India s Economic Outlook

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1 India s Economic Outlook Draft Report India-LINK Team* September 2016 Comments and queries may be addressed to: Pami Dua 1, N.R. Bhanumurthy 2 and Lokendra Kumawat 3 *These forecasts, developed as part of World Project Link, are based on the India-LINK (earlier known as CDE- DSE and IEG-DSE) macroeconometric model for India. This model is maintained at the Centre for Development Economics, Delhi School of Economics by Prof Pami Dua, Delhi School of Economics, Prof. N.R. Bhanumurthy, National Institute of Public Finance and Policy and Dr. Lokendra Kumawat (Assistant Professor, Ramjas College and Research Associate in the Project), with the active support of Professor V. Pandit (Sri Sathya Sai University, Prasanthinilayam). 1 Delhi School of Economics, University of Delhi, dua@econdse.org 2 National Institute of Public Finance and Policy, New Delhi, nrbmurthy@gmail.com 3 Ramjas College, University of Delhi, lokendrak@gmail.com 1

Macroeconomic Outlook for India Introduction In the year 2016-17, there have been significant developments in the domestic as well as the global economy that may impact India s medium-term growth

2 Macroeconomic Outlook for India Introduction In the year , there have been significant developments in the domestic as well as the global economy that may impact India s medium-term growth outlook. On the domestic front, there are many positive developments from normal monsoons after drought like conditions for two consecutive years, significant policy reforms such as passing of GST, implementation of the 7 th Pay Commission award, as well as receiving record FDI inflows. However, there are also other issues such as raising NPAs, high food inflation, the expected outflow of FCNR (B) funds (to the tune of about US 26 billions) from September, and continuous deceleration in export demand that may create uncertainty and have an adverse impact on the growth outlook. At the global level, the uncertainty with respect to the US Federal Reserve s future interest rate policy, impact of Brexit, firming up of global commodity prices as well as subdued external demand continues to be a concern for the medium-term outlook. With this mix of perceptions, overall, there appears to be some optimism in India s growth outlook in the medium-term mainly due to the expected recovery in domestic demand conditions in the current year. With this broad understanding, here we analyse briefly the recent trends in major macroeconomic variables and also provide forecasts for some select variables for the year based on the India-LINK macroeconometric model. As there are data issues, especially with the National Accounts after its revisions in 2015 and no back series data is available for this new series, the forecast is limited only for one year. Trends in the Indian Economy The provisional estimates for suggest that the Indian economy has grown at 7.2 percent, which is same as in (see Chart-1). Against this, for the first quarter of the current financial year ( ), GDP has seen a marginal recovery to 7.3 per cent. While this shows some mild recovery, it is interesting to note that the Government has assumed a growth of 7.6% for the whole of at the time of preparation of the Budget. At the disaggregated level, it is clear that compared to , while the industrial sector registered a higher growth at 8.8 per cent against 6.5 per cent , the services sector, which has been a backbone of India s growth, has decelerated to 8.2 per cent from 9.4 per cent (see Chart-2). This may be due to a decline in the external demand coupled with reduction in the growth of community and personal services expenditures. Agricultural growth has shown a positive growth of 1.2 per cent. On the back of two consecutive bad monsoons, such positive growth in agriculture sector is impressive and also suggests significant agricultural diversification in the country. Chart-1: Annual Growth Rate of GDP (Gross Value Added (GVA)) 2

Chart-2: Growth in components of GVA A further disaggregation of GDP shows that, in the first quarter of 2016-17, the mining & quarrying sector, which had a robust growth of 8.

3 Chart-2: Growth in components of GVA A further disaggregation of GDP shows that, in the first quarter of , the mining & quarrying sector, which had a robust growth of 8.5 per cent in , declines sharply to per cent. Construction sector, which has a strong forward linkage with the core sector growth and employment, has also seen a sharp decline from 5.6 to 1.5 per cent. However, two sub-sectors that have shown significant improvement are electricity and public administration. The rise in public administration may be attributed to the implementation of salary/pension hikes in the defence sector. On the demand side, a huge cause for concern is the sharp deceleration in the Gross Fixed Capital Formation, which has shown a growth rate of -3.1 percent. With this, the investment rate has also declined sharply from 32.7 per cent to 29.6 per cent. This suggests that the investment climate in the country still looks pessimistic. However, in our view, following many reform measures that the government has adopted in the recent period, one should expect revival in the investment rates in the coming quarters. On the trade front, while exports have shown marginally improvement in the first quarter, imports continue to decelerate, suggesting weak demand conditions in the country. Within the industrial sector, the core sector growth suggests that the economy is on the recovery path (Chart-3). In the first quarter of the current financial year, the overall core sector growth has shown significant recovery from 2.5 per cent to 5.4 per cent. Within the core sector, it is the growth in fertilizers (11%), electricity (9%), cement (5.7%), and petroleum refinery products (7.1%), that helped such recovery (Chart-4). Chart-3: Marginal recovery in Core Sector Growth Chart-4: Growth in Components of Core Sector 3

Source: mospi.nic.in However, the crude oil and natural gas sector output continues to show negative growth while steel sector growth appears to be stagnant.

4 Source: mospi.nic.in However, the crude oil and natural gas sector output continues to show negative growth while steel sector growth appears to be stagnant. Inflation After experiencing a sharp surge in inflation in and , the Central Bank and the Government have formally agreed upon a flexible inflation targeting of 4 +/- 2 per cent with CPI as the official target. Since then, CPI inflation declined in average terms from close to 10 per cent in to about 7% in the first half of 2014 and further to about 5% in the recent period (Chart-5). Currently, it is at 5.05 per cent in July It has thus been in the zone being targeted by RBI. Looking at the composition of inflation, it is clear that the high inflation that India has experienced during to has been driven primarily by the food and beverages group, which has also been responsible for the decline in average inflation during last two years. This suggests that the volatility in inflation is mostly due to the volatility in the food group inflation. The other group which continues to show high inflation is the Miscellaneous group. In the food and beverages group, it is clear that while the previous high inflation episode was powered by the cereals and vegetables sub-group, the recent surge is led mainly by pulses, which have been witnessing inflation rates of more than 20% for more than a year now (Chart-6). The other group which continues to show stubborn inflation is Egg-Meat & Fish- Milk (combination of three groups: (i) Meat and Fish (ii) Egg (iii) Milk and Products). Going forward, while we can expect benign inflationary conditions regarding cereals and vegetables, there is no reason to believe moderation in pulses or Egg-Meat & Fish Milk groups. In fact, the recent hike in MSP for pulses might push pulses inflation further in near term before it starts having favourable impact through improved supplies. In the Miscellaneous group, the recent moderation seems to have come largely from the Transport and Communication subgroup, where inflation has come down below 2 per cent now compared to more than 5 per cent earlier. Health and Education continue to be big contributors in this group. Going forward, these trends could reverse once oil prices start hardening in the international market. The Education sector is likely to see higher inflation 4

once the seventh central pay commission starts affecting salaries in the education sector. Thus, there are clear upside risks to inflation, which may limit any further scope for monetary easing.

5 once the seventh central pay commission starts affecting salaries in the education sector. Thus, there are clear upside risks to inflation, which may limit any further scope for monetary easing. Chart-5: Inflation Picks up Marginally Source: mospi.nic.in Chart-6: Food price inflation Money and interest rates The policy rates have been guided by the emerging inflationary scenario, in accordance with the new monetary policy framework. The central bank has tried to accommodate growth concerns through maintaining surplus liquidity in the system but not through reduction in the policy rates. This is because, as in the last round of monetary easing, the transmission of reduction in policy rates to retail lending was found to be weak. Since January 2015, when RBI cut interest rates, policy rates have come down by 150 basis points (Chart-7). In fact, in September 2015 the RBI reduced the rate by 50 basis points in one go, though the hardening of inflationary pressures since then has prevented it from reducing the rate steeply since then. But the transmission of these cuts to lending rates was only about 40 basis points. Further action on this front depends on the emerging inflationary scenario, which does not look benign as of now, and also how far the banks could transmit such cuts to consumers. 5

6 Coming to monetary aggregates, the slackness in the aggregate economic activity as well as the burden of NPAs appears to have hampered bank credit to the commercial sector, restricting its growth to single digit only (Chart-8). This is despite 150 basis points cut in the policy rate by RBI and through provision of surplus liquidity to banks. This also seems to be supported by the growth in credit to the Government sector, which has been rising faster than the overall money supply growth. Going forward, one does not see much hope of quick recovery in the credit to the commercial sector, given the large NPAs and the reluctance of the central bank to reduce policy rates. Another component of the money supply, which is very significant, is the net foreign exchange assets (NFA) with the banking sector, which is currently (July 2016) growing at about 10 per cent. With India attracting large FDI inflows as well as FII flows, the NFA also increased significantly in the recent period. Going forward, with the maturity of about US$ 25 billions in September to December 2016, one might see a reduction in the NFA growth that may put pressure on liquidity as well. Chart-7: Policy Interest Rates Chart-8: Components of Broad Money 6

7 External Sector With subdued external demand due to poor global growth recovery, India s exports (only merchandise) experienced negative monthly growth for over seventeen months (Chart-9). This is despite depreciation of the exchange rate by about 10 per cent since (Chart- 10). A similar negative trend is also found in imports growth as well, although some part of the imports deceleration could be due to low international oil and commodity prices. While these trends in both exports and imports have brought down the current account deficit close to one percent (Chart-11), this also suggests weak domestic demand conditions in the economy. Chart-9: Growth of Merchandise Trade 7

8 Chart-10: Exchange Rate Volatility: A Cause for Concern Chart-11: Worsening Current Account Deficit Threatens Growth Recovery (CAD as percent of GDP) Going forward, while recent developments in the EU as well as ambiguity in the US economic recovery could hamper India s exports, recent policy measures that India had taken may boost the domestic demand and, hence, lead to positive growth in imports. While such scenario would also end up in slightly higher current account deficit, any rise in CAD following recovery in overall growth may not be inconsistent. Key assumptions for To project the GDP growth and macroeconomic indicators, we have used the quarterly macroeconometric model. However, the model is based on the old GDP series and some link equations are used to derive the projections for the new GDP series. Given that the revisions are quite substantial and are comparable with the old GDP estimation methodology and further the new series is available only from without back series, re-estimating the model using the new data series becomes difficult. Here, to overcome this limitation, 8

9 forecasts are derived through a link equation between old GDP and the new series. This may be a limitation of the forecasts for Key assumptions for the year for important exogenous variables are as follows: policy interest rates to be brought down by 50 basis points by March 2017; full implementation of 7 th Pay Commission award; global consumer price inflation and food inflation are expected to increase marginally; world oil prices to be stable at about US$ 50 dollars per barrel; advanced country GDP assumed to follow OECD forecasts, which shows some stagnancy; monsoon is expected to be normal; and a modest recovery in foreign investment inflows is expected, especially following expected improvement in the Ease of Doing Business ranking; and fiscal deficit is assumed to be as per the Budget estimates (3.5% of GDP). The key forecasts are given below: Table: Key Economic Indicators to (All in growth rates) Year (P) (F) Agriculture Industry Services Real GDP CPI Exports Imports #: Industry includes Manufacturing, Mining & Quarrying, Electricity, Gas & Water supply. Construction sector is part of services group (RBI classification) P is Provisional estimates. F-Forecasts from the quarterly India-LINK macroeconometric model. Forecast With the assumption of normal monsoons this year, the model predicts a higher agriculture output growth at 3.6 per cent compared to 1.2 per cent in the previous year, when the monsoons failed for the second consecutive year. Increase in domestic demand following the implementation of the 7 th Pay Commission as well as recovery in the export demand together is expected to increase demand for both industrial as well as services output. However, credit supply constraints in the manufacturing sector could constrain industrial growth to be below the growth in The assumption on reduction in policy interest rates in the current year is expected to have positive impact on private investment demand only with a lag (in ). Overall, GDP growth is expected to be higher at 7.9 per cent in compared to 7.2 per cent in On the inflation front, as the model predicts higher agriculture output due to assumption of good monsoons, inflation is also expected to come down and stay within the target set by the new monetary policy framework. 9

India s Economic Outlook

India s Economic Outlook Draft Report 2017-18 & 2018-19 India-LINK Team* September 2017 *These forecasts, developed as part of World Project Link, are based on the India-LINK (earlier known as CDE- DSE