India has not delivered on its expected growth upswing although real GDP is currently rising at around 5.7%. This still compares favourably with the EM average of 4.6% (IMF forecast) but is nothing like as robust as Indian growth back in 2014 when the BJP government first came to power. The cyclical momentum has flagged because some of the short-term impact of reform measures of the government. Going into 2018, the drag from these reforms is likely to persist. Furthermore, there is some reluctance to deal with the fiscal challenges facing India and at some stage in the future, either this or the next government will need to cut spending, reduce the budget deficit and manage down India’s public sector debt levels. Such actions can only weigh on future growth.
How did we get here?
Investors had previously expected sustainable growth in India at a rate faster than China. Such an outlook appears to have lost its underlying momentum with Indian GDP growth at around 6.4% in 2014 building to a brief peak at around 9% in early 2016 before entering a period of drift. In Q2 2017, GDP growth was 5.7% and recent industrial production, retail sales and business confidence indicators suggest that it could weaken further heading into the third quarter of this year. Private sector credit growth looks depressed and, as of June 2017, was only up 3.6% year on year. This compares to an 8% average during the entire period of the BJP government.
It certainly looks like the following factors are keeping a lid on growth:
- The temporarily disruptive impact of some government reforms such as the demonetisation experiment of late 2016. This forced the exchange of medium to large value bank notes into new ones, prompting a large part of the population to open bank accounts for the first time. It created a short-term impact on high value retail sales and real estate transactions in India.
- The implementation of a new general sales tax came into effect in July this year, replacing the swathe of different sales taxes across India's states. Such an extensive change seems likely to have disrupted the activity of retail businesses in India, who had to adjust to the new accounting, reporting and payment practices associated with the revised tax structure.
- State owned banks have received continuous government and central bank encouragement to strengthen their capital base and recognise their non-performing loans. At the margin, this has probably made these banks more cautious in extending loans to the private sector. Despite local media criticism of the Indian central bank for keeping interest rates high and therefore squeezing growth, there is a strong counterargument as the central bank policy rate was 8.0% back in 2014 and CPI growth was 4.6%. Since then, CPI growth has actually fallen to 3.3% (-130bps) and the policy rate has also reduced to 6.0% (-200bps).
A fiscal millstone to carry
The aforementioned measures are positive for the Indian economy in the long term because: 1. The demonetisation actions can help formalise economic activity and reduce tax avoidance; 2. The new sales tax reduces red tape facing businesses; 3. The bank reforms are ratcheting-up with the government pledging to issue INR 1.35tn (0.9% GDP equivalent) of capitalisation bonds to the weak state owned banks encouraging them to speed up their recognition and resolution of non-performing loans. This should strengthen their balance sheets and position them to extend lending again. The bulk of new lending currently comes from the unencumbered private banks. The price to pay for these measures is slower GDP growth in exchange for stronger and more sustainable economic progress in the future.
On a less positive note, fiscal policy in India appears somewhat neglected. In late 2014 there was some liberalisation of domestic fuel prices meaning a cut in government spending on subsidies. In spite of this measure, the general government deficit in India (federal and state) was still -7.2% of GDP in 2014. Since then, little has happened either to boost general government revenue or to cut spending. The result has been that the general deficit is expected by the IMF to be -6.4% of GDP in 2017. Total public debt is likely to be 68.7% GDP in 2017 - barely changed from 2014. This fiscal position looks unsustainable and at some stage the government will need to take action or risk debt levels trending upwards. If and when fiscal consolidation starts, GDP growth in India could well be hurt.
The ruling government faces a challenging year ahead. Growth has lost a bit of its sparkle and the dividend from the past reforms has not come through as yet. Furthermore, parliamentary elections take place in 2019, which may put the ruling party in a dilemma i.e. hemmed in between wanting to take action to boost growth to win public support or pushing on with the reform agenda.
Emerging Markets Macro and FX strategist