India – cutting growth estimates again
This post is a guest contribution by Chetan Ahya of Morgan Stanley.
Over the past few months, India’s growth outlook has been affected by adverse macro developments. The two key factors that are making us nervous on the growth outlook are inflation persistently staying above policy-makers’ comfort zone and the weak investment growth trend. In this context, we believe that the recent spike in commodity prices and consequent impact on inflation and cost of capital has increased the downside risks to growth. We now expect domestic demand growth to be more constrained than estimated earlier. We cut our F2012 GDP (YE Mar-12) growth forecast to 8.2% from 8.7% in January 2011 (see India EcoView, Clouds Emerging over Growth Outlook, January 25, 2011). We are now cutting it further to 7.7%. On a calendar-year basis, we expect GDP growth for 2011 at 7.7% compared with 8.2% earlier. We have also trimmed our 2012 GDP growth forecast to 8.7% from 9%.
Inflation Pressures Remain High
High inflation expectations have already pushed the cost of capital higher than expected. With global commodity prices continuing to rise and surprising on the upside, the cost of capital is likely to remain high for longer than we had expected, adversely affecting growth. The high inflation expectations have meant a slow rise in bank deposit growth of 16.9%Y as of February 11, 2011, compared to the recent peak of 23.2%Y as of July 2009, whereas credit growth remained high at 23.9%Y as of February 11, 2011. With the central bank continuing to be slow to hike policy rates, banks delayed deposit rate hikes. However, given persistent tightness in interbank liquidity, banks began to resort to aggressive deposit rate hikes from December 6, 2010. The State Bank of India, the largest bank, has increased its deposit rates for the one to two-year period by 175bp to 9.25% currently over the last three months. Some banks are offering 9.5-9.75% deposit rates for the same tenure. We believe that the central bank may continue to follow its gradual pace of lifting rates. We expect another 75bp hike in the repo rate for the rest of 2011. However, we now track the bank deposit rate as a better measure of tightening of monetary conditions instead of the policy rates.
Until recently, we were expecting a quick improvement in interbank liquidity due to the acceleration in deposit growth. For instance, we thought that the deposit rate hikes were aggressive and had expected deposit growth to respond much faster, resulting in banks beginning to cut deposit rates by 25-50bp. However, with the persistent rise in crude oil and other commodity prices, we believe that inflation expectations will remain sticky and interbank liquidity may remain tighter for longer. Currently, overall loan-deposit ratio is extremely tight at 75%, which is a multiple-year high. Considering that the banks are required to invest 24% of deposits in government securities (SLR) and park 6% of deposits with the central bank in the form of cash reserve ratio (CRR), the current credit-deposit (C/D) ratio indicates the stretch in the banking system to fund strong credit growth. Moreover, unlike in 2006-07, when the banking system had excess liquidity as reflected in the form of market stabilisation scheme (MSS) bonds or reverse repo balances, currently the RBI has been injecting liquidity to prevent pressure on interbank rates. We believe that banks are likely to have to slow credit growth with more hikes in lending rates even as deposit growth accelerates, unless deposit growth accelerates all the way up to 22-24% in the near term, which appears unlikely, in our view.
Slowdown in Government Spending and Moderation in Consumption Growth in F2012
Persistent higher inflation, we believe, will hurt private consumption growth. Moreover, we believe that higher bank deposit rates will encourage households to increase savings.
Similarly, we expect the government to cut its expenditure growth in F2012 to reduce the fiscal deficit. In F2012, the central government’s fiscal deficit is likely to be lower at 5.2% of GDP compared with 6.4% (excluding revenue from telecom license fees) in F2011. In the absence of support of one-off revenues, we believe that the government’s expenditure growth will decelerate to 7.5%Y in F2012 from 18.7%Y in F2011. Indeed, the central government’s expenditure has been growing at an average rate of 19.2%Y over the last five years. We believe that this rising government expenditure to GDP over the last five years played a key role in boosting private consumption. Hence, a slowdown in government expenditure will be another factor resulting in moderation in private consumption.
Investment Growth Likely to Be Slower than Earlier Expected
In the context of moderation in consumption growth, acceleration in investment is important. However, we now see investment growth as weaker than estimated earlier.
The pace of recovery in investment appears to have suffered in 4Q10 based on the order book trends for engineering and construction companies. As discussed earlier, the global credit crisis has resulted in a significant decline in total investment to GDP (excluding investments in gold by households) to 33.2% of GDP in F2009 from 37.1% in F2008. More important, private corporate capex, which we believe is the most productive component of total investments, declined from the peak of 17.3% of GDP to 11.5% in the same period. While there has been some rise over the last two years, the pace of increase in investments has been slower than warranted. Total investments (excluding gold investments by households) and private corporate capex has improved to 34.7% and 13.5% of GDP, respectively, in F2011, according to our estimates.
Post credit crisis, the corporate confidence to push for higher investments is taking time to rebound to the levels seen in 2006 and 2007. In 2009, companies were focused on repairing their balance sheets. In 2010, corporate confidence recovered only gradually as the global macro environment was still not comfortable enough. Right up to August 2010, the sovereign debt concerns in the EU had meant that the companies were not ready for an aggressive capex plan. Just as the global environment improved, domestic factors such as corruption-related investigations and the rise in inflation and the cost of capital have held back the investment cycle. Indeed, we did see a recovery in order backlog for engineering and construction companies in 1H10. Order backlogs again decelerated during the quarter ended December 2010, however.
In this context, the further rise in crude oil and other global commodity prices has only increased the risk of inflation remaining higher for longer and the cost of capital remaining higher for longer. Over the past few days, the government’s actions have raised our optimism that it will get back into initiating efforts to clear investment projects transparently. For instance, the environment ministry has started to clear key projects. After a long delay, POSCO’s steel project received approval in January 2011. Similarly, the ministry awarded approval for a 4,000 MW power project in the state of Orissa. Recently, Prime Minister Manmohan Singh approved the constitution of a ministerial panel (to be headed by Finance Minister Pranab Mukherjee) to sort out environmental issues currently holding up the development of coal mines. Also, our conversations with engineering and construction companies indicate that the transportation ministry may soon start to award highway construction contracts in a transparent manner. Moreover, tight capacity should encourage corporate sector to increase capex in F2012. However, we now expect the rise in capex to GDP to be slower than expected earlier.
Strong Rise in Exports Will Help Partly Offset Slowdown in Domestic Demand
In line with the recovery in G3, India and other Asian countries have already seen a major rise in exports over the past few months. Seasonally adjusted goods exports have increased by 18.5% over the past four months. Considering the strong growth estimated by our US economics team for 2011, we expect export growth to remain robust. We believe that to some extent this will help to offset the slower-than-expected domestic demand growth. Strong growth in exports is also helping to contain the current account deficit close to 3% of GDP.
Cutting Our Growth Forecasts for 2011 (F2012)
Incorporating the aforementioned macro developments, we are cutting our GDP growth estimate for F2012 (YE Mar-12) to 7.7% from 8.2%. We are also trimming our F2013 GDP growth to 8.7% from 9%. On a calendar-year basis, we expect GDP growth at 7.7% in 2011 and 8.7% in 2012 (versus 8.2% and 9% earlier). We believe that the following developments can bring upside/downside risks to our growth forecasts:
a) Inflation: We believe that as far as inflation is concerned, monetary policy has effectively tightened considerably, with bank deposit rates having moved up to close to 11-year highs if we exclude the period worst hit by the global credit crisis. While fiscal policy remains expansionary, we believe that the government has finally moved in the right direction, targeting meaningful reductions in underlying fiscal deficit for the first time since the credit crisis unfolded. Increasingly, we believe that global commodity prices are key to the inflation outlook. If global commodity prices moderate quickly with a better supply response, it will help to reduce inflation pressure faster than expected. At the same time, any major further spike in commodity prices would make inflation management even more difficult, hurting growth.
b) Capex: For the overall growth outlook, in the current environment where policy-makers are unlikely to be able to support growth with loose fiscal and monetary policy, we believe that investment growth is key. Our base case currently assumes a gradual recovery in capex, considering the macro environment. If the government manages to implement an aggressive ‘campaign-style’ effort to transparently clear investment projects with coordination from all ministries to revive corporate capex, then this will bring upside risks to our forecasts. Similarly, if the government fails to pursue a concerted effort to ensure a gradual recovery in capex, then there will be further downside risks to our estimate. In this context, apart from the general macro environment, we would be tracking announcements from various government ministries, anecdotal evidence on various investment projects and quarterly order book data of engineering and construction companies.
Medium-Term Growth Remains Unchanged
We believe that the current growth challenges that India is facing are more cyclical in nature. We believe that India will be back to transitioning toward higher sustainable growth of 8.5-9% from F2013 onwards. As we highlighted in India and China: New Tigers of Asia Part III, August 15, 2010, we see India moving to higher sustainable growth, driven by three factors: demographics, reforms and globalization (DRG factors). Indeed, we expect India to have one of the best demographic trends in the world. We expect India’s saving and investment trend to recover, again lifting potential growth.
Source: Morgan Stanley, March, 9, 2011.
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