India's Economy Expands at Fastest Pace in 18 Months, Rate Hikes Appear Imminent

Growth Surges as Government Spending Boosts Manufacturing and Services

India's economy grew at its fastest pace in 18 months in the July–September quarter, showing that low borrowing costs, an expansionary budget, and targeted fiscal spending buoyed domestic demand. During the second fiscal quarter (July–September) of fiscal year (FY) 2009/10 (ending in March 2010), real GDP on a factor-cost basis expanded by 7.9% year-on-year (y/y), according to the Central Statistical Organization. Growth in the second quarter increased from 7.5% a year earlier and rose from the 6.1% registered in the April–July quarter. With the recovery now firmly underway, manufacturing and services provided significant traction during the quarter. Construction increased by 6.5% y/y, while services, including trade, hotels, transport, and financial services, expanded by 9.0%. Mining and quarrying grew 9.6% in the second quarter. Manufacturing growth surged to 9.7%, and industrial production growth during the quarter stood at a respectable 9.1%. However, the agricultural sector registered anaemic growth of 0.8%, with further downside risks looming from 2009's drought, which is expected to affect the winter crop as well. Meanwhile, on the demand side, real GDP at market prices rose 6.8% y/y during the second quarter, up from the first quarter's 6.0% expansion. Real private consumption, the mainstay of India's boom, expanded 5.6%, government spending increased by a steep 26.9%, and fixed investment grew 7.3%. Exports and imports contracted sharply, by 15.0% and 29.8%, respectively.

Drought's Impact on Farm Sector is Contained, But Food Prices Soar

Even the agricultural sector defied expectations of a contraction during the second quarter. Monsoon rains during the June–September season stood at 23% below the long-run average, according to the India Meteorological Department, marking India's worst drought since 1972. The weak rainfall was expected to hit the summer crop, and the agricultural sector was expected to contract during the quarter. The drought is likely to impact India's agricultural growth, affecting rural demand, and hence, overall private consumption. While aggressive government spending targeting the farm sector undoubtedly helped insulate rural incomes to some extent, the agricultural sector will still not escape unscathed, and IHS Global Insight expects agriculture to contract during the October–December quarter as the winter crop is affected. Even with the negative agricultural developments during the summer of 2009, the overall economy managed to shrug off farm sector weakness. While agriculture accounts for less than one-fifth of India's economy, it employs more than half of the country's billion-plus population. Even so, the importance of this once-crucial sector has waned considerably in recent decades.

Concerns have instead gathered around price pressures, rather than the drought's impact on agricultural output and consumer demand. In other data released today, consumer price index (CPI) inflation stood at 11.5% year-on-year (y/y) in October 2009, reflecting soaring prices for agricultural goods. The main gauge for tracking inflation, the overall WPI, increased only 1.36% y/y in October, but the food component within the WPI increased by a steep 15.6% y/y during the week of 14 November 2009. The central bank, the Reserve Bank of India (RBI), has openly worried about the weak monsoon's impact on the inflation profile rather than on economic growth.

Policy Rate Hikes Expected in Early 2010

With economic activity continuing to rebound quickly, we believe the RBI will gradually continue to withdraw its extraordinary monetary stimulus in 2010. The RBI already began to reverse its accommodative monetary stance during its last policy meeting on 27 October, closing some special liquidity support measures. Among other measures, the RBI increased the statutory liquidity ratio (SLR) for banks from 25% back to its pre-crisis level of 24%, representing the first step in unwinding the RBI's substantial monetary easing during the global recession.

During its aggressive easing campaign from October 2008 to April 2009, the RBI slashed its repurchase (repo) rate by a cumulative 425 basis points, to 4.75%. From late 2008, the RBI also lowered its reverse-repo rate by a cumulative 275 basis points, to 3.25%. The central bank also reduced banks' CRR by 400 basis points, to 5.00% during its easing cycle.

Given the quickly recovering economy, the RBI has adopted a more hawkish stance and has signalled that policy rate hikes are imminent. We expect the RBI to keep policy rates unchanged through end-2009 to ensure sustainable growth and support rural demand during the drought. Nonetheless, with growth and inflation expected to come in significantly higher than previous expectations, the RBI is likely to increase policy rates by 50 basis points in January 2010, at its next policy-setting meeting. For the remainder of 2010, we expect the RBI to raise policy rates by approximately 250 basis points, as concerns about liquidity and inflation dictate economic policymaking.

The central RBI also seems willing to allow the Indian rupee to appreciate to help curtail building inflationary pressures. The rupee has already appreciated 10% vis-à-vis the U.S. dollar since March 2009, with the RBI tolerating the appreciation with little intervention. Capital inflows have also surged into India in recent months, as the trough of the global recession passed. Despite surging inflows, the RBI has not expressed too much concern, given that inflows boost liquidity and alleviate pressure on India's current-account deficit.

Looser Credit Will Boost Domestic Demand

We expect that data over the next few months will continue to trend higher, though gradually. Relatively stable overseas workers' remittances will support private consumption, and freer credit availability will spur spending. The sharp pickup in portfolio and FDI inflows following receding overall financial risk aversion and India's positive reform momentum following the May elections' extraordinary mandate will also boost liquidity and asset markets, and bolster consumer spending. Passenger car sales, a proxy for retail sales in India, are surging, with October's 34% y/y growth the fastest in two years.

On the investment side, Indian corporations are once again able to access international capital markets as well as domestic sources of financing as the credit crunch wanes and borrowing restrictions ease. In additional to traditional sources of bank financing, firms have been raising substantial non-bank capital through equity markets, commercial paper markets, and domestic mutual funds. Businesses flush with resources are also directly lending to other firms through inter-company deposits, away from banking system channels. Companies are reporting that sales growth has remained steady in recent months. The corporate sector seems to face no shortage of funding for the moment, boosting prospects for growth in FY 2010/11. We believe that bank credit demand will also continue to pick up in the near term, as consumer and business confidence have recovered strongly. A brighter global demand outlook will also boost credit demand from India's exporters.

Outlook and Implications