majority. With an embarrassingly low 44 seats, the Congress party, which led the coalition government for the past ten years, did not even reach the 10% threshold for forming the opposition. This election marks an end of the coalition politics characterising s politics since 1984, but it may not be an end to the crony capitalism that is holding back s growth. Clear mandate positive for economy The landslide victory came as a surprise. We were expecting the BJP to win the most seats, but we thought they would have to align themselves with other parties to form a coalition which would make reform more difficult to achieve. The clear mandate provides a better, more stable platform for governance. In the absence of stubborn regional parties determined to protect their states electorate and stand in the way of pro-growth reforms, it will facilitate quicker decision-making at the centre. It will also help to reduce uncertainty and political risk, potentially leading to higher business and consumer confidence. For this reason, Moody s credit rating agency deemed the election outcome credit positive. but optimism appears overdone Financial markets welcomed the BJP win; not just because of the clear majority, but also because the BJP : Equity market Index (Dec 30, 2010 = 100) MSCI Emerging Markets (US$) 70 Jan 2011 Jan 2012 Jan 2013 Jan Source: Haver Analytics Bombay Sensex has earned a reputation for being pro-business. Many believe it will help to lift out of its current economic mire. Share prices scaled record highs and the rupee strengthened to its highest level since last June. Fiscal position still precarious We take a more cautiously optimistic stance on the election results, however. is still suffering from a number of fundamental problems that will take time to eradicate. The fiscal position remains precarious and anecdotal evidence suggests that the public finances are in a much worse state than has been officially reported. Therefore, the new government will have little wriggle room to increase capital expenditure to boost infrastructure and raise potential growth. Corporate debt as well as bad loans in the financial sector have risen substantially, holding back the much-needed kick-start to investment. : Investment as a % of GDP % of GDP Source: Oxford Economics / CEIC Forecast 2

3 So regardless of the party in power, businesses will still struggle to invest and banks to lend. Crony capitalism needs to go In the longer term, to be able to achieve the government s target growth rate of around 8%, needs an institutional overhaul aimed at reducing crony capitalism and improving the business environment. There is scant evidence to suggest that the BJP is much better than the Congress in this regard. Indeed, the Prime Minister designate, Mr Narendra Modi, has close ties with big businesses like the Tata, Reliance, Ambani and Adani groups. It would be surprising if he were not to show favouritism towards these giant corporate entities. While having a good relationship with them should help to develop the country s infrastructure, it will also promote the culture of crony capitalism and prevent smaller businesses from flourishing. Not only will this have a net negative impact on the economy, it is also likely to extend the acute inequality that currently prevails in. It s too early to be sure of reform The BJP has mentioned reform and development as primary objectives in its election manifesto, but it remains to be seen whether the party will deliver on these promises. Links to an extremist right-wing group (Rashtriya Swayamsevak Sangh) characterised by Hindu Nationalism, together with Mr. Modi s track record of inaction when thousands of Muslims were killed in 2002 during riots in Gujarat raise questions in some quarters about the priorities and integrity of the BJP. So while we believe there is reason to be optimistic, it is too early to celebrate an economic revival in. This article was originally published on 20 May as a Research Briefing for our newly launched Global Macro Service (Asia Pacific). 3

4 Forecast Overview Q1 GDP disappoints The n economy expanded by 4.% year-on-year in Q1, well below our expectation of 5.2% growth. Manufacturing output fell for the fourth consecutive quarter, declining by 1.4% year-on-year, while services growth slowed from.4% in Q to 5.8%. The expenditure side painted a mixed picture; consumer spending was unexpectedly strong (after two particularly weak quarters) but investment continued to stagnate. In light of this generally discouraging data, we have cut our growth forecast for from 4.7% to 4.5%. and the outlook remains problematic Although growth was only very moderate in Q1, is at least a lot less vulnerable to adverse economic shocks than in 2013; the current account deficit has narrowed sharply and the fiscal deficit has also improved. Despite this, there are numerous problems that will continue to hold growth back in the short term: High inflation wholesale price (WPI) inflation remains above the RBI s 5% comfort zone, albeit it did fall back to 5.2% in April. Meanwhile, CPI inflation rose to 8.% in April, from 8% in February, far above the recommended target of 4% (+/- 2% band). In addition, the prospects of below-average monsoon rains have raised the risk of inflation increasing further in the coming months, as it will restrict food supply and therefore boost food price inflation. As a result, high inflation will continue to eat into consumers purchasing power : Contributions to GDP % year % year GDP : Inflation Net exports Domestic demand Source: Oxford Economics Consumer prices Producer prices Source: Ministry of Commerce & Industry F'cast Relatively tight monetary policy given high inflation, the RBI maintained the repo rate at 8% in June. And with inflation expected to remain sticky in the coming months, we do not expect interest rates to be cut until early Relatively high interest rates are damaging growth by encouraging consumers to save rather than spend and discouraging businesses from borrowing to invest. Having said that, the RBI has lowered the Statutory Liquidity Ratio (SLR) banks mandatory investment in government bonds by 50 basis points to 22.5% to ensure that banks have more resources when credit demand picks up. Rising corporate debt s corporate sector is now highly leveraged, with many companies having borrowed on the assumption that the economy would : Exchange and interest rates Rupee/US$ Repo rate (RHS) Rupee/US$ (LHS) Source: Reserve Bank of %

5 keep on growing by around 8% pa. According to the IMF, s debt-to-equity ratio is elevated at 83%; the highest among all emerging markets, and only surpassed by Greece and Italy. At the same time, the levels of bad debt in the financial system have also risen rapidly. These factors will limit the banks ability to lend and businesses desire to invest. Only moderate export growth export growth has cooled this year, following a solid expansion during H In addition to subdued global demand, exports are probably also being held back by supplyside constraints including weak infrastructure in the power and transport sectors. Net trade will continue to contribute to growth, but this will reflect sluggish imports rather than strong exports. No room for flexible fiscal policy narrowly avoided a sovereign credit rating downgrade to junk status in 2013 after several years of missing its fiscal targets. However, there are high hopes that the new government will develop key power and transport infrastructure and reduce supply-side bottlenecks. But without a wider tax base the government has little room for manoeuvre on the fiscal front and its scope to increase capital expenditure will be limited. despite unexpectedly clear election result s electorate delivered a clear verdict in the general elections. The Bharatiya Janata Party (BJP) won 282 seats of 543 in the lower house of parliament (Lok Sabha), comfortably above the 272 required for a simple majority, while the Congress party won just 44 seats. This marks an end to coalition politics in for the first time since The clear mandate should provide a stable platform for governance, reduce uncertainty and political risk, and improve sentiment across the economy. It should facilitate quicker decision-making, with the government no longer having to negotiate with stubborn regional parties determined to protect their states electorate and stand in the way of pro-growth reforms. Investors have reacted very positively, with share prices scaling record highs. However, given the deep-seated nature of many of the problems facing the n economy, we think that it is too early to assume a more upbeat medium-term economic outlook than previously. Many of the required reforms and initiatives will have adverse consequences for some people in the short term and it remains to be seen whether the new government will have the determination to press on in the face of protests. Debt to equity (non-financial corporations) Brazil Indonesia Russia Mexico Thailand China Turkey Singapore Poland Malaysia South Africa % Source : IMF : Government budget balance and debt % of GDP Source: Oxford Economics : Stockmarket 000s 27 Government debt (RHS) Central government balance (LHS) Source: Bombay Stock Exchange Bombay SE % of GDP 70 F'cast

6 Risk Assessment s economic situation deteriorated significantly between 2011 and 2013, so making the country more vulnerable to domestic or external shocks. GDP growth has slowed and the twin deficits have only recently narrowed from unsustainable levels after drastic action by the government, including policies to curb gold imports and sharp cuts to capital spending. And although the economy is now more stable, sluggish growth and unfavourable domestic conditions (including high inflation, tight monetary policy and a poor investment environment) mean that much needs to be done before the country is on a more secure footing. On a more positive note, the formation of the new government in May under the BJP, which won a clear mandate in the elections, will help to reduce economic uncertainty and political risk, and could spur a pick-up in investment if structural reform is quickly initiated. Emerging risks Further capital outflows despite making progress in cutting the twin deficits, the n economy remains vulnerable to capital outflows stemming from domestic or external shocks, such as tighter monetary policy in the US. Such developments could pose a significant downside risk to our baseline forecast, as heightened uncertainty would discourage investment while capital outflows would push the exchange rate down and inflation and interest rates up. Key risk scenarios Emerging market capital outflows another round of outflows of foreign capital would hit the economy hard by weakening the exchange rate, pushing inflation up and forcing the central bank to raise the repo rate sharply. Growth might slow to around 2% in 2015, compared to around 5% in the baseline. China banking crisis although s exposure to China is relatively limited, the country would be quite badly affected, since a banking crisis in China would not only trigger capital outflows from emerging markets, but also lead to a sharp global slowdown. Outflows of capital, coupled with trade linkages with other countries in the Asia Pacific region and beyond which are heavily exposed to China, would hit s economy hard. In this scenario, growth might slow to around 4% a year in -19, compared to % a year in the baseline World average Sovereign risk Trade credit risk Political risk Regulatory risk GDP growth CPI inflation Current account balance Government balance Government debt External debt -1 Risk index (0=no risk, 100=highest risk) Risk warnings Risk scenarios GDP growth to remain below 5% in both and 2015 Inflation has moderated but still uncomfortably high Deficit halved as a % of GDP in 2013 Fiscal position is less precarious now Government debt to fall over the forecast horizon External debt remains at a manageable level Impact of scenarios on risk index Maximum impact of scenarios on risk index % year China Banking Crisis Capital flows out of EMs Eurozone slumps into deflation Russia Ukraine tension escalates US-led upside Impact of scenarios on GDP growth Baseline Capital flows out of EMs China Banking Crisis Russia Ukraine tension escalates Source : Oxford Economics

7 Long-Term Prospects Favourable factors for long-term growth GDP growth in is expected to average.5% a year in , up from 4.7% a year in This improvement is driven by: Favourable demographics s working age population is expected to grow strongly over the next two decades. Rising middle class the middle class is on course to expand. Indeed, the number of households with an income greater than US$30,000 is likely to more than double over the next decade. Competitiveness is competitive in international markets, with relative unit labour costs among the lowest of the BRIC economies. But weak infrastructure key sectors such as power and transport are suffering from inadequate infrastructure, which has prevented supply from increasing in line with growing demand. This will prevent from achieving its target growth rate of 8% a year in the long term. : Actual & potential output Rupee billion, 2004/2005 prices Potential Actual Forecast Source: Oxford Economics Potential GDP and Its Components Average Percentage Growth Potential GDP* 7..0 Employment at NAIRU Capital Stock Total Factor Productivity *ln(potential GDP)=0.5*ln(Employment at NAIRU) +0.35*ln(Capital Stock)+ln(Total Factor Productivity) Long-Term Forecast for (Average annual percentage change unless otherwise stated) GDP Consumption Investment Government Consumption Exports of Goods and Services Imports of Goods and Services Unemployment (%) Consumer Prices Current Balance (% of GDP) Exchange Rate (vs US$) General Government Balance (% of GDP) Short-term Interest Rates (%) Working Population Labour Supply Participation Ratio Labour Productivity

8 Background Having rarely recorded GDP growth of above 7% prior to 2003, the n economy chalked up five consecutive years above that figure between , with 9%+ growth registered in This not only propelled the country into the economic fast lane alongside China but also meant that it was making an important contribution to the overall increase in world GDP. However, still has a very long way to go along the development path. According to the IMF, s GDP per capita using market prices and exchange rates was just US$1,504 in 2013 while on a PPP basis it was US$4,077; the equivalent figures for China were US$,747 and US$9,844 respectively. But structural problems including supply-side bottlenecks in key sectors such as power and transport, widespread corruption, bureaucratic hurdles and the lack of a transparent and disciplined policy framework have contributed to a sharp slowdown in s economic growth, from above 8% to less than 5% in the last couple of years. As a result, in the general elections, the n electorate, battered by high inflation and poor economic conditions, delivered a clear mandate in favour of the opposition Bharatiya Janata Party (BJP). The BJP won 282 seats of 543 in the lower house of parliament, comfortably above the 272 required for a simple majority. Meanwhile the Congress party, which had been in power for the past ten years, suffered a humiliating defeat. They won only 44 seats, not even crossing the 10% threshold required to form the opposition. This marks an end to coalition politics in for the first time since A decisive government will speed-up decision-making at the centre and reduce political risk, although powerful state governments can still slow the implementation of changes wrought by the national government. With two-thirds of the population living in the countryside and more than half the labour force working in the sector, agriculture is still a key part of the economy. However, in the eleven years to 2009 it only grew by 3.% pa in real terms so its share in the overall economy has fallen significantly, from 20.8% in 2002 to 13.8% in By contrast, the most dynamic sector has been the services sector, recording 9.4% annual growth between 2002 and 2012, with major expansions in distribution, transport, communication, finance and business services. Construction has also boomed, growing by more than 9% pa over the same period. Industry has performed more modestly, with manufacturing recording 8% pa growth. With the boom in the services sector helping to create a relatively affluent middle class, said to be 300m-strong, the links between rural incomes and industrial activity have weakened. Rising incomes and increased access to credit have led to much higher spending on consumer durables such as cars, phones and other electronic items. However, the higher level of inflation since 2005 has particularly constrained the purchasing power of the urban and rural poor. And if the economy is to sustain a high level of growth for several decades, it will need to ensure that an ever-wider number of people are raised above virtual subsistence living, by increasing both output and productivity growth in agriculture, raising educational standards and making cities more attractive to migrants. The 2000s saw a significant integration of the economy with the rest of the world. Exports of services (largely software and business outsourcing) accounted for 8.5% of GDP in 2013 compared to 4.1% in 2002, while the equivalent ratio for merchandise exports increased from 10.9% to 18.3%. Allied to this has been a sharp increase in foreign investment in, either in the form of FDI (despite the many bureaucratic hurdles) or in portfolio flows. The rapid growth in the economy in enabled a sharp fall in the central government budget deficit, from 5.9% of GDP in 2002/03 to 2.7% in 2007/08. However, relatively little was done during this time to widen the tax base. The cyclical nature of the improvement in the budget over these years was shown by the speed of the fiscal deterioration in H as the economy slowed sharply. Indeed the fiscal deficit widened to.7% of GDP in 2009/10. By 2013/14 it was down to 4.9%, but the pace of fiscal consolidation was much slower than planned and the fiscal gap was still uncomfortably wide compared to many other emerging economies. 8

9 Data & Forecasts Key Indicators: Percentage changes on a year earlier unless otherwise stated Industrial Bank CPI CPI PPI Exports Imports Trade production Credit Industrial workers Combined rural & urban (US$) (US$) balance $ bn May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Financial Indicators: Percentage changes on a year earlier unless otherwise stated Repo Money Exchange Exchange Exchange Share Reserves Reserves rate Supply M3 rate rate rate index price cover % % p.a Rup/ avg. Rup/$ avg. Trade End per. $bn months May based Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May

10 INDIA TABLE 1 SUMMARY ITEMS Annual Percentage Changes, Unless Otherwise Specified CONSUMERS TOTAL TOTAL REAL INDUSTRIAL PRIVATE GOVERNMENT WHOLE COMPETIT- PRODUCER CONSUMER EXPENDITURE FINAL FIXED GDP PRODUCTION SECTOR BANK ECONOMY IVENESS PRICES PRICES EXPENDITURE INVESTMENT BANK BORROWING PRODUCT- (2008=100) CREDIT IVITY (C) (TFE) (IF) (GDP) (IP) (BPRIV) (BGOV) (GDP/ET) (WCR) (PPI) (CPI) YEARS BEGINNING Q I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV COPYRIGHT (C), OXFORD ECONOMICS INDIA TABLE 2 SUMMARY ITEMS TRADE CURRENT CURRENT GOVERNMENT GOVERNMENT SHORT-TERM SPREAD REAL EQUILIBRIUM EXCHANGE BALANCE ACCOUNT ACCOUNT FINANCIAL FINANCIAL INTEREST OVER US SHORT-TERM EXCHANGE RATE PER ($ BN) ($ BN) (% OF GDP) BALANCE BALANCE RATE SHORT-TERM INTEREST RATE PER US (RUPEES BN) (% OF GDP) RATE RATE US DOLLAR DOLLAR (BVI$) (BCU$) (BCUR%) (GB) (GB*100 (RSH) (RSH - (Note 1) (RXEQUIL) (RXD) /GDP!) RSH US) YEARS BEGINNING Q I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV Note 1 : REAL INTEREST RATE = Nominal interest rate (RSH) - % change in CPI COPYRIGHT (C), OXFORD ECONOMICS 10

11 Long-Term Forecast for Annual percentage changes unless otherwise specified GDP Consumption Investment Government Consumption Exports of Goods and Services Imports of Goods and Services Unemployment (%) Consumer Prices Current Balance (% of GDP) Exchange Rate (per $) General Government Balance (% of GDP) Short-term Interest Rates (%) Working Population Labour Supply Participation Ratio (%) Labour productivity Employment Output gap (% of potential GDP)

12 Key Facts Politics Chief of state: President Pranab MUKHERJEE Head of government: Prime Minister Narendra MODI Political system: Federal republic Date of next presidential election: July 2017 Date of next legislative election: 2019 Currency: n rupee (INR) Long-term economic & social development * GDP per capita (US$) Inflation (%) Population (mn) Urban population (% of total) Life expectancy (years) Source : Oxford Economics & World Bank Structure of GDP by output * 2012 or latest 2012 available year Agriculture 17.4% Source : CIA Factbook Industry 25.8% Location : Southern Asia, bordering the Arabian Sea and the Bay Services 5.9% of Bengal, between Burma and Pakistan (CIA Factbook) Source : World Bank Long-term sovereign credit ratings & outlook Corruption perceptions index 2013 Foreign currency Local currency Score Fitch BBB- (Stable) BBB- (Stable) Developed economies (average) 74.5 Moody's Baa3 (Stable) Baa3 (Stable) Emerging economies (average) 37.3 S&P BBB- (Negative) BBB- (Negative) 3.0 Emerging Asia 34.7 Structural economic indicators * Current account (US$ billion) Trade balance (US$ billion) FDI (US$ billion) Debt service (US$ billion) Debt service (% of exports) External debt (% of GDP) Oil production (000 bpd) Oil consumption (000 bpd) Source : Oxford Economics / World Bank / EIA Destination of goods' exports (2012) European Union (27) 1.7% United States 12.8% United Arab Emirates 12.3% China 5.1% Singapore 4.7% Source : WTO Source: Transparency International Scoring system 100 = highly clean, 0 = highly corrupt Source : WTO Composition of goods & services exports, 2012 Fuels and mining products 14.9% Agricultural products 9.8% Other commercial services 24.0% Manufactures 41.% Travel 4.1% Other goods exports 1.7% Transportation 3.9% 12