Why India’s recovery will likely be cut short despite strong foundations

Why India’s recovery will likely be cut short despite strong foundations

Updated: 3 months, 15 days, 37 minutes, 49 seconds ago


The global turbulence is likely to increase in amplitude. US

China offers little counterbalance, impeded by Covid restrictions and a weakened property sector. Export slowdown, inventory destocking and tighter financial conditions are overhangs on the rest of Asia. Meanwhile, geopolitical risks abound, and as weak growth combines with tightening liquidity and higher rates, financial stability risks cannot be ruled out.

In this global backdrop, India appears in a relatively stronger position. Its economic foundations are much stronger today than 5-10 years ago. India did not roll out developed economies-style fiscal and monetary policy easing during the pandemic, which should benefit from a macro standpoint. Balance sheets are also much stronger now, with deleveraging by the corporate sector and a stronger banking balance sheet with low non-performing loans.

Over the medium term, the economy should also benefit from some new growth drivers, such as digitalisation, supply chain shifts, and green and infrastructure spending. The greater push towards digitalisation may also unlock productivity gains.

Despite these strengths, India can hardly remain unscathed. The contraction in August industrial production growth demonstrates that the sheen is starting to fade. Investment and consumption indicators in August-September have moderated from their peak in Q2 2022, suggesting weaker sequential momentum in Q3 (July-September). Even the services sector - which was close to 20 percentage points above pre-pandemic level during Q2 - has now moderated to about 8 percentage points, suggesting the post-pandemic reopening tailwinds are slowly ebbing.

The Welcome K-Word
The full impact of the global slowdown on the domestic outlook is also yet to materialise. Past global slowdowns have typically impacted India with a lag of around two quarters. Weak global demand hits not just exports but also the manufacturing and investment-related sectors. With still-sluggish private capital expenditure, weak exports and tightening financial conditions, the growth driver in the coming year will be highly K-shaped consumer and government spending. GDP growth should average 7% in FY2023, but then moderate to 5.2% in FY2024, below consensus expectations of 6-6.5%.

Even for GoI, the arithmetic doesn't get easier. The 'carrot' of slipping on fiscal commitments to support growth comes with the 'stick' of disrupting macro stability. Higher nominal GDP growth so far, upheld by elevated inflation, has led to a tax bonanza, buying valuable fiscal space to accommodate extra spending on food and fertiliser subsidies, excise duty cuts and other revenue shortfalls. However, with growth and inflation expected to moderate in FY2024, this cushion is likely to be short-lived. If GoI continues with its stated ambition of higher capital expenditure, it will very likely compromise on revenue expenditure or on the fiscal consolidation goal.

On the external sector, the moderation in export growth amid seemingly sticky imports appears poised to balloon the current account deficit to 3.8% of GDP in FY2023 from 1.2% in FY2022. While RBI has run down its forex reserves, a less appreciated aspect is that it achieved the twin aims of countering currency volatility as well as simultaneously tightening domestic liquidity (selling dollars means draining rupees out of the system), bringing it more in sync with the monetary policy stance.

Forex reserves remain adequate, and can be used to smoothen volatility. But defending any particular currency level would be self-defeating. Rather, the rupee should be allowed to gradually adjust, considering a weak currency works as a shock absorber, and could help moderate the current account deficit over time.

RBI has its work cut out on inflation. FY2023 consumer price index (CPI) inflation is tracking about 6.8% year-on-year, nearly 1 percentage point higher than RBI's upper tolerance level. Upside risks include higher food inflation, relentlessly high core inflation and potential second-round effects. This is despite global commodity prices moderating, suggesting that firms are recouping their margins rather than passing on the benefit to consumers.

Falling Tide Drops All Boats
With inflationary concerns still 'live', and growth somewhat resilient - for now - economic conditions appear broadly in favour of more rate hikes. However, we don't expect rate hikes for currency defence. Instead, currency weakness is likely to be tackled through forex intervention and macroprudential tools. More policy rate hikes are likely, but driven by domestic considerations, and the terminal repo rate (around 6.5%) shouldn't be too far away.

On the whole, despite stronger foundations, India's post-pandemic recovery will likely be cut short by the incoming global growth slowdown. In a global village, there is no decoupling, and downside risks are plenty. If 2023 was a car ride, the advice is not just to strap on the seat belts but to borrow a helmet too.

With a mix of tighter US Fed policy, a cost of living crisis, geopolitical uncertainties, weak global demand and balance of payment pressures clouding the economic outlook, the global and Indian economies are at crossroads. What lies ahead for India?The global turbulence is likely to increase in amplitude. US inflation remains uncomfortably high, which may necessitate the Fed funds rate rising to 5.25-5.5% by March 2023. This is likely to push the US economy into a recession, with GDP contracting by 1.1% year-on-year in 2023. Beset by rising cost of living, the euro area is likely to contract by 1.6% next year.China offers little counterbalance, impeded by Covid restrictions and a weakened property sector. Export slowdown, inventory destocking and tighter financial conditions are overhangs on the rest of Asia. Meanwhile, geopolitical risks abound, and as weak growth combines with tightening liquidity and higher rates, financial stability risks cannot be ruled out.In this global backdrop, India appears in a relatively stronger position. Its economic foundations are much stronger today than 5-10 years ago. India did not roll out developed economies-style fiscal and monetary policy easing during the pandemic, which should benefit from a macro standpoint. Balance sheets are also much stronger now, with deleveraging by the corporate sector and a stronger banking balance sheet with low non-performing loans.Over the medium term, the economy should also benefit from some new growth drivers, such as digitalisation, supply chain shifts, and green and infrastructure spending. The greater push towards digitalisation may also unlock productivity gains.Despite these strengths, India can hardly remain unscathed. The contraction in August industrial production growth demonstrates that the sheen is starting to fade. Investment and consumption indicators in August-September have moderated from their peak in Q2 2022, suggesting weaker sequential momentum in Q3 (July-September). Even the services sector - which was close to 20 percentage points above pre-pandemic level during Q2 - has now moderated to about 8 percentage points, suggesting the post-pandemic reopening tailwinds are slowly ebbing.The full impact of the global slowdown on the domestic outlook is also yet to materialise. Past global slowdowns have typically impacted India with a lag of around two quarters. Weak global demand hits not just exports but also the manufacturing and investment-related sectors. With still-sluggish private capital expenditure, weak exports and tightening financial conditions, the growth driver in the coming year will be highly K-shaped consumer and government spending. GDP growth should average 7% in FY2023, but then moderate to 5.2% in FY2024, below consensus expectations of 6-6.5%.Even for GoI, the arithmetic doesn't get easier. The 'carrot' of slipping on fiscal commitments to support growth comes with the 'stick' of disrupting macro stability. Higher nominal GDP growth so far, upheld by elevated inflation, has led to a tax bonanza, buying valuable fiscal space to accommodate extra spending on food and fertiliser subsidies, excise duty cuts and other revenue shortfalls. However, with growth and inflation expected to moderate in FY2024, this cushion is likely to be short-lived. If GoI continues with its stated ambition of higher capital expenditure, it will very likely compromise on revenue expenditure or on the fiscal consolidation goal.On the external sector, the moderation in export growth amid seemingly sticky imports appears poised to balloon the current account deficit to 3.8% of GDP in FY2023 from 1.2% in FY2022. While RBI has run down its forex reserves, a less appreciated aspect is that it achieved the twin aims of countering currency volatility as well as simultaneously tightening domestic liquidity (selling dollars means draining rupees out of the system), bringing it more in sync with the monetary policy stance.Forex reserves remain adequate, and can be used to smoothen volatility. But defending any particular currency level would be self-defeating. Rather, the rupee should be allowed to gradually adjust, considering a weak currency works as a shock absorber, and could help moderate the current account deficit over time.RBI has its work cut out on inflation. FY2023 consumer price index (CPI) inflation is tracking about 6.8% year-on-year, nearly 1 percentage point higher than RBI's upper tolerance level. Upside risks include higher food inflation, relentlessly high core inflation and potential second-round effects. This is despite global commodity prices moderating, suggesting that firms are recouping their margins rather than passing on the benefit to consumers.With inflationary concerns still 'live', and growth somewhat resilient - for now - economic conditions appear broadly in favour of more rate hikes. However, we don't expect rate hikes for currency defence. Instead, currency weakness is likely to be tackled through forex intervention and macroprudential tools. More policy rate hikes are likely, but driven by domestic considerations, and the terminal repo rate (around 6.5%) shouldn't be too far away.On the whole, despite stronger foundations, India's post-pandemic recovery will likely be cut short by the incoming global growth slowdown. In a global village, there is no decoupling, and downside risks are plenty. If 2023 was a car ride, the advice is not just to strap on the seat belts but to borrow a helmet too.