The long road back to normality - Capital Economics
India Economics

The long road back to normality

India Economic Outlook
Written by Shilan Shah
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India’s failure to contain the coronavirus and the government’s underwhelming policy response mean the economy will suffer its largest drop in annual output on record this year. In addition, the recovery is likely to be one of the weakest among major economies.

  • Overview – India’s failure to contain the coronavirus and the government’s underwhelming policy response mean the economy will suffer its largest drop in annual output on record this year. In addition, the recovery is likely to be one of the weakest among major economies.
  • Output & Activity – Activity is gradually recovering as containment measures are eased, but the road back to normality will be long. On the domestic front, household spending and investment will remain very weak, with exports unlikely to provide much support.
  • External Stability – The national lockdown and a collapse in domestic demand means India’s current account has in all likelihood swung into a rare surplus. While this should prove temporary, the deficit will remain small for the foreseeable future. With capital inflows holding up, the external position looks secure for the time being.
  • Inflation & Policy – Price pressures appear to have weakened and with demand likely to remain depressed, inflation will not be a pressing concern. The RBI has already loosened policy significantly and has left the door open for further easing. But the fiscal response has been underwhelming.
  • 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 years. We doubt that output in India will return to its pre-virus path for a decade.

Key India Forecasts

 

Quarterly

Annual

% y/y

(unless otherwise stated)

2020

2021

       

Q1

Q2e

Q3f

Q4f

Q1f

Q2f

2019

2020

2021

2022

 

                   

Output & Activity

                   

GDP

3.1

-15.0

-7.0

-3.0

0.0

22.5

4.9

-5.5

11.0

7.0

Household Consumption

2.7

-22.0

-11.0

-5.0

1.0

30.0

6.2

-9.0

14.0

8.0

Government Consumption

13.6

20.0

10.0

10.0

7.0

6.0

11.8

13.5

6.5

2.0

Investment

-6.5

-25.0

-10.0

-5.0

1.0

25.0

0.0

-11.5

11.5

8.0

Exports

-8.5

-40.0

-15.0

-8.0

4.0

45.0

1.4

-18.0

21.0

10.0

Imports

-7.0

-50.0

-20.0

-10.0

6.0

50.0

-4.9

-22.0

24.0

13.0

                     

External Sector (% of GDP)

                   

Current Account (4Q Sum)

-0.8

0.0

0.3

0.1

-0.3

-1.0

-1.0

0.1

-1.0

-1.5

                     

Prices

                   

Consumer Prices

6.7

5.3

3.9

3.2

3.0

3.7

3.7

4.8

4.0

4.3

Wholesale Prices

2.1

-2.5

-3.0

-3.0

-2.5

1.0

1.9

-1.5

0.5

1.0

                     

Fiscal (% of GDP)

                   

Central Government Balance1

-3.6

-4.6

-12.0

-5.0

Gross Government Debt

68.0

82.0

80.0

78.5

                     

Monetary (end period, %)

                   

Repo Rate

4.40

4.00

3.50

3.50

3.50

3.50

5.15

3.50

3.50

3.50

Reverse Repo Rate

4.00

3.35

2.85

2.85

2.85

2.85

4.90

2.85

2.85

2.85

Cash Reserve Ratio

4.00

3.00

2.50

2.50

2.50

3.00

4.00

2.50

3.50

4.00

                     

Markets (end period)

                   

Sensex Equity Index

29,469

34,916

36,500

38,000

39,400

40,900

41,254

38,000

43,750

43,500

5-yr Government Bond (%)

5.57

5.27

5.75

5.50

5.50

5.50

6.46

5.50

5.50

6.00

10-yr Government Bond (%)

6.13

5.88

5.75

5.50

5.50

5.50

6.55

5.50

5.50

6.00

INR/USD

75.3

75.5

77.0

78.0

78.5

79.0

71.4

78.0

80.0

81.0

                     

Gold ($/oz)

1,612

1,784

1,650

1,600

1,600

1,575

1,517

1,600

1,550

1,500

Brent Crude ($/pb)

23

41

42

45

47

50

66

45

55

60

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


Overview

The long road back to normality

  • India’s failure to contain the spread of the coronavirus, and the government’s underwhelming support package for firms and households, means the economy will suffer its largest drop in output on record this year. And relative to potential, the recovery is likely to be one of the weakest among major economies.
  • Stringent lockdown and containment measures have been scaled back over recent weeks, enabling a rebound in activity. Our COVID recovery tracker is now at roughly 50% of pre-virus levels. (See Chart 1.)
  • However, the number of new confirmed virus cases remains on a sharp upward trajectory. (See Chart 2.) Limited testing in India means the true number of cases is almost certainly higher. As such, many restrictions will need to remain in place for an extended period and, in areas where virus cases are rising particularly fast, a re-imposition of tighter measures is likely. Output in sectors of the economy that require social interaction such as transport, retail, leisure and recreation will remain weak.
  • External demand has taken a major hit amid the bleak global backdrop. But with domestic demand faring worse and global oil prices very low, India’s current account looks set to record a rare surplus. And although this should prove to only be temporary, the deficit will remain small for the foreseeable future. (See Chart 3.)
  • CPI inflation data have not been published for two months, but high-frequency data suggest that food inflation is dropping, while fuel inflation remains contained. What’s more, underlying inflation is likely to have eased given the collapse in domestic demand.
  • All of this means that policymakers should be doing as much as they can to support the economy. The RBI has stepped up and helped to ensure financial stability with large-scale liquidity injections and hefty rate cuts. Further easing is likely. (See Chart 4.)
  • By contrast, 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 5.) It appears that concerns over the public debt ratio – misplaced in our opinion given what is at stake – is the key factor preventing the Finance Ministry from unleashing more stimulus.
  • This will leave a legacy of unemployment and firm failures that will take a long time to reverse. The banking sector – which already has one of the highest ratios of non-performing loans in the emerging world (see Chart 6) – will take a further hit as more loans turn sour. A lack of willingness to lend is likely to be another key constraint on the recovery over the coming years.
  • Bringing all of this together, real GDP in India is likely to contract by more than 5% this year, the worst performance since reliable annual data started being collected sixty years ago. (See Chart 7.) And we think the economy will be 7% smaller in real terms at the end of 2022 than would have been the case had the virus not existed. (See Chart 8.)
  • It is difficult to find many positives at the moment. However, 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 coronavirus crisis. These moves will do little to boost demand in the near term. But if India can successfully contain the virus and the reforms become permanent, that could lay the foundation for faster growth further ahead.

Overview Charts

Chart 1: CE India COVID Recovery Tracker
(% Difference from Baseline, Latest = 3rd Jul.)

Chart 2: New Daily Confirmed COVID-19 Cases
(Latest = 6th Jul.)

Chart 3: Current Account Balance (4Q Sum, % of GDP)

Chart 4: RBI Policy Rates (%)

Chart 5: Announced Fiscal Stimulus in Response to Coronavirus* (% of GDP)

Chart 6: Non-Performing Loans
(% of Total Loans, Latest)

Chart 7: Annual GDP (% y/y)

Chart 8: GDP (2019 = 100)

 

Sources: WHO, CEIC, World Bank, Capital Economics


Output & Activity

A slow and fitful recovery

  • GDP growth slowed to an 11-year low in Q1, and that only captured the very early stages of the lockdown. Q2 will have been much worse. While activity has picked up following the lifting of containment measures (see Chart 9), the failure to control the spread of the virus and the government’s underwhelming support package mean the recovery will be bumpy and protracted.
  • Many recent data releases have been curtailed due to the lockdown but those that have been published show a total collapse in activity in April and only a small rebound in May. (See Chart 10.) Timely surveys such as the PMIs picked up further in June – which we interpret as a sign that activity is recovering – but still weak by past standards. (See Chart 11.) This supports evidence from lower-profile, high-frequency indicators such as electricity consumption, which remain below normal levels. (See Chart 12.)
  • Focussing on the expenditure side of the national accounts, household spending is set to remain extremely weak. With virus cases still rising sharply, social distancing measures will remain in place for an extended period which will weigh on spending on 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. (See Chart 13.)
  • The outlook for investment is also grim. The government has offered loan guarantees to SMEs but, in reality, firms will remain cautious even as they reopen given the likely damage to balance sheets and the high chance of localised lockdowns being reintroduced.
  • Compounding the issue, the ailing banking sector will take a further hit as more loans turn sour after the debt moratorium is lifted. Admittedly, the RBI has stepped up support for banks with large-scale liquidity injections and cuts to the reverse repo rate. But banks continue to tread very cautiously: inflows into the RBI’s reverse repo window remain very high. (See Chart 14.)
  • Bank lending was slowing even before the crisis (see Chart 15) and further damage to balance sheets is likely to make them even more risk averse, which will be another key 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. That said, the response has been timid (see the Policy section for more).
  • The economy will receive little external support given the extremely weak global backdrop. We think the global economy will contract by 5.5% this year, its worst performance since the Second World War.
  • Bringing all of this together, real GDP in India is likely to contract by 5.5% this year. (See Chart 16.) And while GDP growth will surge in 2021, this is largely due to very favourable base effects. The big picture is that India is likely to suffer one of the weakest recoveries among major EMs.

Output & Activity Charts

Chart 9: COVID-19 Government Response
Stringency Index

Chart 10: Activity Indicators (% y/y)

Chart 11: Purchasing Managers’ Indices

Chart 12: Daily Electricity Consumption (GWh)

Chart 13: RBI Consumer Confidence Survey*

Chart 14: Flows into RBI Reverse Repo Window (INRbn)

Chart 15: Bank Lending to Commercial Sector

Chart 16: GDP (% y/y)

 

Sources: Oxford University, CEIC, Markit, POSOCO, RBI, CE


External Stability

External position will remain secure

  • The current account deficit narrowed from 1.0% of GDP in 2019 to 0.8% of GDP in the four quarters up to Q1 2020, due in large part to a sharp narrowing in the goods trade deficit. (See Chart 17.) The nationwide lockdown and the weakness of domestic demand mean there is a strong chance that the current account has since flipped into a surplus.
  • We doubt that the current account surplus will last. Admittedly, domestic demand is likely to be weaker than external demand given India’s failure to control the virus. Indeed, exports posted a stronger rebound than imports in May. (See Chart 18.)
  • However, the import bill will be boosted by recovering commodity prices. Most significant, oil prices are rising from the rout in Q1. (See Chart 19.) Our Commodities teams expect the price of Brent Crude to rise to $45pb by the end of the year, from a recent low of $20pb.
  • What’s more, there are good reasons to think that remittances – which show up in the current transfers section of the balance of payments – will drop. In particular, labour market prospects for Indian migrants in the Gulf and the US have deteriorated significantly due to the damage that had been caused by the lockdowns and tightening foreign worker restrictions there. These economies account for 75% of total remittances. (See Chart 20.)
  • Bringing all of this together, we are forecasting a current account deficit of around 1.0-1.5% of GDP over the coming quarters. (See Chart 21.)
  • The key point, however, is that this would hardly be a matter of concern. The current account deficit would still be well within the RBI’s 2.0% of GDP threshold that it considers sustainable and also much smaller than was the norm a few years ago.
  • The quality of inflows that are financing the current account deficit adds to our belief that the external position remains secure. Net foreign direct investment inflows, which tend to be the most stable and long-term source of funding, edged up in Q1 and remained significantly higher than volatile portfolio inflows. (See Chart 22.)
  • It’s difficult to know exactly what will have happened to foreign direct investment during the pandemic though it seems probable that both outward and inward FDI will drop substantially. However, daily data show that net portfolio flows have stabilised since March’s market rout. (See Chart 23.) We think they will hold up for now as risk appetite returns to global markets.
  • On the rupee, we expect a little more weakness against the US dollar over the next couple of years as commodity prices make up some lost ground and due to India’s failure to contain the virus. We expect the rupee to depreciate to 78/$ by end-2020 and 80/$ by end-2021, from around 75/$ currently.
  • There should be limited economic fallout from this. After all, the decline in trade-weighted terms will be mild, and India has a very low burden of FX debt (see Chart 24), meaning that renewed currency weakness won’t exacerbate strains in the banking sector.

External Stability Charts

Chart 17: Goods Trade Balance (US$bn)

Chart 18: Goods Exports and Imports (% y/y)

Chart 19: Oil Prices and Imports

Chart 20: Top 10 Sources of Remittances to India

(% of Total, 2019)

Chart 21: Current Account Balance (4Q Sum, % of GDP)

Chart 22: Net Capital Flows (4Q Sum, % of GDP)

Chart 23: Daily Net Foreign Portfolio Inflows
(INRbn, Rolling 1m. Sum)

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

 

Sources: CEIC, Capital Economics, World Bank


Inflation and Policy

RBI steps up as finance ministry flounders

  • Release of consumer price inflation data has been severely curtailed over the past few months due to problems collecting information during the lockdown. However, high-frequency price data suggest that food inflation – which accounts for 50% of the CPI basket – is dropping. (See Chart 25.) If forecasts of a good monsoon prove correct, that will add to downward pressure on food inflation.
  • Meanwhile, the collapse in domestic demand caused by job and income losses from the lockdown will cause underlying price pressures to weaken. At 4% in March, core inflation was already low by past standards. We think it may now drop below 3%. All of this means that headline CPI inflation is likely to drop below the RBI’s 4.0% target over the coming months. (See Chart 26.)
  • With inflation of little concern, the focus of policymakers should be to support the economic recovery as much as possible. The RBI has been emphatic in its response. 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 eased financial regulations. This includes the introduction of a new targeted long-term repo operation and a loan moratorium that will run until at least August.
  • All of this has helped to ease strains in the financial sector. Interbank rates are lower now than they were prior to the outbreak of the virus (see Chart 27), and our proprietary index shows that broader financial conditions in India have eased substantially over the past couple of months. (See Chart 28.)
  • Looking ahead, we think the RBI will still do more. After all, the central bank’s policy stance remains “accommodative”, and all members of the MPC have become more bearish on the outlook for economic growth.
  • We’ve pencilled in another 50bp of cuts in the repo and reverse repo rate. (See Chart 29.) The cash reserve ratio could also be reduced by another 50bp, and further liquidity injections are possible too. Further ahead, policy will remain loose for a long time.
  • Turning to fiscal policy, the Finance Ministry has unveiled a stimulus package it claims is 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 30.) 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 this year anyway. We forecast it to rise from 4.6% of GDP in FY19/20 to 12% of GDP in FY20/21. (See Chart 31.)
  • In turn, we expect public debt to rise to 82% of GDP this year, from 68% last year. This would be very high by EM standards. (See Chart 32.) However, almost all of India’s public debt is denominated in rupees and held domestically, while policymakers have options to keep borrowing costs in check. The threat of a public debt crisis is low.

Inflation and Policy Charts

Chart 25: Daily Food Prices and
Food CPI (% y/y)

Chart 26: Consumer Prices (% y/y)

Chart 27: Interbank Rates (%, Latest = 3rd Jul.)

Chart 28: CE Financial Conditions Index for India (Standard Deviation)

Chart 29: RBI Policy Rates (%)

Chart 30: Announced Fiscal Stimulus in Response to Coronavirus* (% of GDP)

Chart 31: Central Government Fiscal Deficit
(% of GDP*)

Chart 32: Gross Government Debt
(% of GDP, CE 2020 Forecasts)

 

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


Long-term Outlook

Long-term outlook still bright despite COVID crisis

  • The coronavirus crisis and the government’s unwillingness to respond adequately to it will leave a legacy of impaired household and corporate balance sheets and a damaged banking sector 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 a decade.
  • But we don’t think that the virus will do lasting damage to the supply potential of the economy. India’s population is relatively young, and younger people appear much less likely to die from an infection. The expansion of the working age population is set to continue and India will replace China as home to the world’s largest labour force by 2025. (See Chart 33.)
  • What’s more, some BJP-led states have expedited temporary 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 if investment and employment rise in those states, local assemblies will find it easier to argue that the measures should become permanent. And state governments that have not yet followed may be encouraged to do so.
  • As far as the capital stock goes, the virus has not led to destruction of productive capacity as occurs in wars or natural disasters. Admittedly, investment growth will be weak over the coming years, denting the growth of the capital stock. But the crisis will increase the incentive for firms to invest more in areas like touchless technologies.
  • Other productivity-boosting measures are also likely. Prime Minister Modi’s BJP secured the largest single-party majority in the Lok Sabha (lower house of parliament) since the early 1980s in the 2019 general election (see Chart 34), which should lay the platform for continued gradual reform. Further ahead, growing pressure from businesses and investors should ensure that politicians continue to make reform progress regardless of who holds power.
  • Our optimism about long-run productivity prospects is also underpinned by the fact that India has massive scope to shift the labour force from low to high productivity sectors, and replicate the best practices of richer economies.
  • 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 35) due to a combination of strong economic growth 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 permanent current account deficit over the long term. After all, domestic investment is likely to remain higher than domestic savings given the government’s tendency to run a budget deficit.
  • 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 36.)

Long-term Outlook Charts

Chart 33: Working Age Population (Millions)

Chart 34: Lok Sabha Election Results
(% of Seats Won by Leading Party)

Chart 35: Gross Government Debt (% of GDP)

Chart 36: 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

4.5

7.5

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

5.5

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

78.0

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