Indian economy showing early signs of reversal

Chetan Ahya


The two key determinants of an economy’s growth trend are demographics and productivity. While demographic and productivity trends in Asia were supportive of growth until 2007, they have turned less supportive in recent years. Many countries in the region (China, Hong Kong, Korea, Singapore and Taiwan) are now facing a demographic challenge due to a sharp deceleration in the growth of the working age population, thereby forming a headwind to growth. Moreover, post-credit crisis growth in the AXJ (Asia ex-Japan) region has largely lacked the productive dynamic as domestic demand has been pushed higher via loose monetary and fiscal policies rather than through structural reforms.

The productivity dynamic in India has also been weak post the credit crisis. As the credit crisis unfolded, policy makers boosted government spending aggressively, pushing fiscal deficit from 4.8% in FY 2008 to 9.9% in FY 2009. Moreover, in FY 2009, policy makers also pushed through the implementation of the national rural employment scheme, which resulted in strong rural wage growth without commensurate productivity gains. While the combination of loose fiscal policies and high rural wage growth boosted domestic demand, weak investment spending has meant limited productivity gains. Hence, even while demographics trends remain supportive of growth, the weak productivity dynamic has resulted in an environment of slowing growth and an endemic inflation problem.


SIGNS OF A REVERSAL

After almost three years of this stagflation-type environment, we are now seeing early signs of a reversal. The government has started to move in the right direction to improve the productivity dynamic, with simultaneous efforts on fiscal consolidation and reviving private investment. Policy measures to improve the bad growth mix have led to a gradual improvement in the macro stability environment.

Since September ’12, policy makers have taken the first step to lower the fiscal deficit and will likely stay the course going into FY 2014. The government has brought down the fiscal deficit very sharply, with the 3-month trailing annualised deficit reducing from 8.4% of GDP in August ’12 to 3.8% in February ’13. The government has achieved this with decisive steps to control oil subsidy and an aggressive reduction in expenditure growth, particularly expenditure ex interest and subsidy payments. Fiscal consolidation is a positive for the economy as it helps trim the risks to macro stability from CPI inflation, current account deficit and sluggish deposit growth. We expect that fiscal consolidation will gradually help improve the macro stability indicators further.

The key macro stability indicator to track, in our view, will be CPI inflation. High inflation expectations (better reflected by CPI inflation in this cycle) is leading to high gold imports as savers reduce their allocation to financial savings in face of lower rates, keeping deposit growth weak. As CPI inflation moderates, inflation expectations will also moderate. This will help bring down gold imports, thereby improving the current account deficit and deposit growth. We expect CPI inflation to ease to 6.5% by March ’14 from 9.4% currently, helped by a slowdown in government spending, moderation in rural wage growth after five years of continuous acceleration, lagged effect of slowdown in domestic demand and lower global commodity prices as reflected by decelerating WPI.

Alongside this improvement in the macro stability environment, we are also expecting GDP growth to recover gradually. Most high frequency indicators are showing signs of a gradual recovery in growth. To be sure, we expect this to be a challenging cycle and hence the recovery will be gradual, with GDP growth recovering from 4.5% in QE December ’12 to 6% in QE March ’14. In the near term, the drivers of growth will be external demand and capex spending as the starting point of macro stability indicators will constrain domestic demand from staging a big recovery.