India's Economy Accelerates to Fastest Pace in Two Years During Q1

Growth Gathers Pace on Buoyant Manufacturing and Services, Agriculture Starts to Recover

India's economic growth continued at a torrid pace in the April–June 2010 quarter, with resounding growth in the important manufacturing and service sectors, while the agricultural sector began to recover from the country's worst drought in 37 years.

In the first quarter of the year, growth surged. During the first fiscal quarter (April–June) of fiscal year (FY) 2010/11, real GDP on a factor-cost basis expanded by 8.8% year-on-year (y/y), according to the Central Statistical Organisation (CSO). Growth in the first quarter rose sharply, from 6.0% a year earlier, and even outpaced the 8.6% registered in the January–March quarter.

With the first quarter's overall GDP figure, India's recovery looks to have consolidated, with manufacturing and services providing significant traction during the quarter. Manufacturing growth rose 12.4% y/y, and industrial production growth during the quarter stood at a healthy 11.7% compared with the year-earlier period. Mining and quarrying grew 8.9% y/y in the first quarter. Overall services expanded by a vigorous 8.6% y/y, with encouraging expansion across all subsectors. Construction increased by 7.5% y/y with the steady expansion in building and infrastructure activity. Trade, hotels, and transport rose 12.2% y/y, community and social services rose 6.7%, while financial, real estate, and business services increased 8.0%.

The agricultural sector began its gradual recovery, posting growth of 2.8% y/y during the first quarter, as the farm sector starts to shrug off the effects of the 2009 drought. Farm output had contracted 2.8% during FY 2009/10 as the drought hit the winter crop. The impact of the farm sector's slowdown was pervasive, affecting rural demand, and hence overall private consumption, despite aggressive expansionary government spending in the rural market. Nevertheless, even with 2009's negative agricultural developments, the overall economy managed to largely withstand farm sector weakness. The importance of the once-key agricultural sector to India's larger economy has diminished considerably in recent decades.

Meanwhile, according to preliminary data from the CSO, on the demand side real GDP at market prices rose at a much weaker 3.7% y/y during the first quarter. Real private consumption, the mainstay of India's boom, expanded 3.4%, government spending declined by a steep 1.6% with a pullback of fiscal stimulus, and fixed investment grew by a modest 3.7%. Exports and imports contracted in the first quarter, by 4.3% and 1.9% respectively. Please note, since these demand-side figures contrast starkly with the supply-side breakdown, the official sectoral supply-side data outlined above should be favoured while making assessments about India's current state of economic health.

Inflation Remains Elevated

Developments on the inflation front remain worrisome. Prices remain stubbornly elevated, even as they have gradually begun to ease in recent weeks. The wholesale price index (WPI) increased 9.97% y/y in July, down slightly from June's 10.55% rise, and within the overall WPI index, food prices rose 10.3%, fuel prices increased 14.3%, and manufactured goods' prices increased 6.2%.

Inflationary pressures are now arising from both supply- and demand-side sources. On the supply side, food prices have only recently begun to retreat from highs recorded earlier in 2010, with marginal moderation occurring as the drought's impact has receded. Meanwhile, high commodity prices are all putting upward pressure on headline inflation. Any significant impact from easing food prices on the overall WPI index could be short-lived. In fact, the fuel component of the WPI is likely to accelerate further on the government's recent deregulation of fuel prices. The higher fuel prices, partially reflected in July, will probably be evident in the WPI print from the August data onward, since price increases only took effect from 26 June. Sequentially, in line with higher fuel prices, overall WPI inflation will remain high, as the domestic oil price kicks in.

Demand-side consumer inflation has remained significantly above-trend. In data released separately today, consumer price index (CPI) inflation stood at 11.3% y/y in July, down from June's 13.7%, reflecting more subdued prices for agricultural goods. Increased inflationary pressures signal India's strengthening domestic demand. With India's quick rebound from the global recession, inflationary expectations are further building up rapidly.

Monetary Tightening to Continue

Even with recent price moderation, with inflation remaining high as measured by both the CPI and WPI metrics, IHS Global Insight expects the Reserve Bank of India (RBI) to continue its monetary tightening. The RBI has increased policy rates four times since March, with two hikes in July, as it seeks to rein in persistent inflation. Over the past 10 months, the central bank has unwound all its liquidity-support measures implemented during the global financial crisis. So far in 2010, the RBI has increased the policy repo rate by a cumulative 100 points, the reverse repo by a cumulative 125 basis points, and the cash reserve ratio (CRR) by a total 100 points to rein in liquidity.

At its most recent monetary meeting on 28 July, the RBI indicated it was in full-blown hawkish mode, with inflationary concerns at the forefront. It clearly prefers to keep liquidity in the system tight. Its recent rate moves were essential to check rising inflationary expectations and continue toward policy-rate normalisation. With inflation at full throttle with galloping demand, sequential monetary tightening will continue.

Faster near-term growth and rising interest rates will support rupee strength, and the RBI is likely to countenance more rupee appreciation to curb inflation. Capital inflows will continue on India's buoyant growth outlook and interest-rate differentials. Recent monetary policy moves signify a continued increase in interest rates through 2010 and 2011. We expect an additional 50 basis points of policy rate hikes by end-2010 and further policy normalisation in 2011. Reserve requirements and liquidity will also tighten, resulting in further gradual easing in price pressures. As the RBI continues to tighten policy, we expect inflationary expectations to generally come under control, with the requisite lags. But inflation is expected to remain fairly high through FY 2011/12 as the economy booms.

Outlook and Implications

Even in a faltering global environment, India's recovery remains firmly on track. The economy will continue to log impressive growth rates over the near term. Economic indicators over the next few months will continue to trend somewhat higher, even as favourable base effects fade. Domestically, credit is more freely available, and even in an uncertain global financial climate, India remains one of the bright spots for investment. Passenger car sales, a proxy for retail sales in India, are surging, with July's 37% y/y increase maintaining recent months' strong momentum. Rising domestic credit will spur consumer spending and business investment.

Certainly, risks to the global recovery loom during the second half of 2010, such as lingering debt concerns in Europe and the potential slowing of growth in the United States and China. Any significant dent in global trade would have some impact on India's growth, but for the most part, India's outlook is coloured more by its solid domestic demand rather than external developments.

India's property and stock markets continue to recover on rising portfolio and FDI inflows, bolstering liquidity and spending. Meanwhile, Indian firms, relatively healthy even during the downturn, are now cash-rich, and are accessing both domestic and international capital markets more freely. The new FY 2010/11 budget has targeted infrastructure spending as a priority, and takes further steps to improve the investment environment.

We expect GDP to expand at trend rates (about 8%) over the next two years: 8.2% in FY 2010/11 and 8.0% in FY 2011/12. A low base for agriculture and improving domestic credit growth and consumer spending reinforce the positive outlook. Accelerating domestic demand, particularly investment and infrastructure-led investment, will power the economy.