Dire outlook will prompt further monetary easing - Capital Economics
India Economics

Dire outlook will prompt further monetary easing

India Economic Outlook
Written by Shilan Shah
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The continued rapid spread of COVID-19 in India and the need for prolonged containment measures has plunged the economy into a double-digit contraction this year. A tepid fiscal response means the recovery will underwhelm too. The dire economic situation will prompt the Reserve Bank to loosen policy further: we think markets are wrong to expect no further rate cuts over the coming months.

  • Overview – The continued rapid spread of COVID-19 in India and the need for prolonged containment measures has plunged the economy into a double-digit contraction this year. A tepid fiscal response means the recovery will underwhelm too. The dire economic situation will prompt the Reserve Bank to loosen policy further: we think markets are wrong to expect no further rate cuts over the coming months.
  • Output & Activity – Activity is recovering as containment measures are eased, but the road back to normality will be slow and fitful. Household spending and investment will remain very weak, with exports unlikely to provide much support.
  • External Stability – The current account swung into a surplus for the first time on record in the four quarters to Q2. While this will prove fleeting, the external risks will remain mangeable for the foreseeable future.
  • Inflation – An acceleration in food inflation and ongoing virus-related supply disruptions have kept headline CPI inflation higher than we had anticipated, but price pressures should ease soon.
  • Fiscal & Monetary Policy – The RBI has loosened policy significantly in response to the COVID-19 crisis and the door is still open for further easing. But the fiscal response has been underwhelming and concerns over the public debt ratio will prevent the government from taking adequate action.
  • Long-term Outlook – The coronavirus crisis and the government’s inadequate response will leave a legacy of impaired household and corporate balance sheets and a damaged banking sector that will cast a shadow over the economy for many years. We doubt that output in India will return to its pre-virus path for at least a decade.

Key India Forecasts

 

Quarterly

Annual

% y/y

(unless otherwise stated)

2020

2021

    

Q2

Q3e

Q4f

Q1f

Q2f

Q3f

2019

2020

2021

2022

 

          

Output & Activity

          

GDP

-23.9 -12.0 -8.5

-5.0

31.0

14.5

4.9

-10.0

11.5

7.0

Household Consumption

-26.7

-15.0

-10.0

-3.0

35.0

15.0

6.2

-12.0

13.0

8.5

Government Consumption

16.4

10.0

10.0

7.0

6.0

6.0

11.8

12.5 6.2 2.0

Investment

-47.1 -25.0 -15.0 -8.0

40.0

20.0

0.0

-23.5

13.0

8.5

Exports

-19.8

-12.0

-8.0

4.0

40.0

20.0

1.4

-12.0

19.0

10.0

Imports

-40.4

-20.0

-10.0

6.0

45.0

20.0

-4.9

-19.5

20.5

12.8

           

External Sector (% of GDP)

          

Current Account (4Q Sum)

0.4

1.4 1.5 1.2 0.0

-0.8

-1.0

1.5

-1.0 -1.5
           

Prices

          

Consumer Prices

6.6

6.7

4.7

3.8

4.0

4.0

3.7

6.2

4.0

4.3

Wholesale Prices

-2.2

0.0

-1.0

-0.5

2.0

1.0

1.9

-0.3

1.0

1.5

           

Fiscal (% of GDP)

          

Central Government Balance1

-3.6

-4.6

-10.0

-5.0

Gross Government Debt

68.0

82.0

84.0

83.0

           

Monetary (end period, %)

          

Repo Rate

4.00

4.00

3.75

3.50

3.50

3.50

5.15

3.75

3.50

3.50

Reverse Repo Rate

3.35

3.35

3.10

2.85

2.85

2.85

4.90

3.10

2.85

2.85

Cash Reserve Ratio

4.00

3.00

3.00

3.00

3.00

3.00

4.00

3.00

3.00

3.00

           

Markets (end period)

          

Sensex Equity Index

34,916

38,068

39,000

40,000

41,000

42,000

41,254

39,000

43,000

46,000

5-yr Government Bond (%)

5.27

5.39

5.50

5.50

5.50

5.50

6.47

5.50

5.50

6.00

10-yr Government Bond (%)

5.88

6.01

5.50

5.50

5.50

5.50

6.55

5.50

5.50

6.00

INR/USD

75.5

73.6

77.0

78.0

78.5

79.0

71.4

77.0

80.0

81.0

           

Gold ($/oz)

1,784

1,900

2,000

2,025

2,050

2,075

1,521

2,000

2,100

2,100

Brent Crude ($/pb)

41

41

45

47

50

53

66

45

55

60

Sources: Refinitiv, Bloomberg, Capital Economics; 1Fiscal years (2020 = FY19/20)


Overview

Dire economic outlook will prompt further easing

  • The continued rapid spread of COVID-19 in India and the need for prolonged containment measures has plunged the economy into a double-digit contraction this year. A tepid fiscal response means the recovery will underwhelm too. The dire outlook will prompt the Reserve Bank to loosen monetary policy further: we think markets are wrong to expect no further rate cuts over the coming months.
  • India has become the epicentre of the global pandemic. New virus cases have edged down recently but remain by far the highest in the world (see Chart 1), and total infections will surpass those in the US before long. Given the severity of the outbreak, the authorities have little choice but to keep restrictions in place for a prolonged period, and tighten them in areas where outbreaks threaten to overwhelm healthcare capacity. This will hold back the post-lockdown recovery.
  • Supply disruptions from containment measures have pushed up core inflation. But it still seems likely that broader price pressures will drop as the hit to household incomes and collapse in consumer demand eventually offsets the impact of ongoing supply constraints. That has been the story in the rest of the world: India is currently an outlier. With food inflation also dropping following a bumper monsoon harvest, headline CPI inflation will soon fall back to more comfortable rates. (See Chart 2.)
  • All of this means that policymakers should be doing as much as they can to support the economy. As inflation concerns ease, the RBI is likely to resume easing policy before long. That is in contrast to market expectations for policy rates to remain on hold for a prolonged period. (See Chart 3.)
  • The finance ministry’s response has been timid. Demand-boosting measures amount to around 2% of GDP, far lower than in many other countries. (See Chart 4.) It appears that concern over the public debt ratio is the key factor preventing the finance ministry from unleashing more stimulus.
  • The lacklustre policy response and protracted economic slump will leave a legacy of unemployment and firm failures that will take a long time to reverse.
  • A heavily-impaired banking sector will be another headwind to the recovery. India’s banks already have one of the highest ratios of non-performing loans in the emerging world (see Chart 5), and many more loans are likely to fail.
  • Bringing all of this together, real GDP in India is likely to contract by 10% this year, one of the most severe falls anywhere. (See Chart 6.) We think the economy will still be more than 10% smaller in real terms at the end of 2022 than would have been the case had the virus not existed. (See Chart 7.)
  • It is difficult to find many positives at the moment. Perhaps the most that can be said in the near term is that the weakness of domestic demand leaves the external position looking secure. The current account has flipped into a rare surplus. While this should prove temporary, the deficit will remain small for the foreseeable future. (See Chart 8.)
  • In addition, the BJP has recently expedited land and labour reforms that normally face stiff political resistance, ostensibly as part of efforts to support recovery from the COVID-19 crisis. These moves will do little to boost demand in the near term. But if India does eventually contain the virus, they could lay the foundation for faster growth further ahead.

Overview Charts

Chart 1: New Daily Recorded Coronavirus Cases (Current Top 4 Countries, 7-day Average)

Chart 2: Consumer Prices (% y/y)

Chart 3: Repo Rate (%)

Chart 4: Direct Fiscal Responses to Coronavirus*
(% of GDP)

Chart 5: Non-Performing Loans
(% of Total Loans, Latest)

Chart 6: CE GDP 2020 Forecasts (% y/y)

Chart 7: Real GDP (2019 = 100)

Chart 8: Current Account Balance (4Q Sum, % of GDP)

 

Sources: CEIC, Refinitiv, Bloomberg, Capital Economics


Output & Activity

A slow and fitful recovery

  • GDP shrank by almost a quarter in Q2, one of the largest lockdown-induced slumps anywhere in the world. (See Chart 9.) That marked the bottom, as the subsequent loosening of restrictions led to an initial burst of activity. But indicators such as the core infrastructure index suggest that the recovery has stuttered more recently (see Chart 10), and we think it will remain slow and fitful for a long time yet.
  • Focussing on the expenditure side of the national accounts, household spending is set to remain extremely weak. After all, new virus cases remain high (see Chart 11) and, unlike many other economies now dealing with second waves, there is no evidence yet of Indian authorities decisively bringing the outbreak under control.
  • There is little choice but to keep restrictions in place for a prolonged period, and even tighten them in areas where outbreaks have been particularly severe. Oxford University’s government stringency index shows that containment measures in India are still more severe than in most other EMs. (See Chart 12.) This will weigh particularly heavily on consumer spending in areas that require social interaction such as retail, restaurants, leisure, recreation, and transport.
  • Job losses and a fall in incomes during the lockdown mean that spending more generally will remain subdued. Surveys show that consumers have turned significantly less optimistic about the current and future situations since the start of the year. (See Chart 13.)
  • The outlook for investment is also grim. The government has offered loan guarantees to SMEs but firms will remain cautious for a long while yet given the likely damage to their balance sheets and the slow speed of the economic recovery.
  • Compounding the issue, the ailing banking sector will take a further hit as more loans turn sour (see Chart 14) even with a debt restructuring scheme in place. Bank lending was slowing even before the crisis (see Chart 15) and further damage to balance sheets is likely to make banks even more risk averse, which will be another constraint on investment.
  • The only support for domestic demand over the near term is likely to come from government expenditure. Fiscal support for households has been ramped up, mainly through food and cash handouts. But the response has been timid compared to most other major EMs. (See the Policy section for more).
  • The economy will receive moderate external support as many economies battle a second wave of virus outbreaks. We think the global economy will contract by 4.8% this year, its worst performance since the Second World War.
  • Bringing all of this together, real GDP in India is likely to contract by 10% this year. While GDP growth will surge in 2021, this is largely due to very favourable base effects. (See Chart 16.) The big picture is that India is likely to suffer one of the weakest recoveries among major EMs.

Output & Activity Charts

Chart 9: Q2 2020 GDP (% y/y)

Chart 10: Core Infrastructure Industries &
Industrial Production (% y/y)

Chart 11: New Daily Recorded Coronavirus Cases (Current Top 4 Countries, 7-day Average)

Chart 12: Government Response Stringency Index

Chart 13: RBI Consumer Confidence Survey (Index*)

Chart 14: NPLs (% of Total Bank Loans)

Chart 15: Private Sector Bank Credit

Chart 16: Quarterly GDP (% y/y)

 

Sources: CEIC, Oxford University, RBI, Capital Economics


External Stability

External risks will remain manageable

  • The current account swung into a surplus for the first time on record in the four quarters to Q2. For a country like India facing perennial balance of payments strains, a surplus would normally be welcome. In this case though, it is the result of the nationwide lockdown and resulting collapse in domestic demand.
  • We doubt that the current account will remain in surplus for more than a few quarters. Both exports and imports are already recovering – albeit slowly – as containment measures have been scaled back abroad and in India. (See Chart 17.) The monthly goods trade balance has swung back into deficit. (See Chart 18.)
  • Looking ahead, oil prices are likely to rebound further (our Commodities teams expect the price of Brent Crude to rise to $55pb by end-2021, from $41pb currently). And remittances – which show up in the current transfers section of the balance of payments – are also likely to drop further given the extreme economic weakness and tighter labour restrictions in the Gulf. These economies account for over 50% of total remittances into India. (See Chart 19.)
  • Bringing this together, the current account surplus this year will prove temporary and make way for a deficit of 1.0-1.5% of GDP in 2021 and 2022. (See Chart 20.)
  • The key point, however, is that this would hardly be a matter of concern. It would be well within the RBI’s 2.0% of GDP threshold that it considers sustainable and much smaller than was the norm just a few years ago.
  • On the financial account, a shift in the composition of capital inflows over recent years adds to our belief that the external position will remain stable. FDI inflows remain significantly higher than volatile portfolio inflows. (See Chart 21.) Inflows dropped in Q2. But they still held up reasonably well given the collapse in economic activity both at home and abroad – a reflection of the fact that FDI tends to be a relatively stable and long-term source of funding. Large foreign investments in Jio Platforms should provide further support over the coming quarters.
  • Most Asian currencies have strengthened a little against the US dollar over the past couple of months, but the rupee has been an exception. Part of the reason appears to be greater intervention by the RBI – as illustrated by the surge in its FX reserves this year. (See Chart 22.)
  • We expect weakness against the US dollar over the next few years, even without explicit internvention from the RBI. Further cuts to policy rates that we are expecting would put downward pressure on the rupee. In addition, commodity prices are likely to continue making up lost ground, which would weaken India’s terms of trade.
  • In all, we are forecasting the rupee to depreciate to 77/$ by end-2020 and 80/$ by end-2021, from around 74/$ currently. The analyst consensus is for the rupee to remain broadly stable over the next two years. (See Chart 23.)
  • There should be limited economic fallout from a weaker rupee. The pass through to inflation is very small by EM standards, and India has a very low burden of FX debt. (See Chart 24.) For that reason, renewed currency weakness wouldn’t exacerbate strains on corporate balance sheets or in the banking sector.

External Stability Charts

Chart 17: Goods Exports and Imports (US$, % y/y)

Chart 18: Goods Trade Balance (US$bn)

Chart 19: Top 10 Sources of Remittances to India

(% of Total, 2019)

Chart 20: Current Account Balance
(4Q Sum, % of GDP)

Chart 21: Net Capital Inflows (4Q Sum, % of GDP)

Chart 22: FX Reserves (US$bn)

Chart 23: Rupee vs US$

Chart 24: FX Debt (% of GDP, Latest)

 

Sources: CEIC, World Bank, Capital Economics


Inflation

Headline inflation close to peaking

  • An acceleration in food inflation and virus-related supply disruptions have pushed up headline consumer price inflation over the past few months. But the headline rate should drop back towards the RBI’s 4.0% inflation target towards the end of the year.
  • For a start, food inflation should soon begin to ease. A bumper food harvest should at the very least stablise food prices and that would be enough for food inflation to fall. (See Chart 25 & 26.) The modest hikes that have been announced to the Minimum Support Prices for key crops should only have a muted impact. The drop in food inflation that we are anticipating would knock 2%-pts off the headline rate by the end of 2020.
  • The stickiness of core inflation is more of a challenge to our view. The impact of virus-related supply disruptions has been more severe than we had anticipated. These disruptions are likely to continue as restrictions on activity are set to remain in place for an extended period.
  • But other temporary factors have also been pushing up core inflation. The recent jump in core inflation has been focussed in two sub-components: “personal care & effects” and “transport & communications”. (See Chart 27.)
  • The jump in “personal care & effects” can largely be attributed to the surge in gold prices. We think gold prices will edge up further ahead, but that would still mean that the bulk of the rise in this component of the CPI basket is behind us and that it will drop by the turn of the year. (See Chart 28.)
  • Meanwhile, the rise in the “transport & communications” category has been boosted by a combination of higher excise duties on fuel prices and phone tariff hikes. These factors will prop up core inflation for several more months and only drop out of the annual comparison next year. But it seems unlikely that they will contribute any more to inflation over the coming months.
  • Inflation in several other core components such as clothing, recreation and education has eased in recent months. We continue to think that price pressures in these components will weaken further as the hit to household incomes and collapse in consumer demand more than offsets the impact of ongoing supply constraints.
  • It’s worth noting too that households are expecting inflation to drop over the coming year. (See Chart 29.)
  • Bringing all of this together, it still seems likely to us that headline inflation will drop back over the coming months (see Chart 30), albeit more gradually and from a higher starting point than we had expected at the start of the virus crisis. That should assuage the central bank’s concerns over inflation and allow it to refocus its attention on supporting the economy.
  • Headline wholesale price inflation has risen in recent months but it has remained low by past standards. (See Chart 31.)
  • We think headline WPI inflation will continue rising as fuel inflation is set to accelerate on the back of a recovery in global oil prices. (See Chart 32.) But this won’t be too concerning as subdued underlying price pressures will help to keep a lid on the headline rate for some time to come.

Inflation Charts

Chart 25: Kharif Sowing Area (Million Hectares)

Chart 26: Daily Food Prices and Food CPI (% y/y)

Chart 27: Core CPI Inflation
(%-pt Contribution to Headline CPI Inflation)

Chart 28: Gold Prices and Personal Care Prices (% y/y)

Chart 29: Inflation Expectations
(%-diff. between one year ahead and current)

Chart 30: Consumer Prices (% y/y)

Chart 31: Wholesale Prices (% y/y)

Chart 32: Brent Crude Oil Prices & Fuel WPI (% y/y)

 

Sources: CEIC, Dept of Consumer Affairs, RBI, Finance Ministry, IMF, CE


Fiscal & Monetary Policy

Policymakers are determined to keep borrowing costs in check

  • The RBI has been proactive in its response to the coronavirus crisis. The repo and reverse repo rates have been lowered by a cumulative 115bp and 155bp respectively since March. In addition, the central bank has ramped up liquidity measures and introduced a debt restructuring scheme for struggling borrowers. All of this has helped to prevent the emergence of lasting strains in the financial sector. Interbank rates are at multi-year lows (see Chart 33), and our proprietary index shows that broader financial conditions in India have eased substantially since March. (See Chart 34.)
  • While no policy changes are likely in the very near term, we think that the RBI will resume easing policy before long as price pressures subside. In total, we are forecasting another 50bp of cuts in this cycle. That would bring the repo and reverse rates down to 3.50% and 2.85%, both of which would be record lows. Our policy rate forecasts are more dovish than the prevailing market view. (See Chart 35.)
  • On fiscal policy, the Finance Ministry has announced a COVID-19 support package worth INR12trn (6% of GDP). But much of this is made up of loan guarantees and notional values on long-term reforms, while actual demand-boosting measures are underwhelming. We estimate that these are worth roughly 2% of GDP, which is small compared to what we’ve seen in other major economies. (See Chart 36.)
  • Crucially, this won’t be enough to help arrest the steep decline in output this year and guarantees that many firms and households will emerge from the crisis with impaired finances that will hold back the recovery.
  • Despite the Finance Ministry’s reticence to spend more, a slump in tax revenues means the central government deficit is likely to widen significantly anyway. We forecast it to rise from 4.6% of GDP in FY19/20 to 10% of GDP in FY20/21. (See Chart 37.) In turn, we expect public debt to rise from 68% last year to 82% of GDP this year. (See Chart 38.)
  • The fact that almost all of India’s public debt is denominated in rupees and held domestically means the threat of a debt crisis is low. Nevetheless, the government still appears keen to return the debt ratio to a sustainable path as soon as it can. For better or worse, policymakers have emphasised the need to protect India’s investment-grade rating on sovereign debt.
  • One path to debt sustainability is for borrowing costs to be kept lower than the growth rate of nominal GDP, as has been the case over most of the past decade. The cuts to policy rates that we are expecting will help in this regard. The RBI has also committed to more open market operations over the coming months, which have previously helped to drive down yields. (See Chart 39.)
  • There are also signs of the authorities turning towards more financial repression – policies that keep borrowing costs artificially low by channelling funds to the public sector. The fact that much of the banking sector is state-owned means that these measures can be implemented without resistance.
  • One example is the use of the statutory liquidity ratio which requires banks to buy large volumes of government debt. The ratio is currently at 18%. (See Chart 40.) This could be raised back to its recent peak of 25% if borrowing costs become a threat again.

Fiscal & Monetary Policy Charts

Chart 33: Interbank Rates (%)

Chart 34: CE Financial Conditions Index for India (Standard Deviation)

Chart 35: Repo Rate (%)

Chart 36: Direct Fiscal Responses to Coronavirus*
(% of GDP)

Chart 37: Central Gov’t Fiscal Deficit (% of GDP)

Chart 38: Gross Government Debt
(% of GDP, CE 2020 Forecasts)

Chart 39: 10-Yr Government Bond Yield (%)

Chart 40: Statutory Liquidity Ratio (%)

 

Sources: CEIC, Bloomberg, RBI, Capital Economics


Long-term Outlook

Long-term outlook bright but COVID-19 crisis will take a major toll

  • The coronavirus crisis and the government’s inadequate response will leave a legacy of impaired household, banking and corporate balance sheets that will cast a shadow over growth for years. With demand weak, we doubt that output in India will return to its pre-virus path for at least a decade.
  • The crisis also looks increasingly likely to damage the supply potential of the economy. In particular, an impaired banking sector will weigh heavily on investment which will harm the growth of the capital stock. However, the virus has not led to destruction of productive capacity as occurs in wars or natural disasters. And the crisis will increase the incentive for firms to invest more in areas like touchless technologies.
  • There are some areas where a more positive view on long-term prospects is still justified, at least relative to other EMs. The expansion of the working age population is set to continue. India will replace China as home to the world’s largest labour force around 2025. (See Chart 41.)
  • And in a rare positive recent development, Prime Minister Modi’s BJP has expedited labour market reforms that normally face stiff political resistance, ostensibly as part of efforts to support recovery from the coronavirus. These will do little to boost demand in the near term. But over time these measures could start to deliver benefits by reducing disincentive that hold back growth of labour-intensive firms.
  • The reforms also send a positive signal of the BJP’s willingness to use its burgeoning political clout – it has the largest Lok Sabha majority since the 1980s (see Chart 42) – to push ahead with measures that would previously have been deemed too contentious. If further labour (and land) reforms follow, that would lay the foundation for strong potential growth.
  • If the government does embrace this opportunity, the long-term benefits to productivity could be substantial. India has massive scope to shift the labour force from low to high productivity sectors, and replicate the best practices of economies that have already transitioned to higher income.
  • The coronavirus crisis will cause the budget deficit to widen sharply and the public debt ratio to surge this year. But over the long term, public debt should drop back as a share of GDP (see Chart 43) due to a combination of relatively strong growth in nominal GDP and policymakers keeping a lid on long-term yields through financial repression.
  • The broad trend is that inflation typically falls as emerging economies converge with advanced economies. We suspect that the RBI will reduce its inflation target over time, as central banks in many wealthier EMs have done.
  • India is likely to run a small but persistent current account deficit over the long term. That shouldn’t be a problem as long as it remains in check. Indeed, if the deficit was the result of strong investment, that would be a positive.
  • The real exchange rate is likely to continue appreciating due to relatively strong productivity gains. And given structurally lower rates of inflation now, the pace of depreciation in the nominal rupee exchange against the US dollar will be slower than it has been over the past couple of decades. (See Chart 44.)

Long-term Outlook Charts

Chart 41: Working Age Population (Millions)

Chart 42: Lok Sabha Election Results
(% of Seats Won by Leading Party)

Chart 43: Gross Government Debt (% of GDP)

Chart 44: Rupee vs US$

 

Sources: UN, CEIC, Bloomberg, Capital Economics

Key Forecasts (% y/y, Averages, unless otherwise stated)

 

2006-2010

2011-2015

2016-2020

2021-2025

2026-2030

2031-2050

Real GDP

7.1

6.4

3.6

8.0

6.5

5.0

Inflation (%)

4.9

9.7

4.1

4.0

4.0

3.5

Policy interest rate (%, end of period)

7.8

8.0

3.5

4.5

6.0

4.0

Ten-year government bond yield (%, end of period)

7.8

8.2

5.5

6.5

6.5

5.0

Government budget balance (% of GDP)

-7.6

-7.4

-8.0

-8.3

-6.0

-5.0

Gross government debt (% of GDP)

72.0

68.0

71.0

77.0

71.0

65.0

Current account (% of GDP)

-0.1

-5.1

-1.1

-1.5

-1.7

-1.5

Exchange rate (Indian rupee per US dollar, end of period)

41.4

53.4

80.0

83.0

85.0

102.0

Nominal GDP ($bn, end of period)

1,708

2,087

2,573

4,577

7,315

34,580

Population (millions, end of period)

1,231

1,309

1,383

1,445

1,504

1,639

Sources: UN, CEIC, Refinitiv, Bloomberg, Capital Economics


Shilan Shah, Senior India Economist, shilan.shah@capitaleconomics.com
Darren Aw, Asia Economist, darren.aw@capitaleconomics.com
Mark Williams, Chief Asia Economist, mark.williams@capitaleconomics.com