India's Economic Growth Hits Three-Year Low on High Borrowing Costs, Poor Investor Sentiment

Manufacturing, Mining Weakness Weigh Down Growth, Services Retain Traction

India's economic growth slowed dramatically in the October–December 2011 quarter, the third quarter of fiscal year (FY) 2011/12, as manufacturing slowed to a crawl and mining output contracted, official data released today show. Real GDP on a factor-cost basis expanded by only 6.1% year-on-year (y/y), according to the Central Statistical Organisation (CSO). With a palpable slowdown in the fiscal third quarter, the economy continues to lose momentum and expanded at its weakest pace since the first quarter of 2009.

The latest GDP print highlights the rapid slowdown in momentum. Manufacturing growth barely eked out 0.4% y/y growth, and industrial production remained stagnant during October–December, with growth at an anaemic 1.0%, compared with the year-earlier period. Mining and quarrying declined 3.1% y/y in the third quarter, contracting more than in the second quarter. Overall, services expanded by a healthy 7.7% y/y, with positive expansion across all sub-sectors. Construction increased by 7.2% y/y with expansion in building and infrastructure activity, and rose from the second quarter's 4.3% y/y growth. Trade, hotels, and transport rose 9.2% y/y, community and social services rose 7.9% y/y, and financial, real estate, and business services increased 9.0% y/y.

The agricultural sector growth was muted, at 2.7% y/y during the third quarter. Although discouraging, the modest expansion is largely due to the higher base from last year's emphatic rebound. The expected 2012 monsoon will help the farm sector maintain vigour during the next fiscal year, proving to be beneficial to rural demand and overall consumer spending as the economy recovers. Although the importance of the once-key agricultural sector in the economy has faded over the past few decades, the rural populace remains overwhelmingly dependent on the farming sector for income and employment. Overall, the ascendance of the manufacturing and service sectors emphasise the continuing diversification of the economy's base and the declining exposure of overall growth to agricultural cycles, as export-oriented and industrial sectors develop quickly.

On the demand side, according to the newly released data from the CSO, real GDP at market prices rose at 6.3% y/y during the fiscal third quarter, lower than the 6.7% y/y posted during the second quarter. Real private consumption, the mainstay of India's boom, gained strength, expanding 6.2% y/y, while public spending rose 4.4% y/y as the government attempted to pull back expenditures in an environment of elevated global oil prices and weaker growth and revenue collection. Fixed investment tumbled, contracting 1.2% y/y, contracting for the second consecutive quarter, though the decline was lower than the second quarter's 4.0% contraction; capital expenditures collapsed on higher borrowing costs. Exports surprisingly gained ground in the third quarter, by 13.1% y/y, and imports rose 17.3% y/y, further widening the already large trade and current-account deficits. Recent large government revisions to demand-side figures have led to swings in national-income accounts data, but the demand-side data reinforce the tepid overall economic picture.

Inflation Finally Retreating, Triggering More Accommodative Monetary Policy

Price pressures have eased and inflation has suddenly retreated in December and January after having been alarmingly high for two years. The benchmark wholesale price index (WPI) increased at 6.55% y/y in January, substantially lower than December's 7.47% y/y increase. Within the overall WPI, food prices declined 0.5% y/y, fuel prices increased 14.2% y/y, and prices of manufactured goods grew 6.5% y/y. WPI inflation has receded primarily because of rapid declines in food price inflation, although manufactured products inflation (a proxy for core inflation) has begun to retreat as well. But fuel price inflation remains elevated, as recent gasoline price increases filter through into the general WPI.

The Reserve Bank of India (RBI) has begun easing monetary policy, after a stringent two-year-long monetary tightening campaign that saw 13 rate hikes and 375 basis points of repo-rate increases. The RBI's language in its January monetary meeting was the most dovish in more than two years, and the bank cut the cash reserve ratio by 50 basis points to ease tight liquidity. Even though the improvements in the inflation profile are mainly attributable to falling food prices, which might not be sustainable, the RBI will continue to adopt more accommodative policy in the months ahead. It will probably reduce reserve requirements again when it next meets in March, and will begin lowering the benchmark repo rate in April, as a cooling economy reduces inflation risks.

Outlook and Implications

The GDP print underscores the dramatic deceleration in domestic and external demand sparked by systematic monetary tightening and continued uncertainty in the global economy. Sovereign debt issues continue to plague Europe, and while economic prospects have improved somewhat in the United States, overall final demand still remains weak.

Domestic demand trends have improved from last quarter, however, even as it remains fairly lackluster. Private consumption has perked up in the third quarter, and investment, while still in contractionary territory, has improved from the second quarter. Car sales (a proxy for retail sales) increased 7.2% in January, reviving from late-2011 contractions, and interest-sensitive sectors such as automobile sales will continue to recover as credit conditions loosen. The momentum in India's manufacturing sector has picked up sharply (albeit from comparatively low levels), to reach the highest level in eight months. The purchasing managers' index (PMI) accelerated from 54.2 in December to 57.5 in January. Improved business sentiment showed that activity in the manufacturing sector is rebounding, led by higher demand from both domestic and foreign clients, suggesting that the momentum in the sector is possibly stronger than official and industrial production data suggests. Industrial activity, hit by higher borrowing costs and weaker investor sentiment, will also probably begin gradually regaining momentum in the coming months. As financial conditions improve, domestic businesses will slowly find it easier to access overseas capital markets.

With inflation already trending downward, the cyclical downturn will help further reduce price pressures. Additional monetary easing is definitely on the cards. RBI Governor D. Subbarao has firmly stated that the recent reserve ratio should be interpreted as a "signal of easing intent", and that future policy will be more accommodative. IHS Global insight expects additional reserve requirement cuts when the RBI next meets in March. But we believe that the RBI will not lower its policy repo rate just yet (in March). The RBI will probably choose to wait until after the upcoming annual budget is released on 16 March to assess fiscal consolidation measures and the potential effect on prices. Unless domestic and external economic conditions deteriorate dramatically in the next two weeks (which is unlikely), the RBI will wait until its April monetary meeting to reduce the policy repo rate. We continue to expect the RBI to reduce reserve requirements by another 50 basis points and to implement 125 basis points in policy repo rate cuts by end-2012.

Certainly, the fiscal backdrop has worsened over the last year as the economy has decelerated. The FY2012/13 budget will be presented at a time when the government's finances have deteriorated substantially. We believe that its ambitious previous fiscal targets will be completely overshot, mainly due to a slowdown in revenues. While the RBI has been focused on inflation and the wage-price spiral over the past year, on the fiscal side, slowing growth is causing a sharp increase in the fiscal deficit and higher bond yields, which is putting further downward pressure on growth. We expect the FY2012/13 to focus on fiscal consolidation, with tax measures dominating. After all, India's fiscal deficit remains one of the highest among large emerging markets, and is largely driven by its low tax base, rather than too much spending. The perennial fiscal slippages lead to an excessive reliance on monetary policy to fight inflation and stabilise the economy. Hence, the RBI will probably wait to assess the new budget and the fiscal impact before embarking on more concerted monetary easing.

Economic growth will remain tepid in the final quarter of FY2011/12 (January-March), which could drag drown growth below our current forecast of 6.8%. But the prospects for FY2012/13 (ending in March 2013) are considerably brighter, and in fact, there is upside to our forecast of 7.2% growth. Manufacturing will revive slowly, but the vibrant service sector will recover more quickly as credit conditions improve. A renewal in investment and a boost to corporate confidence is essential. Some of the recent policy reforms, if they can get past the political maelstrom, would help improve prospects for corporate investment. The government has already quietly approved 100% foreign ownership in single-brand retail, and will probably reconsider and liberalise foreign direct investment in the highly controversial multi-brand retail sector in the coming weeks once contentious state elections are completed. No doubt, additional initiatives, such as those targeted at infrastructure, are needed to revive investor sentiment and capital inflows. The government is trying to stimulate investment through public and private channels, but it also needs a more committed approach to implement policy reforms to jumpstart near-stalled private investment.