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 and IEG-DSE) macro-econometric 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). Comments and queries may be addressed to: nrbmurthy@gmail.com 1
Summary of India s macroeconomic outlook Indian economy has faced two major back to back policy shocks in the form of Demonetisation as well as implementation of GST. As the demonetisation has sucked away 85 per cent worth of the currency from circulation, it was widely expected that it could have a dampening impact on the GDP growth atleast in the short run while some positive outcomes in the medium to long term through less-cash economy as well as through increasing formalization of predominantly informal economy. While the economy did take a hit in the short run with GDP growth declining to from 6.7 per cent in the Q3 to 5.6 in Q4 of 2016-17, the quarter after the policy shock, what is more concerning is the deceleration of growth even after remonetisation. For the 2017-18:Q1, the GDP reached a lowest growth of 5.7 per cent, lowest in the last four-year period. One reason could be the implementation of GST in the month of June, 2017. As GST is one of the major tax policy reforms and not much clarity regarding the channels and extent of its impact on GDP and inflation, there appears to be holding up of economic (both consumption and production) activity as well as increase in the cost of doing business. There is deceleration in all the demand side variables except the government sector. More concern is on the sharp fall in the private investments, which has declined to 27.5 per cent (of GDP) in 2017-18:Q1 from 31 per cent in the same period last year. This is despite nearly 150 basis point reduction in the interest rates since 2015-16. However, there appear to be some modest recovery in the trade sector, although imports appear to be growing at faster rate than exports, resulting to sharp widening of current account deficit (to 2.4 per cent in 2017-18:Q1 from 0.7 in the previous quarter). On the inflation front, the subdued trends in both CPI and WPI continue with CPI inflation (policy anchor) continued to be well below the Central Banks target rate. On the other policy front, India has taken many structural reform measures, in addition to GST implementation. Passing of Insolvency and Bankruptcy Code, sticking to FRBM targets, relaxation of FDI norms and opening few more sectors to foreign investors, adopting Direct Benefit Transfers (DBT) in the social sector, allowing new Banks, Financial Inclusion (Jan Dhan Yojana), reforms in the Rural Housing and Electricity, etc. On the back of these reforms, one should expect improvement in the overall ratings as well as Ease of Doing Business rankings and strengthen the confidence on the economy among the foreign participants through confidence channel. With not so benign external sector, how to revive growth in India through domestic policies? As the slowdown in the economy is largely due to weak demand conditions, one of the ways that can be revived is to adopt the counter cyclical fiscal policy measures. But, as the quality of public expenditures matters a lot in fiscal expansions, one option is through larger public capital expenditure even if there is some slippage in the fiscal deficit target (of 3 per cent for 2018-19). Another way is through reviving the banking sector. As the banks are struggling with huge non-performing assets that are struck in the long-term projects, banks appear to minimize the losses by safely funding the government expenditure. One way to revive could be to partially recapitalize the banking sector through public resources. Assuming that there could be some pick up in the demand side, GDP is expected to be at 6.9 and 7.6 per cent in 2017-18 and 2018-19, respectively. However, there are some downside risks for these forecasts. It depends on the extent and quality of of fiscal and monetary stimulus provided to revive the economy as well as on the assumptions on the monsoon and the external variables. 2
Trends in some Macroeconomic Variables Introduction The financial year 2017-18 has seen significant developments in the global economy and especially in the domestic economy. While in the global economy the developments are more transient as well as positive with reasonable recovery in the advanced countries, the developments in the Indian economy were more unanticipated/shocks and potential to have significant impact on both medium and long-term growth prospects. The government s decision to demonetize nearly 85 per cent worth of the money supply has been the major disruption to the economy and was expected to have differential impacts on the economic agents in the short, medium and long term. In addition to the demonetization, the implementation of the Goods and Services Tax (GST), which has been under discussion for more than a decade, from June 2017 is also expected to make large disruption to the consumption as well as production activity. On the monsoon front there appears to be some setback with poor rains in some parts of India while some experiencing flooding. However, the banking sector continue to be distressed with every increasing NPAs appear to be exert downward pressure on the Indian economy. With this background, this note tries to review the overall trends in the Indian economy and attempts to understand future prospects. The forecasts are provided for two years: 2017-18 and 2018-19. (India has revised its GDP estimation procedure, thus, making it to be consistent with the SNA 2008. However, due to lack of consistent back series prior to 2011-12, forecasting models face severe constraints while revising the models). Trends in the Indian Economy While there were expectations on the Indian economy to rebound in 2016-17, on the back of demonetization, the growth appears to have declined sharply from 7.9 per cent in 2015-16 to 6.6 per cent (provisional estimates, see Chart-1). However, the slowdown in the economy appeared to have extended to 2017-18 as well. The first quarter growth (April-June) has stuttered to 5.7 per cent, lowest since 2012-13. This also reflects continuous decline for six consecutive quarters. Except for trade in services as well as the government sector, the rest of the sub-sectors decline with sharpest decline in the manufacturing sector, which has declined from 10.7 to 1.2 per cent between first quarter of 2016-17 to the first quarter of 2017-18. Mining sector continue to decelerate with negative growth. However, construction as well as financial services also declined substantially. Even in the demand side, which has taken a sharp hit due to demonetization and declined significantly in the October-December, 2016, the recovery appears to be still marginal. The investment demand is still growing at as low as 1.6 per cent in 2017-18:Q1 compared to 7.9 per cent in 2016-17:Q1. However, with the government s decision to frontload it s both consumption as well as capital expenditures (especially in defence, road and railways) appear to have resulted in substantial increase in the government demand and it appear to have rescued the economy from sharp slowdown. On the trade front, with a marginal recovery in the global economy, the exports demand has increased in the first quarter. However, as there is also sharp increase in the imports (especially valuables), the current account deficit widened sharply in the first quarter to 2.4 per cent. Chart-1: Annual Growth Rate of GDP (Gross Value Added (GVA)) 3
10 8 6 4 2 0 Annual Growth rate of GVA (%) 7.9 7.2 6.6 6.1 5.4 2012-13 2013-14 2014-15 2015-16 2016-17 Chart-2: Growth in components of GVA 12 10 8 6 4 2 0-2 Growth in Components of GVA (%) 10.2 8.6 8.9 9.1 7.0 6.9 7.0 6.9 5.6 4.5 4.9 4.2 1.5 0.7-0.2 2012-13 2013-14 2014-15 2015-16 2016-17 Agriculture Industry Services Government s commitment to stick to the fiscal targets as set under the FRBM at the same time front loading of public capital expenditure as well as tax devolution to the sub-national governments appears to have contained sharp fall in the GDP. However, weak transmission of monetary policy, following both demand (from the corporate) as well as supply (from the banking sector) constraints, appear to have not resulted in pick-up in the investment demand. However, the slowdown in the growth, especially in the service sector growth, while there is a recovery in the global economy is unusual and a cause for concern. As shown in chart-2, the industrial sector growth, that shown a robust growth for two consecutive years, has started decelerating since 2016-17. This has further decelerated to about 1.2 per cent in the first quarter of 2017-18. Within the industrial sector, the core sector growth suggests that the economy is in slippery slope (Chart-3). In the first quarter of the current financial year, the overall core sector growth has slipped to 2.8 per cent compared to 5 per cent growth in 2016-17. Chart-3: Marginal recovery in Core Sector Growth 4
Chart-4: Growth in Components of Core Sector Source: mospi.nic.in Within the core sector, the performance is mixed. At the disaggregated level, it is the growth in cement (6.2%) and coal (4.9%) that ensure positive growth in the overall core sector growth (Chart-4). However, both steel (-1.9%) and electricity (2.9%) continue to grow negatively for the three consecutive months (April-June, 2017). As core sector growth is treated as a leading indicator for overall industrial and as well as GDP growth, deceleration in the core sector growth and negative growth in some of its components suggest a subdued demand conditions in the economy. Inflation With the flexible inflation targeting as well as the Monetary Policy Committee (MPC) in place, there appears to be some stability in the overall inflation in India (Chart-5). Currently the CPI inflation is at 2.36% in July 2017 while WPI inflation at 1.88%. From the recent trends it appears that, although there is a marginal increase in the recent period, the inflation in the economy appears to be subdued for a long time. Looking at the composition of inflation, it is clear that the sharp rise is noticed in the housing sector (4.8%) and is largely due to implementation of housing allowance under the 7 th Central Pay Commission 5
recommendations. However, the food inflation, which was the main reason behind high and volatile inflation during high inflation regime (between 2012-13 to 2014-15) is just at 0.43%. Within the food basket, the inflation in pulses nosedived to -24.75%, which may be largely due to high base as well as increase in the supplies due to high prevailing prices. What explains this subdued inflation in the economy and what would be its future trajectory? While the tight fiscal and monetary policies have certainly helped to bring down the demand side inflation, as it appears, it is the demonetization measure (and subsequent drop in the money supply) that appear to have brought down the overall inflation significantly. While almost all the old currencies have been remonetized, there is a clear 15 per cent decline in the money supply (reserve money) and this appear to have brought down the overall demand. On the other hand, government s measures to remove the overall supply bottlenecks as well as good agriculture output appear to have also resulted in downward pressure from the supply side. Another major factor is the very low international oil prices, which also contained through cost-push channel. Going forward, while we can expect the inflation to be within the Central Bank s target range, the inflationary expectations appear to be higher. The reasons could be the bad monsoons this year, expected higher foreign capital inflows, higher oil prices than last year, and GST implementation. While the monsoons are quite erratic and large regional variation could trigger food inflation, surprised surge in the foreign capital inflows could exert the inflation from the demand side. On the GST front, there appears to be large ambiguity about its overall impact on growth and inflation. However, as many transactions, which were otherwise not part of the tax net, are getting in to tax net, there could be increase in inflation from the cost push channel. Overall, we expect the inflation to go up, but within the range of RBI target. Chart-5: Inflation Picks up Marginally 15 WPI and CPI Inflation 10 5 0-5 -10 Apr-13 Jun-13 Aug-13 Oct-13 Dec-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 Dec-14 Feb-15 Apr-15 Jun-15 Aug-15 Oct-15 Dec-15 Feb-16 Apr-16 Jun-16 Aug-16 Oct-16 Dec-16 Feb-17 Apr-17 Jun-17 CPI WPI Source: mospi.nic.in Money and interest rates 6
As the government has announced the demonetization of nearly 85 per cent of total currency in circulation on 8 th November, 2016, the assessment of monetary policy become quite complex. As the recent report suggested nearly 99 per cent of the demonetized currency is either got back to the banking sector or has been remonetized with new currency, it would be interesting to understand the role of monetary policy in achieving its objective of growth with stable inflation. Since the last review, at present, India also adopted the Monetary Policy Committee framework to set the interest rates and the Committee meets once in two months. Since its formation, the Committee has met five times and has reduced the Policy rate twice (25 basis points each time) while maintaining the status quo in the rest of the meetings. While the overall policy rates appear to be guided by the growth and inflation expectations, off-late there seems to be some concerns about the open-economy macroeconomic issues as well. As discussed earlier, due to subdued inflation for quite some time, there was downward pressure on the interest rates. However, the Policy rates were largely sticking with a reduction of about 50 basis points (from 6.50 in April 2016 to 6% in August 2017). One of the reasons for sticky policy rates appear to be its weak transmission mechanism as the reduction in policy rates had not transmitted to the retail loan sector. However, the transmission appears to be better on the deposit rates as banks have brought down the deposit rates quite significantly compared to loan rates. Further policy rate cuts depend on the inflationary expectations as well as on the overall transmission mechanism. Chart-7: Policy Interest Rates Coming to monetary aggregates, as the demonetization hit the banking sector, the money supply growth has declined sharply to 6.6% (in August 2017) compared to 10.3% in the same period last year. This drop is accentuated due to negative growth in the reserve money which has declined by 4.5%. With the money supply growth, main source appears to be the banking sector s credit to the government (at 10.5%) while credit to commercial sector has declined from 9.2% (in August 2016) to 6.1% at present (see Chart-8). The credit to government 7
sector, which is the only factor that exerts demand in the economy, is also declining the recent times, which is largely due to tight fiscal deficit targets set by the government. The sharp decline in the overall demand conditions as well as huge NPAs in the banking sector appear to have led such subdued demand for credit in the economy. However, one positive factor in the overall trends in the monetary sector appears to be improvement in the velocity of circulation of money in the post-demonetisation period. But the extent of improvement could depend on size and depth of the banking and financial sector. Chart-8: Components of Broad Money 30 25 20 15 10 5 0-5 Jan-12 Growth of Monetary Aggregates (%) May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 May-16 Sep-16 Jan-17 NFA Credit to Govt Credit to Com Sector May-17 External Sector After a prolonged negative growth in the trade sector, India s exports appear to have shown some recovery. The recent data suggest that India s exports registered an average growth of 9.3% in the first quarter of current financial year (April-June, 2017). But most importantly, in the last two months, the exports growth appears to be nearly 14% (chart-9). Similar trends are also found in imports, but with higher than exports growth, an average growth of 33% in the first quarter of current financial year. However, such high imports growth appears to be largely due to sudden spurt in the growth of Valuables in the first quarter. With modest recovery in the global growth as well as subdued domestic industrial output, such high growth in imports could be a leakage from the overall domestic demand. This has appeared to have pushed the current account deficit to 2.4 in Q1:2017-18 compared to 0.7% in Q4 of the last financial year (see chart-11). Chart-9: Growth of Merchandise Trade 8
80.0 60.0 40.0 20.0 0.0-20.0-40.0 Growth of Merchandise Trade (%) Apr-11 Aug-11 Dec-11 Apr-12 Aug-12 Dec-12 Apr-13 Aug-13 Dec-13 Apr-14 Aug-14 Dec-14 Apr-15 Aug-15 Dec-15 Apr-16 Aug-16 Dec-16 Apr-17 Aug-17 Exports Imports Chart-10: Exchange Rate Volatility: A Cause for Concern Chart-11: Current Account Deficit (CAD as percent of GDP) On the exchange rate front, with the rise in US interest rates, there were expectation that Rupee/US dollar exchange rate to depreciate. However, as it appears, there is appreciation 9
pressure on the Rupee and this could be largely due to large and unexpected inflow of foreign capital, especially to the stock markets. As the Rupee is appreciating, there are arguments for holding the Rupee from further appreciation as it could have negative impact on exports. However, as the exchange rate could be differential impact on different tradeable/nontradeable, intervening in the foreign exchange market to maintain weak currency could be counter-productive as it could trigger inflation with not much impact on exports. Going forward, given the subdued domestic economic activity, there could be some pressure on the Rupee to depreciate. However, as India has undertaken many reform measures, mostly structural, one should expect that confidence on India among the foreign investors to be credit positive. While both exports and imports expected to be growing in the rest of the current financial year, there could be some moderation in both due to uncertainty regarding the effect of GST on overall trade. Key assumptions for 2017-18 and 2018-19 As India has revised its GDP estimation procedure consistent with SNA-2008, there is a change in the overall GDP estimation methodology. And the new series is available only from 2011-12 onwards, while the government is still working on providing back series based on new methodology. In the absence of such long-time series, here, to project the GDP growth and other macroeconomic indicators, we used the existing quarterly macroeconometric model. However, some link equations are used to derive the projections for the new GDP series. And this could be a limitation of this forecasts for 2017-18 and 2018-19 that is presented in the table. Key assumptions for the year 2017-18 and 2018-19 are as follows. Government stick to the fiscal deficit targets as set by the FRBM Act; policy interest rates to be brought down by 25 basis points by March 2018 and further by 50 basis points by March 2019; global consumer price inflation and food inflation are expected to increase marginally; world oil prices to be stable at about US$ 54 dollars per barrel; advanced country GDP assumed to follow OECD forecasts, which shows some recovery; the monsoon is expected to be below normal in 2017 while normal in 2018; and a modest recovery in foreign investment inflows is expected, especially following expected improvement in the Ease of Doing Business ranking. The key forecasts are given below: Table: Key Economic Indicators 2012-13 to 2018-19 (All in growth rates) Year 2012-13 2013-14 2014-15 2015-16 2016-17(P) 2017-18(F) 2018-19(F) Agriculture 1.5 5.6-0.2 0.7 4.9 1.2 4.3 Industry # 4.5 4.2 8.6 10.2 7.0 3.6 6.6 Services 7.0 6.9 8.9 9.1 6.9 8.2 8.0 Real GDP 5.4 6.1 7.2 8.0 7.1 6.9 7.6 CPI 10.1 9.4 6.0 4.8 4.1 3.3 4.2 Exports 6.7 7.3 1.7-5.3 4.5 3.8 4.4 Imports 5.96-8.4 0.8-5.9 2.3 1.6 5.2 #: 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 10
In the earlier review, we have predicted a growth of 7.6% for 2017-18. However, with the major disruptions due to demonetization as well as GST implementation, there are some uncertainty regarding the growth in 2017-18. Erratic as well as below normal monsoon has only aggravated the growth prospects. Although the first quarter GDP shown a growth of 5.7%, overall the GDP is expected to grow at 6.9%. This suggest that the economy has already bottomed-out and one should expect recovery from now on. At the disaggregated level, while both agriculture and industrial sector expected to slowdown compared to 2016-17 with sharp deceleration in the industrial growth, services sector expected to register marginally higher growth in 2017-18 compared to 2016-17. This could be due to two factors: recovery in the global growth as well as increased expenditure by the government sector. However, the model predicts a slower growth of exports (both goods and services) in 2017-18 despite reasonably high growth in the first quarter of the current financial year. On the inflation front, as there is overall compression in the demand, with large agricultural surpluses, inflation to be below 4% in the current year. However, as the commodity prices in the international markets are firming up, once could see a marginal higher inflation in 2018-19. For 2018-19, with the normalization of both demonetization as well as GST effects, one should expect recovery in the overall economic activity. In the model, this happens through two factors: improvement in the revenue buoyancy and through downward pressure on money demand that could bring the overall interest rates down. Further, as we assume normal monsoon next year, there is general recovery in the commodity producing sector. 11