After a year to forget in 2019, a combination of policy loosening and more effective measures to deal with the malaise in the shadow banking sector will push economic growth in India back up to a healthier pace in 2020. And with core inflation set to rise, markets are wrong to assume that interest rates will stay on hold for the next two years. We think the RBI will switch to tightening mode much sooner than generally expected, possibly before the end of this year.
- Overview – After a year to forget in 2019, a combination of policy loosening and more effective measures to deal with the malaise in the shadow banking sector will push economic growth in India back up to a healthier pace in 2020. And with core inflation set to rise, markets are wrong to assume that interest rates will stay on hold for the next two years. We think the RBI will switch to tightening mode much sooner than generally expected, possibly before the end of this year.
- Domestic Demand – A sharp pullback in credit from the shadow banking sector caused growth to slow dramatically in 2019. But efforts to deal with the problems facing shadow banks have been stepped up, while fiscal and monetary policy have been loosened. This should lead to a gradual recovery in investment and household spending over the coming quarters.
- External Demand & Risks – India’s current account deficit narrowed in the four quarters to Q3 2019 and while this is likely to soon reverse, there is little threat of the external shortfall ballooning to unsustainable levels.
- Inflation – Consumer price inflation has jumped above the RBI’s 4.0% target in recent months as a result of a sharp rise in food inflation. And with underlying price pressures likely to rise, the headline rate looks set to remain above target throughout 2020.
- Monetary & Fiscal Policy – Fiscal policy has been loosened significantly in recent months, and further expansionary measures are likely to be unveiled in the upcoming budget amid growing anti-government protests. By contrast, the RBI’s easing cycle is likely to have run its course and we think the central bank will switch to tightening mode much sooner than most others expect, perhaps by the end of 2020.
- Long-term Outlook – We expect India to sustain growth of 5-7% per year over the next three decades, making it the fastest-growing major economy in the world. As a result, its share of world GDP should more than triple by 2050.
Key India Forecasts
(unless otherwise stated)
Output & Activity
External Sector (% of GDP)
Current Account (4Q Sum)
Fiscal (% of GDP)
Central Government Balance1
General Government Balance1
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 (2018 = FY17/18)
The road to recovery
- After a year to forget in 2019, a combination of policy loosening and more decisive measures to deal with problems in the shadow banking sector will push economic growth in India back up to a healthier pace in 2020. And with core inflation set to rise, markets are wrong to assume that interest rates will stay on hold for the next two years. We think the RBI will switch to tightening mode much sooner than generally expected, possibly before the end of this year.
- India’s economy grew by barely 5% in 2019, its worst performance since the global financial crisis and far slower than we and most others had expected. The slowdown has been due to a pullback in credit from the non-bank financial (NBFC) sector ever since a large-scale default in late 2018. This has caused investment and household consumption growth to slump.
- But as the severity and longevity of the problems in the shadow banking sector have become clear, policymakers have stepped up their efforts to deal with the strains they have caused. Licences for many of the worst-performing shadow banks have been cancelled, while lending rules for the better-performing NBFCs have been eased. These and other measures are helping to ease pressure on shadow banks. The spread of NBFC bond yields over government bond yields has dropped sharply in recent weeks (See Chart 1.)
- Broader measures to support the economy have also been enacted. The RBI slashed interest rates aggressively last year. Fiscal policy has been loosened too, albeit at the cost of the finance ministry missing its budget deficit target. (See Chart 2.) All of this should help drive a gradual recovery in growth over the coming quarters. We are forecasting economic growth to rise to 5.7% in 2020, with the acceleration continuing through the year. (See Chart 3.)
- The external position looks secure. Relatively lacklustre domestic demand will keep a lid on imports in the near term. Barring a surge in oil prices, this should keep the current account deficit contained. (See Chart 4.) And India’s low level of foreign-currency debt means that the further falls in the rupee we are expecting won’t have severe economic consequences.
- On inflation, the headline CPI rate has spiked in recent months, driven largely by supply shocks pushing up food prices. Underlying price pressures are still weak. But the RBI appears to be concerned about second-round effects and a rise in inflation expectations. And further ahead, stronger growth will also push up core inflation. So while headline inflation will peak in early 2020, the RBI will be faced with both core and headline inflation above its 4% target by Q3. (See Chart 5.)
- This will put pressure on the central bank to act. We are firmly non-consensus in expecting the RBI to hike interest rates within the next few quarters, possibly before the end of 2020. (See Chart 6.) Financial markets expect interest rates to stay on hold for the next two years.
- There are some emerging risks to growth prospects over the long term – most notably the lurch towards more populist policymaking – but we remain optimistic. Aided by the strongest electoral mandate since the early 1980s (see Chart 7) as well as a relatively stable consensus over the importance of reform, the Modi government is likely to continue gradually implementing growth-enhancing measures over the course of its second term. In all, we think the economy will be a star performer in the emerging world over the next decade. (See Chart 8.)
Chart 1: Spread of AAA Rated NBFC Bond Yields Over Government Bond Yields (%-pts)
Chart 2: Central Gov’t Fiscal Deficit (% of GDP)
Chart 3: GDP (% y/y)
Chart 4: Current Account Balance (4Q Sum, % of GDP)
Chart 5: Consumer Prices (% y/y)
Chart 6: RBI Policy Rates (%)
Chart 7: Lok Sabha Election Results
Chart 8: CE GDP Forecasts
Sources: Refinitiv, CEIC, Bloomberg, Capital Economics
Turning the corner
- India’s national accounts data are much-maligned, but the slump in growth they showed in 2019 tallies with evidence from other indicators. For example, the OECD’s leading indicator for India, which aims to capture swings in the business cycle, dropped throughout the year. (See Chart 9.)
- According to the GDP data, investment was the biggest drag on growth in Q3. Timely data on production of capital goods suggest that the slump in investment has yet to bottom out. (See Chart 10.)
- But we think investment growth will turn a corner soon. Much of the slowdown has been due to a sharp pullback in credit from India’s shadow banks, which are struggling to raise finance after the default of IL&FS Group. For example, mutual funds have drastically cut their exposure to shadow banks. (See Chart 11.)
- But more recently, policymakers have stepped up efforts to deal with the malaise. Licences for many of the worst-performing shadow banks have been cancelled, while lending rules for the better-performing NBFCs have been eased. These and other measures are helping to ease pressure on shadow banks. The spread of NBFC bond yields over government bond yields has dropped sharply over recent weeks. (See Chart 12.) That should help shadow banks to raise funding and, eventually, boost lending.
- Household consumption growth strengthened in Q3 and we think it has further to rise. The drop in issuance of car loans from NBFCs is now easing, with the result that the sharp fall in auto sales has now eased. (See Chart 13.)
- More broadly, consumption of smaller ticket items should hold up well over the coming months. Growth in production of non-durable goods has remained robust despite the broader slowdown in industrial production. Consumers will also benefit from the (partial) guaranteed income scheme introduced by the government after the general election.
- A renewed sharp spike in global oil prices would pose a risk to real incomes. But on our current forecasts of modest further increases over the rest of this year, oil prices should not be a major constraint. (See Chart 14.)
- Structural factors, including India’s youthful demographics and a low level of household debt (see Chart 15), provide further reasons to remain upbeat on the long-run prospects for private consumption.
- Government consumption growth was strong throughout 2019. While another surge is doubtful, it is unlikely to become as much of a drag as we had previously thought. The finance ministry has recently unveiled several expansionary measures including cuts to corporation tax, with an estimated cost of US$20bn (0.7% of GDP), and it is highly likely that income tax rates will be lowered in next month’s budget. The efficacy of this will be limited – the vast majority of people don’t pay tax – but at the margin, it is another reason to be more positive on growth. (See the Monetary & Fiscal section below for more on the implications for the fiscal deficit.)
- Bringing all of this together, we think the economy will grow by 5.7% this year and 6.5% in 2021. Our forecasts are below those of most forecasters, including the IMF. (See Chart 16.) But we would not characterise our forecasts as downbeat. After all, the economy should be growing above 6% by the end of the year and, in any case, India will remain one of the world’s fastest-growing economies.
Domestic Demand Charts
Chart 9: OECD Composite Leading Indicator
Chart 10: Investment & Capital Goods Production
Chart 11: Mutual Fund Holdings of NBFC Bonds
Chart 12: Spread of AAA Rated NBFC Bond Yields Over Government Bond Yields (%-pts)
Chart 13: New Passenger Vehicle Sales
Chart 14: Brent Crude ($pb)
Chart 15: Household Debt (% of GDP, 2019)
Chart 16: GDP (% y/y)
Sources: CEIC, Bloomberg, BIS, Capital Economics
External risks look manageable for now
- India’s current account deficit narrowed in the four quarters to Q3 2019 and, while this is likely to soon reverse, there is little threat of the external shortfall ballooning to unsustainable levels.
- We expect the current account deficit to widen for two reasons. First, we are forecasting a slow recovery in the global economy this year. If we are right, then the weakness in merchandise export growth (see Chart 17) is likely to persist. India’s decision to opt-out of the Regional Comprehensive Economic Partnership (RCEP) won’t help export prospects either.
- Second, we think that the slump in domestic demand will soon bottom out. That should lead to a rise in import growth, which has collapsed over recent months. (See Chart 18.)
- However, the rebound in import growth that we are expecting should be limited. In particular, shipments of gold and oil – which account for around 30% of the overall import bill – are likely to remain in check.
- Gold prices remain high by recent standards, but a structural shift in consumers’ preferences for the precious metal should keep import volumes contained. We think that gold imports will stay at around 1% of GDP in annual terms, in contrast with past highs of more than 3%.
- We are forecasting oil prices to rise to $75pb by the end of the year from around $66pb currently. There are upside risks given events in the Middle East. But prices would have to rise considerably higher to lift the cost of oil imports to the levels seen in 2012 and 2013 (see Chart 19), when India was pushed to the brink of a balance of payments crisis.
- Finally, India is the largest recipient of overseas remittances in the world (see Chart 20), and we think that inflows will remain fairly strong over the coming years – in part a reflection of the fact that newer technologies are helping to reduce the cost of sending money home.
- Bringing all of this together, we expect the current account deficit to remain within a comfortable range of 1.5-2.5% of GDP over the next few quarters. (See Chart 21.)
- What also matters is how the current account deficit is financed. The latest data show that net foreign direct investment inflows – which tend to be the most stable and long-term source of funding – remain significantly higher than volatile portfolio inflows. (See Chart 22.) The loosening of investment restrictions into various sectors of the economy last year should boost FDI inflows in the near term.
- But it’s not all rosy. An emerging risk to foreign inflows is the BJP government’s shift towards more populist policymaking over the past few months – most recently with the passage of the citizenship amendment bill. Timely data suggest that this hasn’t had any impact on portfolio inflows. But if the government’s attention to economic policymaking slips, that could cause foreign investor sentiment to sour over the long term.
- On the rupee, we expect weakness against the dollar over the next couple of years as the greenback remains globally strong. We expect the rupee to depreciate to 74/$ by end-2020 and 76/$ by end-2021, from around 72/$ currently. (See Chart 23.)
- 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 Demand & Risks Charts
Chart 17: Goods Exports ($USbn)
Chart 18: Goods Imports (% y/y, 3ma)
Chart 19: Oil Prices and Imports
Chart 20: Remittances Inflows ($USbn)
Chart 21: Current Account Balance (4Q Sum, % of GDP)
Chart 22: Net Capital Inflows (4Q Sum, % of GDP)
Chart 23: Rupee vs $US
Chart 24: FX Debt (% of GDP, 2018)
Sources: Bloomberg, CEIC, Capital Economics, World Bank
Headline inflation to stay above RBI’s target
- Consumer price inflation has jumped above the RBI’s 4.0% target in recent months as a result of a sharp rise in food inflation. And with underlying price pressures likely to pick up, the headline rate looks set to remain above target throughout 2020.
- Predicting movements in headline CPI inflation in India is difficult given the volatile nature of food and fuel prices and their large weighting in the consumer price basket. (See Chart 25.) However, high-frequency price data can provide some indication over the near term.
- The impact of monsoon-related supply disruptions that recently caused vegetable prices to surge continues to linger and food inflation is likely to remain high for a while. But if vegetable prices now stabilise, vegetable price inflation will begin to recede by Q2. (See Chart 26.)
- By contrast, transport inflation is set to rise over the course of 2020 (see Chart 27), in large part due to a weak base set up by last year’s drop in global oil prices.
- Beyond the volatile components, we think that the recent drop in core inflation will soon bottom out and then rise gradually this year.
- Admittedly, rural wage growth will only receive a small boost from modest increases in minimum support prices for key winter crops. (See Chart 28.) However, given the scale of policy loosening in 2019, domestic demand is likely to start picking up over the coming quarters. That should, in turn, cause underlying price pressures to strengthen.
- In addition, the primacy of food prices in India means that the recent jump in food inflation could affect perceptions of broader price pressures and seep into underlying inflation expectations. Indeed, these have already edged up in recent months despite the current weakness in economic growth. (See Chart 29.)
- Meanwhile, India’s three largest telecoms firms raised mobile phone tariffs by 15-50% in December. As a result, mobile phone price inflation looks set to rise to its highest on record. (See Chart 30.) We estimate that this will add 0.2%-pts to headline inflation throughout the year.
- All told, we expect headline inflation to average 5.5% this year, with both the headline and core rate above 4.0% in the second half of 2020. (See Chart 31.) Our CPI forecasts are well above consensus expectations for inflation to average 4.0% this year.
- If our forecasts prove correct, there would be limited space for further monetary easing, and we expect the RBI to leave policy rates on hold in the near term. Further ahead, we think that the central bank will switch to tightening mode much sooner than is generally expected.
- Wholesale price inflation fell steadily throughout most of 2019. (See Chart 32.) This was in part due to the weakness in fuel inflation, which accounts for a larger share of the wholesale price basket than the CPI measure. But with fuel inflation and underlying price pressures set to rise, we are forecasting the headline rate to climb back up and expect it to average 3.0% this year.
Chart 25: Consumer Price Basket (%)
Chart 26: Weekly Vegetable Prices and
Chart 27: Brent Oil Price and
Chart 28: Minimum Support Prices (% y/y)
Chart 29: Inflation Expectations (%)
Chart 30: Mobile Phone Charges CPI (% y/y)
Chart 31: Consumer Prices (% y/y)
Chart 32: Wholesale Prices (% y/y)
Sources: Refinitiv, CEIC, Dept of Consumer Affairs, RBI, CE
RBI’s easing cycle has run its course
- The finance ministry is aiming to reduce the central budget deficit from 3.4% of GDP in FY18/19 to 3.3% of GDP in FY19/20. But this is highly doubtful. After eight months, the deficit has exceeded the amount that was budgeted for the entire year. (See Chart 33.)
- Revenue streams are proving less fruitful than the finance ministry expected. Proceeds from the Goods and Services Tax (GST) remain below target (see Chart 34) and are likely to weaken further if PM Modi delivers on his promise to lower rates on several essential goods.
- In addition, a lack of interest from the private sector in purchasing Air India means that revenues from privatisation, which the finance ministry had projected at a record high (see Chart 35) will also fall short.
- Looking ahead, faced with a weak economy and growing social unrest, we think Finance Minister Nirmala Sitharaman will deliver additional fiscal stimulus in the upcoming budget for FY20/21. (See Chart 36.)
- There are rumours that the finance ministry is considering a reduction in the personal income tax rate, as well as an abolition of taxes on dividends paid by companies, on securities transactions on financial exchanges, and on long-term capital gains. Other measures such as cuts to excise duties on fuel are also likely.
- All of this would provide a boost to the economy, albeit a small one given that most people in India don’t pay any income tax. The cost is that debt levels won’t fall as fast as anticipated. We estimate that public debt will fall to 66% of GDP by 2023, compared to the IMF’s current forecast of a fall to 63% of GDP. (See Chart 37.)
- On monetary policy, the Reserve Bank slashed interest rates by 135bp last year, and this is now gradually being transmitted to lending rates. (See Chart 38.) Looking ahead, there is limited room for further easing. Admittedly, the MPC maintained its “accommodative” policy stance when it kept rates on hold in December. But the larger-than-expected acceleration in both food and headline inflation since then suggests to us that the loosening cycle is now at an end.
- Further ahead, we think that both core and headline inflation will be above 4.0% in the second half of 2020. Under those circumstances, we think the RBI will switch to tightening much sooner than is generally expected. We are forecasting modest rate hikes in 2021, with the first move possible before the end of 2020. (See Chart 39.) Such a quick turn in the interest rate cycle would hardly be unprecedented in India. After all, rates were hiked as recently as August 2018, before being cut in January 2019.
- Our forecasts are in stark contrast to consensus expectations. The analyst consensus is for further, modest loosening in the near term, while financial markets expect the repo rate to stay on hold for the next two years, even though this hasn’t happened since introduction in 2001.
- If we are right in thinking that the RBI will reverse course much sooner than investors appear to be discounting, government bond yields are likely to end this year some way above their current levels. (See Chart 40.)
Monetary & Fiscal Policy Charts
Chart 33: Central Gov’t Fiscal Deficit
Chart 34: Central Gov’t Revenues From GST (INRbn)
Chart 35: Central Gov’t Asset Sales (INRbn)
Chart 36: Central Gov’t Fiscal Deficit (% of GDP)
Chart 37: Gross Government Debt (% of GDP)
Chart 38: Lending Rates (%)
Chart 39: RBI Policy Rates (%)
Chart 40: 10-Yr Government Bond Yield (%)
Sources: Controller General Accounts, RBI, Refinitiv, Capital Economics
A global outperformer
- We expect India to sustain growth of 5-7% per year over the next three decades, making it the fastest-growing major economy in the world. As a result, its share of world GDP should more than triple by 2050.
- Employment growth will hold up relatively well for two reasons. First, the expansion in the working-age population is set to continue. India will replace China as home to the world’s largest labour force by 2025. (See Chart 41.)
- Second, female employment is likely to increase from its current very low levels. (See Chart 42.) India’s low female participation rate is often attributed to entrenched cultural norms. But we think it reflects a historic failure to implement labour market reforms and develop the strong manufacturing base that has been the gateway for women in poor countries to enter formal employment.
- Labour market reform will probably continue to be sluggish in the near term, but some of India’s more progressive states – such as Rajasthan – have been rolling out reforms to ease the process of hiring and firing workers and reduce trade union power. Such reforms should eventually spread to other states and influence policymaking by the central government.
- 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 43), 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 structural factors. India’s low per capita income means it has the potential to deepen its capital stock, shift the labour force from low to high productivity sectors, and replicate the best practices of richer economies. India should also benefit from high savings and investment rates.
- But the outlook is not universally upbeat. The recent pursuit of populist policies – such as the controversial citizenship amendment bill – is a concern and, further ahead, India will be among the worst-affected major nations from climate change. Extreme heat will weigh on worker productivity, while rising sea levels will reduce land use in coastal areas.
- The combined central and state budget deficits will remain fairly high, but public debt is unlikely to jump sharply as a share of GDP due to the economy’s rapid growth rate.
- 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 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 Ages Population (Millions)
Chart 42: Female Labour Force Participation (%, 2018)
Chart 43: Lok Sabha Election Results
Chart 44: Rupee vs US$
Sources: UN, CEIC, Bloomberg, Capital Economics
Key Forecasts (% y/y, Averages, unless otherwise stated)
Unemployment rate (%, end of period)
Policy interest rate (%, end of period)
Ten-year government bond yield (%, end of period)
Government budget balance (% of GDP, average over period)
Gross government debt (% of GDP, average over period)
Current account (% of GDP, average over period)
Exchange rate (Indian rupee per US dollar, 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, +65 6595 1511, email@example.com
Darren Aw, Asia Economist, +65 6595 5193, firstname.lastname@example.org
Mark Williams, Chief Asia Economist, +44 20 7811 3903, email@example.com