The drop in new COVID-19 cases and the resulting scaling back of containment measures in India has provided a much-needed boost to the economy, and an effective vaccine will further support the recovery in 2021 and 2022. But even widespread vaccination won’t restore the economy to full health given the extreme weakness of the banking sector and tepid fiscal support. Output is likely to remain below its pre-virus trend for many years.
- Overview – The drop in new COVID-19 cases and the resulting scaling back of containment measures in India has provided a much-needed boost to the economy, and an effective vaccine will further support the recovery in 2021 and 2022. But even widespread vaccination won’t restore the economy to full health given the extreme weakness of the banking sector and tepid fiscal support. Output is likely to remain below its pre-virus trend for many years.
- Output & Activity – Household spending and investment will lead the recovery over the coming quarters, given that they dropped the most during the early stages of the pandemic.
- External Stability – The current account reached its largest surplus on record in the four quarters to Q3 2020. Though the deficit should return over the coming quarters, external risks will remain manageable for the foreseeable future.
- Inflation – An acceleration in food inflation and virus-related supply disruptions have kept headline CPI inflation higher than we had anticipated over recent months, but price pressures are now set to ease in earnest.
- Fiscal & Monetary Policy – The RBI is likely to keep monetary policy very loose for a long time to come. But concerns over the public debt ratio will prevent the Finance Ministry from doing much more to support the economic recovery.
- Long-term Outlook – The COVID-19 crisis and the government’s inadequate response will leave a legacy of impaired household, corporate and bank balance sheets that will stymie the recovery. That said, there are still several structural reasons to be positive on India’s longer-term growth prospects.
Key India Forecasts
(unless otherwise stated)
Output & Activity
External Sector (% of GDP)
Current Account (4Q Sum)
Fiscal (% of GDP)
Central Government Balance1
Gross Government Debt
Monetary (end period, %)
Reverse Repo Rate
Cash Reserve Ratio
Markets (end period)
Sensex Equity Index
5-yr Government Bond (%)
10-yr Government Bond (%)
Brent Crude ($/pb)
Sources: Refinitiv, Bloomberg, Capital Economics; 1Fiscal years (2020 = FY19/20)
On the road to recovery
- The drop in new COVID-19 cases and the resulting scaling back of containment measures in India has provided a much-needed boost to the economy, and an effective vaccine will further support the recovery in 2021 and 2022. But even widespread vaccination won’t restore the economy to full health given the extreme weakness of the banking sector and tepid fiscal support. Output is likely to remain below its pre-virus trend for many years.
- COVID-19 ravaged India’s economy in 2020 and GDP is all but certain to have suffered its largest slump on record last year. But new virus cases have dropped sharply (see Chart 1), and the recent approval of two vaccines has brightened the outlook. We now assume that most of India’s most vulnerable people will be vaccinated within the next 12-18 months. That would allow a rolling back of restrictions on most domestic activity during the second half of this year. Despite being loosened, restrictions are still tighter than in most other EMs. (See Chart 2.) Fears over the virus should subside too, which will support consumer spending.
- However, there are still headwinds to the recovery. The severe downturn – exacerbated by the government’s disappointingly slow and weak fiscal support (see Chart 3) – will leave lasting wounds in the form of firm closures and higher unemployment, even in a large informal economy like India. Extremely high demand for work on the government’s Guaranteed Rural Employment (MGNREGA) scheme is a sign that the labour market is still in distress.
- All of this will further impair the banking sector, which entered the crisis in poor health. India’s non-performing loan ratio was already one of the highest among EMs (see Chart 4), and it is likely to rise further now that the RBI’s debt moratorium and other extraordinary measures have now elapsed.
- Bringing this together, a strong recovery in growth is likely this year and next, but we think that GDP in 2022 will still be 6% below its level had the virus not existed. (See Chart 5.)
- In these circumstances, policymakers should be focussed on doing as much as possible to support the economy. One constraint in recent months has been high inflation. But we are hopeful that the recent drop in headline CPI inflation is the start of a downward trend as supply constraints ease and the jump in food inflation reverses. (See Chart 6.)
- In all, we think markets are too hawkish in expecting rate hikes over the next 12-18 months – we wouldn’t rule out further modest rate cuts in the near term. (See Chart 7.)
- On the external sector, the current account swung into an unprecedented surplus in 2020 and, though it is likely to flip back into deficit this year, it should remain small by past standards. (See Chart 8.) Inflows of capital are also likely to hold up well as global risk appetite continues to rebound. As such, the external sector is unlikely to return as a source of vulnerability any time soon.
- On the longer term outlook, 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 contain the virus, they could lay a foundation for faster growth further ahead.
Chart 1: New Recorded COVID-19 Cases in India
Chart 2: Government Response Stringency Index
Chart 3: Direct Fiscal Response to COVID-19*
Chart 4: Non-Performing Loans
Chart 5: Real GDP (2019 = 100)
Chart 6: Consumer Prices (% y/y)
Chart 7: Repo Rate (%)
Chart 8: Current Account Balance (4Q Sum, % of GDP)
Sources: CEIC, Oxford University, IMF, Capital Economics
Vaccine will be a shot in the arm for the economy
- The slump in Indian GDP eased substantially in Q3 2020 but output was still around 10% below pre-virus levels. (See Chart 9.) Industrial output growth rebounded back to trend in October. (See Chart 10.) But other sectors of the economy continue to fare much worse, particularly services. Railway and air traffic are 70-80% below pre-virus levels, suggesting that the economy has a long way to go before it has fully made up its pandemic losses.
- Focussing on the expenditure side of the national accounts, household spending is set to pick up sharply. After all, new virus cases have dropped sigificantly from their peak in September (see Chart 11), and we think that majority of India’s most vulnerable will be vaccinated over the next 18 months following the emergency approval of two COVID-19 vaccines in January. That should allow restrictions to be scaled back further and fears over the virus to subside. All of this should support a resumption in spending, particuarly in sectors that require social interaction such as retail, restaurants, leisure, recreation and transport.
- That said, job losses and the hit to incomes during the downturn will still hold back the recovery. Households are currently the most downbeat on income and employment prospects since the RBI started conducting regular surveys. (See Chart 12.)
- Monthly activity data indicate that investment has rebounded sharply from the depths of the lockdown. (See Chart 13.) A further recovery is likely over the coming months but the pace of the rebound will slow. The government has offered loan guarantees to SMEs but many firms will remain cautious for a while yet given the likely damage to their balance sheets and the fact that there is still a large amount of spare capacity in the economy. (See Chart 14.)
- What’s more, the ailing banking sector will take a further hit as more loans turn sour now that the debt moratorium has elapsed. 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. This will be another headwind to the investment recovery.
- Government expenditure is likely to fade as a tailwind to growth over the coming quarters. Admittedly, it is a very busy year for state elections, which has historically persuaded governments at both the national and state level to keep the purse strings loose. But in order to preserve its investment-grade rating on sovereign bonds, the government is keen to return the debt burden to a sustainable trajectory as soon as possible. This makes a further loosening of fiscal policy unlikely.
- Finally, the economy is likely to receive only moderate external support this year and next. Admittedly, some services exports such as tourism are likely to recover in the second half of this year and into 2022. But we don’t expect a recovery in global GDP to substantially lift goods exports, given that they are already back to near the pre-virus path.
- Bringing all of this together, we forecast real GDP in India to grow by 12% and 9.5% respectively in 2021 and 2022. Our forecasts are stronger than the consensus. (See Chart 16.) But even if we are right, that would still leave GDP around 6% below its pre-virus trend by the end of 2022.
Output & Activity Charts
Chart 9: GDP (% y/y)
Chart 10: Industrial Production (Volumes)
Chart 11: New Recorded COVID-19 Cases in India
Chart 12: RBI Consumer Confidence Survey
Chart 13: Investment & Capital Goods Output (% y/y)
Chart 14: Capacity Utilisation (%-Diff Between Share of Positive & Negative Responses)
Chart 15: Private Sector Bank Credit
Chart 16: GDP (% y/y)
Sources: CEIC, RBI, Capital Economics
External risks manageable even if current account deficit returns
- India posted its largest current account surplus on record in the four quarters to Q3 2020. But the renewed widening in the monthly goods trade deficit at the end of last year (see Chart 17) suggests that the surplus will prove fleeting, and we expect the current account deficit to return in 2021.
- Exports should receive a boost from unprecedented global demand for vaccines over the coming quarters given that India is home to the world’s largest producer (the Serum Institute). But exports more broadly are unlikely to receive a major lift even as the global economic recovery continues, given that they have already rebounded back to near pre-virus levels. (See Chart 18.)
- On the import side, widespread vaccinaction should boost domestic demand, given that social distancing is still a drag on activity. More generally, global oil prices are likely to continue grinding higher as demand around the world normalises. These factors will push import values higher.
- That said, we expect oil prices to remain a long way below their levels from the years 2010 to 2013 when India faced significant balance of payment strains. (See Chart 19.) What’s more, prospects for remittances into India – the world’s largest recipient – look stronger in 2021 than they were last year. The incoming Biden administration is likely to reverse blocks to H-1B visas for Indian nationals, and the Gulf economies are getting back on their feet. These countries are the most important source of remittances into India. (See Chart 20.)
- In all, we think the current account will tip back into a small deficit of around 1.0% of GDP in 2021, and widen further to 1.5% of GDP in 2022. (See Chart 21.) That would be well within the 2.0% of GDP threshold that the RBI considers sustainable, and much smaller than was the norm from 2010 to 2013, when the deficit averaged 4% of GDP.
- The strength of capital inflows adds to our belief that the external position won’t return as a source of vulnerability. Foreign direct investment – a relatively stable and long-term source of funding – rebounded in Q3 and remained significantly higher than volatile portfolio inflows. (See Chart 22.) And daily data indicate that portfolio inflows themselves rose sharply at the end of Q4. We think these will hold up over the coming quarters as global risk appetite continues to improve.
- With a small current account deficit likely to return and the external position looking secure, we think that the rupee will continue to weaken gradually in nominal trade-weighted terms, continuing the trend of the past four years. (See Chart 23.)
- We don’t think a weaker nominal rupee exchange rate poses any significant macro problems. The exchange rate pass through to inflation in India is very small by EM standards. What’s more, India has a very low burden of FX debt (see Chart 24), which is largely denominated in US dollars. Indeed, we think that, like most other currencies, the rupee will strengthen against the US dollar over the coming years amid the rise in global risk appetite. We forecast the rupee to end 2022 at 72/$, from around 74/$ currently.
External Stability Charts
Chart 17: Goods Trade Balance (US$bn)
Chart 18: Seasonally-Adjusted Export Values
Chart 19: Oil Prices and Imports
Chart 20: Largest Sources of Remittances into India
Chart 21: Current Account Balance
Chart 22: Net Capital Inflows
Chart 23: Rupee Trade-Weighted Exchange Rate
Chart 24: FX Debt (% of GDP, Latest)
Sources: CEIC, World Bank, Refinitiv, Capital Economics
Inflation likely to ease in 2021
- Consumer price inflation rose throughout 2020 (see Chart 25), but there are several reasons to think it will ease over the course of 2021.
- In the immediate term, daily data suggest that food inflation dropped in December and early January. (See Chart 26.) Beyond that, modest hikes to Minimum Support Prices for key crops (see Chart 27), and policy measures including the ramping up of food provisions from the government’s centralised stocks should help to anchor prices. The large weighting of food in the CPI basket (see Chart 28) means the drop in food inflation we are anticipating could knock 1.5%-pts off the headline rate over the next few months.
- The stickiness of core inflation over the past few months is more of a challenge to our view. The impact of virus-related supply disruptions has been more severe than we had anticipated. But these disruptions are likely to ease as falling infections and a vaccination programme allow restrictions on activity gradually to be scaled back.
- Other more specific factors that have been pushing up core inflation should also begin to unwind. The jump in “personal care & effects” can largely be attributed to the surge in gold prices last year. (See Chart 29.) We think the rally in gold prices is now largely behind us, which should pave the way for a sharp drop in inflation in this category throughout the course of 2021.
- Meanwhile, the rise in “transport & communications” inflation has been boosted by a combination of higher excise duties on fuel prices and phone tariff hikes. Further hikes are likely in both this year, but the early signs are that the increases will not be as large as they were in 2020. If this proves the case, transport & communication inflation should also start to drop after Q1.
- It’s also worth noting that households are expecting inflation to drop over the coming year. (See Chart 30.)
- All of this should help to alleviate the RBI’s recent concerns over inflation and allow it to focus on supporting the economy by keeping policy loose for a prolonged period. A particularly sharp drop in inflation could open the door to further modest rate cuts over the coming months.
- One upside risk to the inflation outlook is a potential relaxation of the RBI’s inflation targeting regime, which is set by the government every five years. The current target of 4% CPI inflation, with a “tolerance band” of 2-6%, runs until the end of March 2021. Some members of government are keen to relax the target, but this could cause inflation expectations to become unmoored and lead to higher inflation over the long term.
- Finally, headline wholesale price inflation rose towards the end of 2020 as core inflation accelerated. (See Chart 31.) We expect the headline rate to rise a little further this year as the recovery in oil prices pushes fuel inflaton higher. (See Chart 32.)
Chart 25: Consumer Prices (% y/y)
Chart 26: Daily Food Prices and Food CPI (% y/y)
Chart 27: Minimum Support Prices of
Chart 28: Consumer Price Basket (%)
Chart 29: Gold Prices and Personal Care Prices (% y/y)
Chart 30: Household Inflation Expectations (%)
Chart 31: Wholesale Prices (% y/y)
Chart 32: Brent Crude Oil Prices & Fuel WPI (% y/y)
Sources: CEIC, Dept of Consumer Affairs, RBI, Capital Economics
Policymakers aim to keep borrowing costs in check
- The RBI has received plaudits for its response to the COVID-19 crisis. The repo and reverse repo rates were lowered by a cumulative 115bp and 155bp respectively last year while liquidity measures have been ramped up. 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 are exceptionally loose. (See Chart 34.)
- We see little prospect of the central bank tightening policy any time soon, and we think that markets are too hawkish in expecting rate hikes by the end of 2021. (See Chart 35.) In fact, the RBI has left the door open for policy rates to be cut further in the near term, contingent on a sharp drop in inflation.
- On fiscal policy, the Finance Ministry’s cumulative COVID-19 support package now stands at INR20trn (10% of GDP). But much of this is made up of loan guarantees and notional values on long-term reforms, while actual demand-boosting measures remain underwhelming. We estimate that these are worth roughly 2% of GDP, which is small compared to relief packages in other major economies. (See Chart 36.)
- This means 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, the slump in tax revenues means the central government deficit has widened significantly. We forecast it to rise from 4.6% of GDP in FY19/20 to 8% of GDP in FY20/21. (See Chart 37.) In turn, public debt is set to rise from 72% of GDP before the pandemic to over 85% of GDP this year.
- 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. Keeping rates at their current record lows, or lowering them further, would 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 long-term yields. (See Chart 38.)
- 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 (see Chart 39) 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*
Chart 37: Central Gov’t Fiscal Deficit (% of GDP)
Chart 38: 10-Yr Government Bond Yield (%)
Chart 39: State-Owned Banks’ Share of Bank Assets (%)
Chart 40: Statutory Liquidity Ratio (%)
Sources: CEIC, Bloomberg, IMF, RBI, Capital Economics
COVID-19 crisis to take a toll but long-term outlook still bright
- The COVID-19 crisis and the government’s inadequate response will leave a legacy of impaired household, corporate and bank balance sheets that will cast a shadow over demand for years. We think that the economy will be 5% smaller in 2050 than it would have been had the crisis not occurred.
- There are ways in which the crisis may also affect the supply potential of the economy. For example, a damaged 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 some areas like touchless technologies.
- What’s more, there are still a few reasons why a more positive view on India’s long-term prospects is still justified, at least relative to other EMs. The expansion of the working age population in India is set to continue. It will replace China as home to the world’s largest labour force by around 2025. (See Chart 41.)
- What’s more, Prime Minister Modi’s BJP has expedited labour market reforms that normally face stiff political resistance, ostensibly as part of efforts to support the recovery from COVID-19. These will do little to boost demand in the near term. But over time, these measures could start to deliver benefits by reducing the disincentives 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 COVID-19 crisis will cause the budget deficit to widen sharply and the public debt ratio to surge. 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 persistent current account deficit over the long term. That shouldn’t be a problem as long as it remains small, as it has been for the past five years. 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 our expectations of structurally higher rates of inflation in the US over the coming years, we also think the nominal rupee exchange against the US dollar will appreciate slightly over our forecast horizon. (See Chart 44.)
Long-term Outlook Charts
Chart 41: Working Age Population (Millions)
Chart 42: Lok Sabha Election Results
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)
Policy interest rate (%, end of period)
Ten-year government bond yield (%, end of period)
Government budget balance (% of GDP)
Gross government debt (% of GDP, end of period)
Current account (% of GDP)
Exchange rate (Rupees per USD, end of period)
Nominal GDP ($bn, end of period)
Population (millions, end of period)
Sources: UN, CEIC, Refinitiv, Bloomberg, Capital Economics
Shilan Shah, Senior India Economist, firstname.lastname@example.org
Darren Aw, Asia Economist, email@example.com
Mark Williams, Chief Asia Economist, firstname.lastname@example.org