Growth is likely to accelerate for the remainder of this year, but the longer-term performance of the Indian economy will hinge on the outcome of its upcoming election.
Economic growth will likely improve in the coming quarters, but the pace of growth may remain gradual because of persistent challenges.
With each quarterly economic outlook, India seems to be struggling with a new set of economic challenges. But while a few challenges are sporadic and some of them are completely new, certain challenges are persistent and recurring. Regardless of their traits, these challenges have heavily weighed on growth in the last few quarters as is evident from recent revisions of the growth numbers for FY 2012–2013 and the latest GDP growth in Q3 of FY 2013–2014. That said, economic data suggests that the worst is probably over, and economic growth may have bottomed out. Economic growth will likely improve in the coming quarters, but the pace of growth may remain gradual because of persistent challenges. The growth outlook will also hinge on the national election outcomes in May 2014.
A year ago, India was mired in problems of external and internal account imbalances. The country’s current account indicated a record-breaking deficit in FY 2012–2013 of 4.8 percent of GDP because of high crude oil and gold imports in addition to falling exports. At the same time, the government registered a fiscal deficit of 4.9 percent of GDP in FY 2012–2013. The fiscal account deficit worsened to 8.5 percent of GDP1 in H1 of FY 2013–2014 due to increased government expenses and less-than-expected tax revenues.
Last summer, India faced an additional challenge of reversal of capital inflows after the US Federal Reserve’s hint of tapering its monetary policy. This was aggravated by speculations by institutional investors whose confidence in the economy was low due to poor fundamentals. The sudden capital outflows resulted in a sharp depreciation in India’s currency, sending it down by 24 percent in a span of four months from April to August 2013. The Reserve Bank of India (RBI) had to step in to contain the exchange rate volatility and the current account deficit. Prompt monetary measures along with tighter credit conditions helped stabilize currency.
By the end of 2013, significant corrections were made to the fiscal and the current account imbalances as seen in figure 1. The fiscal deficit was contained to 3.8 percent of GDP in Q3 of 2013–2014, though the government has already exhausted 95.2 percent of the budget estimate of fiscal deficit for FY 2013–2014. Current account deficit also improved to less than a percent, helped by improving trade account. Slowdown in imports, particularly gold, and improvements in global trade helped India’s trade deficit to contract continually since May 2013. The volatility in currency and capital flows also stabilized as investors’ perceived risks about the implications of the US monetary policy tapering started diminishing (see figure 2). While the downside risks are still high, these challenges are no longer the biggest concerns now.
Political uncertainty is the latest concern as India elects its government at the center in May 2014. The assembly election results in five states of India in December 2013 affirmed the widely felt dissatisfaction with the current ruling government. The involvement of several senior government officials in multiple corruption scandals, lack of clear leadership, and poor policy initiatives to boost growth have tarnished the image of the ruling party. In addition, the stunning entry of the Aam Aadmi Party (the “Common Man Party,” or AAP) in the Delhi state assembly elections in December 2013 marked a shift in the political arena. The rising significance of regional parties suggests a rising demand for accountability from the government in a manner that was not so pervasive earlier. However, at the same time, the presence of regional parties makes it very difficult to predict the election outcomes, adding to uncertainty.
The persistent challenges
Some challenges have been more persistent in nature. One such recurring challenge has been high and rising inflation, which has afflicted India for more than half a decade. Barring a few months, the consumer price inflation remained in double digits for the whole of calendar year 2013 (see figure 3).
Policy uncertainties have been another challenge in the economy. The government’s efforts to undertake meaningful reforms have been followed by disappointing implementation. In the past, reforms have been repeatedly watered down, which continues to frustrate business fraternity and impact investor sentiments. However, the biggest challenges of all are the structural bottlenecks like poor infrastructure, complicated tax structures, and poor investment environment that underlie all the problems stated above.
The government has taken several initiatives to tackle structural deficiencies. About 50,000 MW of thermal and hydel power capacity are under construction after receiving clearances and approvals. Several nuclear power plant projects are under construction, and a few are already generating power. FDI policies in telecommunication, pharmaceuticals, civil aviation, power trading exchange, and multi-brand retail have been liberalized to attract large investments. However, the initiatives are not enough for India’s growing market, and the pace of improvement is very poor.
Previous editions of the Global Economic Outlook have addressed structural deficiencies; this article will focus on the RBI’s fight to contain inflation and its justification for its policy actions.
Tackling inflation has become a test for the RBI as it fights to reduce the demand-supply gap and check pressure on prices by impacting the demand side. Recent data points to a rise in the aggregate demand from certain quarters as indicated by the pickup in capacity utilization, decline in inventories retention to sales, increase in order books, and rise in prices of intermediates in conjunction with rise in bank credit. Rise in core prices and services are indicative of wage pressures.
The RBI has made it a priority to check rising prices and anchor inflation expectations among its monetary policy objectives, and it is determined to bring it down slowly and steadily. It raised its key policy rate by 25 basis points to 8 percent for the third time in five months. The tightening of monetary policy in January 2014 surprised the investors and the industrialists, who have been demanding a rate cut. However, the raise in policy rates is in line with the recommendations of an expert committee, the Patel Committee, set up by the RBI governor to adopt consumer price inflation as the nominal anchor for monetary policy framework with a target of 4 percent and a range of 2 percent around it in the long term.
Tackling inflation at the expense of growth?
The RBI recognizes that the economic growth is currently weak, but lowering interest rates is not a feasible option when inflation in the economy is in double digits. Any reduction in interest rates will generate more demand for goods and raise their prices. Elevated prices will, thereby, increase the risks of currency depreciation, erode household budgets, and constrict the purchasing power of consumers. This, in turn, will discourage investments and will result in falling consumption. In other words, under a high-inflation scenario, reducing interest rates will boost demand, but only for a short period. In the long run, prices will spiral up and impact growth sustainability. Besides, high inflation taxes the poor more than the rich, so it will increase income inequality.
The RBI’s move to keep interest rates high is justifiable. Tighter monetary conditions will discourage investment, and consumers will postpone consumption and save more. A lower domestic demand, in turn, will help contain inflation as the supply-demand gap reduces. Once prices start descending, people will expect inflation to stay low and raise their consumption demand.
Slow and steady rate hikes
So far, the key policy rates have been hiked by only 25 basis points in three of the four policy meetings since September. Given that inflation is largely a structural problem and an outcome of supply shortages, the impact of this rate hike on prices will likely be slow. The RBI has made it clear that it prefers to influence inflation slowly over time rather than abruptly. This is because any sharp rise in interest rates may reduce inflation drastically, but it will likely impact demand adversely, causing significant damage to the economic growth.
The RBI has assured that once inflation is low, it will start cutting interest rates to generate a sustained increase in demand and thus, growth.
Tightening credit has slowly started impacting inflation, as evident from the fall in both consumer and wholesale prices in recent months. The RBI has assured that once inflation is low, it will start cutting interest rates to generate a sustained increase in demand and thus, growth. However, the RBI has also assured that it is prepared to do what is necessary if the economy deviates from the projected inflation path or if there is any threat to financial stability.
Impact of challenges on growth
The challenges noted above, regardless of their traits—sporadic or persistent, domestic or external—had a significant impact on both the demand and production, bringing down growth, as evident from the recent releases. The economy grew at 4.7 percent year over year2 in Q3 of FY 2013–2014. The average growth in the first three quarters of FY 2013–2014 has been 4.6 percent.3 Weaker-than-expected growth in the third quarter implies that it will be a challenge to meet the government’s estimated annual growth rate of 4.9 percent.4
Growth in the services industries improved in Q3 of FY 2013–2014, but growth in the agriculture, manufacturing, and construction sectors slowed significantly, weighing down the overall economic growth. The fall in growth in the manufacturing and the construction sectors was probably a combined effect of low business confidence, poor investment growth, slowing domestic demand, and tightening monetary policies by the Reserve Bank of India (RBI).
Industrial production (IIP) growth indicators point to weak fundamentals in the industrial sector. Production in the manufacturing sector contracted for the fifth consecutive month. Growth in the capital goods and consumer goods industries declined as well, while growth in the production of consumer durable goods remained highly negative (see figure 4). This has been the fifteenth consecutive month of negative growth in the consumer durable goods industry, which shows a sustained decline in domestic consumption demand.
The growth in private consumption expenditure was a mere 2.5 percent, which further substantiates the fact that consumers are postponing their consumption decisions due to high economic uncertainties and tighter credit conditions. Growth in investment also turned negative due to negative business sentiment as consumers decide to postpone their investment decisions.
The annual real GDP growth estimates for FY 2012–2013 were revised down from 5 percent to 4.5 percent, which is the slowest annual growth in a decade, due to lower-than-expected growth in the primary and secondary sectors (see figure 1). Growth in the secondary sector (which constitutes manufacturing, electricity, gas and water supply, and construction) was reduced to half its earlier estimate due to poor performance in all its subsectors. On the demand side, growth in consumption demand has been revised up marginally for a few quarters. However, downward revisions to growth in investment spending were substantial.
Election outcome critical to growth outlook
The downward revision of earlier growth estimates and weaker growth in the latest quarter indicate that the economy has been on a path of a sustained slowdown. While the underlying economic growth trends are weak, the downside risks to the economy have reduced substantially compared with 2013. The consensus forecast shown in figure 5 indicates that the worst is probably over and economic growth may have bottomed out. Economic growth will likely improve in the coming quarters, but the pace of growth may remain gradual because of the persistent challenges.
That said, the growth outlook for the economy will primarily hinge on the election outcomes. A better government with a clear mandate will likely boost business and investors’ confidence. Since 1984, there have been eight national elections, of which, five elections were followed by a stable government. As shown in figure 6, growth gained momentum after these five elections. In the quarters prior to elections, both average economic growth and average IIP fell due to political uncertainties. However, in the quarters after the elections, both IIP and growth picked up momentum. The impact of a stable government on business sentiment was more prominent as evident from the immediate rise in the IIP numbers after elections; growth, however, followed the trend with a lag.
Growth will likely improve in the second half of FY 2014–2015 once there is more political and policy certainty.
Growth will likely improve in the second half of FY 2014–2015 once there is more political and policy certainty. Coordinated, defined monetary and fiscal policies will likely mitigate risks as the economy continues on its path to gradual growth. However, rapid reforms and substantial improvements in structural bottlenecks will likely remain a low possibility even after elections.
EndnotesView all endnotes
- Fiscal deficit as a share of GDP is calculated from fiscal deficit figures by Ministry of Finance and GDP figures by Press Information Bureau, government of India. The ratio is tentative and will be revised along with revisions in GDP estimates.
- Growth mentioned in the article refers to year-over-year growth, unless otherwise specified.
- The growth numbers for Q1 and Q2 of FY 2013–14 have not yet been revised as per the revision policy.
- “Key features of budget 2014–15,” http://indiabudget.nic.in/ub2014-15/bh/bh1.pdf.