Short-term pain is obscuring the potential for long-term gain

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1 India economic outlook Short-term pain is obscuring the potential for long-term gain March 213 P. K. Basu, Regional Head of Research & Economics (6)

2 India: external sector has been transformed by economic reform (YoY %) (2) (4) India: both merchandise and services exports soared over 2 decades(us$m) 33, 28, 23, 18, 13, 8, 3, -2, Mar-92 Mar-96 Mar- Mar-4 Mar-8 Mar-12 Source: CEIC, PKB Merchandise exports: YoY % (LHS) Invisible exports: YoY % (LHS) Merchandise exports, four-quarter rollingsum (RHS) Invisible exports, four-quarter rollingsum (RHS) Trade/GDP ratio resumes rising in the 199s..having edged lower until the mid 7s Source: CEIC, PKB Exports, % of GDP Imports, % of GDP The export/gdp ratio declined from 7% in the early-19s to 3-% in much of the period, but has since rebounded steadily to 1.2% now. Goods exports rose from US$18.bn in FY199/91 to US$31bn in FY211/12, and invisible exports from US$7.bn to US$22bn over the period. The surge in exports (especially of services) enabled the import/gdp ratio to rise sharply (to 23%, from <1% in 19-9), broadening consumer choice. Sharply rising incomes in the export sector (goods and services) have filtered through to the rest of the economy, pushing out India s potential GDP growth rates.

3 India: fastest-growing economy among the world s democracies Mexico Brazil Indonesia Thailand Philippines Korea Malaysia Singapore India China 21 real GDP (1992=1) (%) S Asia goods exports to the US: trend decline in ASEAN economies' share, 3. India gains from a low base Jan-97 Jan-99 Jan-1 Jan-3 Jan- Jan-7 Jan-9 Jan-11 Jan-13 Malaysia export: mkt share in US Indonesia export: mkt share in US Philippines exports: mkt share in US Thailand exports: mkt share in US Singapore exports: mkt share in US India exports: mkt share in US Never has a democracy with even 2m people sustained annual real GDP growth of 6.3% over a 3-year period: India s achievement since 198 is unprecedented! In human history, Japan (7.1% growth annually, 19-8) is the only democracy that has seen faster economic growth over a 3-year period. Tariff reductions, financial-sector liberalisation and industrial de-licensing have contributed to more efficient capital-allocation and a robust external sector. Revealed comparative advantage in services, and knowledge- and resource-intensive manufacturing. However, the vast potential in labour-intensive manufacturing is untapped. Fiscal reform still needed, as the FRBM Act was simply ignored by the UPA, and the gains of 21-4 have been dissipated. India s goods exports performed very well in the 2-11 period. Last year was a poor year, but India s goods exports continued to gain US market share (especially at ASEAN s expense).

4 192/3 194/ 196/7 198/9 196/ / /6 1966/ /69 197/ / /7 1976/ /79 198/ / /8 1986/ /89 199/ / /9 1996/ /99 2/1 22/3 24/ 26/7 28/9 21/11 India: medium-term potential growth has risen with higher national savings and investment rates; but the latter moderated in (YoY %) (2) (4) (6) India: real GDP growth, five- and ten-year moving averages 1 India: Slight moderation in nvestment/gdp ratio slows growth pace Real GDP Real GDP, 1-year moving avg. Real GDP, five-year moving avg. GDP: YoY%: yrma(lhs) GDI: % of GDP (RHS) Real GDP growth slowed in FY211/12 to 6.%, primarily because of the moderation in the investment/gdp ratio to 3.% (from 36.2% in FY1/11) far from catastrophic, especially as the savings rate remained above 31%. Investment/GDP is likely to have moderated further to 33%, and savings to 29%, as real GDP grew just.2% in FY212/13. The 1-year moving average of real GDP growth has risen steadily to 7.8% now (the same as the -year moving average, which peaked at 8.8% in FY27/8, just before the global financial crisis). That inflation remains high despite the slowdown in GDP growth (almost stagflationary ) is a reflection of the RBI s policy error in 21 (when it was too slow to raise rates amid 1%+ inflation, and had to consequently tighten too sharply in FY211/12). Inflation is now finally below 7%YoY, but at the cost of slower growth. 4

5 India: services are structurally strong; the cyclical slowdown in capex has sharply reined-in manufacturing activity (YoY %) Manufacturing contraction drags down real GDP growth () (1) (1) Dec-2 Dec-4 Dec-6 Dec-8 Dec-1 Dec-12 Real GDP Agriculture Manufacturing Services Source: CEIC, Maybank-KE 7 6 Industrial slump led by capital goods (YoY %, 3mma), recovery by consumer (1) (2) (3) Dec- Dec-2 Dec-4 Dec-6 Dec-8 Dec-1 Dec-12 Source: CEIC, Maybank-KE Consumer Goods Capital Goods Basic Goods Intermediate Goods Services account for half of GDP, and expanded at an average pace of 1% annually in The wider cross-border tradability of services bolstered their expansion, as India was still a price-taker for internationally-traded services. After decelerating substantially in the aftermath of the GFC, we expect Services to return to the pace seen in the previous decade. NREGA, and the shift in internal terms of trade in favour of agriculture, boosted rural consumption strongly. But policy paralysis contributed to the moderation in capex in the last 2 years. The slump in manufacturing would have reduced the current-account deficit, but rising oil prices caused the deficit to widen to 4% of GDP for FY11/12. The weak rupee, and lower oil prices, should allow the current account deficit to moderate in FY213/14 to 3.6% of GDP (from 4.3% in FY213/14).

6 India: the trade deficit widened sharply as oil prices soared, but the pass-through to consumers since Sep12 is reining in the fiscal deficit (1,) (2,) (3,) (4,) (,) (6,) Source: CEIC, MBKE India: trade deficit's 6-month improvement ended in Sep 212 Jan-93 Jan-97 Jan-1 Jan- Jan-9 Jan-13 Trade Balance, 3m rollsum, US$m (LHS) Exports, %YoY, 3mma (RHS) Imports%YoY,3mma (RHS) (1) (3) 8 Fiscal and primary deficits have settled at an elevated level (1) (2) Jan-3 Jan- Jan-7 Jan-9 Jan-11 Jan-13 Fiscal deficit: 12mma, %GDP Primary deficit: 12mma, %GDP Source: CEIC, MBKE The trade deficit widened to new record levels in FY211/12, as surging oil prices raised the oil-import bill causing imports to outpace even the fast 3%YoY pace of export growth. With oil prices moderating in the Apr-Jun12 quarter, India s exports resumed outpacing imports in Apr- May 212 and the trade deficit began to edge lower. But exports declined YoY in Jul12-Jan13, and imports (especially of oil) continued to rise, worsening the trade deficit. The sharp increases in domestic oil prices (especially diesel and LPG since September 212) have helped cap the fiscal deficit, and the trade deficit is likely to begin improving in the current quarter (with February seeing % YoY growth in exports). 6

7 India Budget 213: Meeting the challenges of turning growth around while reining in the fiscal deficit? Fiscal deficit target:.3% of GDP this year, 4.8% in FY213/14. Increased taxes on the super-rich, lower stockmarket transactions tax, but a new commodities transaction tax. Services tax net being substantially widened. About a 1% reduction in the subsidy bill, primarily through a reduction in oil subsidies (resulting from changes already effected in the oil price regime in Sept-Oct 212). Provision of only Rs1bn for the Food Security Bill appears to be the one measure that will be most difficult to sustain in an election year. An ambitious target for disinvestment proceeds. Key provision to boost fixed investment: an investment allowance (similar to what Singapore and Malaysia have long had). Overall: Should provide a modest boost to economic growth to slightly over 6% YoY in FY213/14, thereby providing a modest further boost to revenue. But achieving the 4.8% fiscal deficit target will be politically very challenging. 7

8 India: interest rates are set to moderate gradually Real interest rates are positive using WPI (but not CPI!) (3) Mar-3 Mar- Mar-7 Mar-9 Mar-11 Mar-13 WPI (93/94): YoY % CPI-IW: YoY % Repo rate WPI (4/): YoY% 33 Inflation is edging steadily lower -- except food (2) (7) (12) Jan-1 Jan-3 Jan- Jan-7 Jan-9 Jan-11 Jan-13 RBI was behind the curve in fighting inflation in 21, but turned more realistic (and hawkish in 211, with two bp rate hikes, and several 2bp hikes taking the repo rate to 8.%. Although the RBI cut the repo rate bp to 8% in Apr 212 (using a window of 7-8% YoY WPI inflation), inflation proved stubborn and the next two 2bp rate cuts were only possible in Jan-Mar 213. Core (non-food manufactures) inflation is likely to moderate further, but the persistence of high food inflation (and steady fuel price increases) will slow additional rate cuts with only another bp of cuts in the repo rate likely before Dec 213. The combination of lower interest rates, the investment allowance, and a modest pick-up in reform should allow a mild investment-led recovery to 6.3% YoY growth in FY213/14. However, a post-election, more-reformist government is key. WPI, YoY % WPI: Food, YoY % WPI: Energy, YoY % WPI: Manufactured products, YoY %

9 India: equity valuations are in the middle of their 1-year range; politics will be a major factor in the next few months India: valuations (trailing P/E) in the middle of their 1-year average range 21, 6 19, 17, 1, 4 13, 11, 3 9, 2 7,, 1 3, Feb-97 Feb-99 Feb-1 Feb-3 Feb- Feb-7 Feb-9 Feb-11 Feb-13 BSE Sensex-3 Index (LHS) PE Ratio: BSE Sensex (RHS) 1th Lok Sabha United Progressive Alliance (UPA) + supporters UPA (participants in the Union cabinet) Pledged support 7 Indian Nat'l Congress 26 JMM 2 Samajwadi 23 Dravida Munetra Kazhagam (DMK) 18 KC(M) 1 BSP 21 NCP 9 AIMIM 1 JD(S) 3 J&K National Conference 3 VCK 1 RJD 4 Muslim League 2 NPF 1 Rashtriya Lok Dal BDF 1 Indpt 4 Opposition 238 Nat'l Dem'c Alliance 14 Left Front Others BJP 116 CPI(M) 16 BJD 14 Shiv Sena 11 CPI 4 AIADMK 9 Janata Dal (U) 2 AIFB 2 TDP 6 Shiromani Akali Dal 4 RSP 2 HJC 1 TRS 2 SDF 1 Asom Gana Parishad 1 MDMK 1 AUDF 1 Indpts 7 Trinamool Congress+SUCI 2 The equity market s trailing PER is in the middle of its 1-year range. Corporate earnings held up reasonably well during the global downturn, but have weakened in the past year as nominal GDP growth slowed. We think the pipeline of disinvestment proceeds will restrain the upside for equity prices, and a sharp moderation in nominal GDP growth is likely to hurt corporate earnings. The UPA government has a thin 1-seat majority in parliament after the withdrawal of the DMK; this means that the SP (23) and BSP (21 seats) have the ability to bring the government down, and will have a stranglehold over policy. The government will face a difficult 6 months, and an early election appears likely.

10 Asia s demographics: well-endowed for the next decade in India and Indonesia, less so in Korea and China China Indonesia India Republic of Korea 3 2E 24E 24E 23E 23E 22E 22E 21E 21E Dependency ratio (ratio of population aged -14 and 6+ per thousand population 1-64) We expect non-japan Asia to continue to benefit from declining dependency ratios until 22. Typically, savings rates rise during periods of declining dependency ratios (this began to happen in Asia from 196 onwards; in India from 198). Higher savings should be able to fund higher investment rates, enhancing the productivity of the increasing workforce. Technology (embodied in FDI and through imports) should ensure strong total factor productivity (TFP) growth and a rapid economic catch-up for Asia. We think India has the demographic advantage in

11 India: demography should support steadily stronger growth India Source: UN, PKB Note: females on the left; males on the right Source: UN, PKB Note: females on the left; males on the right The huge number of young people in the population today will reach working age over the next 1-2 years. By 22, India is expected to have 27m people (almost equal to today s total US population) between the ages of 1 and 3. Savings rates and productive potential should be at their highest. In our view, the challenge for India is to develop a more labour-intensive growth model to take full advantage of the productive potential of the masses. The literacy rate of 74% should help to some extent. 6 India

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