11 February 2020

Since the election in May, India’s GDP growth has decelerated sharply: advancing only 4.5% in Q3 2019 compared to 7.3% in 2018. Does this sharp slowdown in economic activity simply reflect short-term volatility or is something more ominous going on? Identifying the sources of the current weakness will help answer this question. As in most countries, uncertainties about world-wide growth and the prospect of a global trade war have contributed to a slump in Indian exports and business investment. In addition, however, several domestic factors also have played an important role in the recent deterioration in economic conditions.

In a blog last year entitled “India: Long Growth Runway Still Lies Ahead“, I suggested that as a result of successful reforms, Indian GDP growth was already outpacing the rest of Asia, including China. Despite that achievement, the Chart above illustrates that India’s per capita GDP remains well below other Emerging Market nations. Therefore, India could still look forward to a long growth runway leading to a convergence in prosperity levels.

To be sure, many challenges exist: poverty remains high, despite lifting millions out of destitution; inequality is chronic; female participation is low, etc. etc. In addition, the anti-Muslim bias of the Modi government’s recent immigration policy proposals may lead to widespread protests and political instability. Nevertheless, I believe the recent GDP growth deceleration simply reflects some mid-cycle turbulence. And, I am optimistic that already-implemented policy changes will boost activity in 2020, producing 7%-plus GDP growth by 2021.

Consumer Slump: Rural Sector Reform Must Be a Priority

Weaker consumer spending has played a central role in India’s recent slump. Indeed, household spending growth cooled from over 9% in 2018 to only 3% by the middle of last year. The Chart above illustrates that significant weakness in rural incomes — caused by lower food prices in 2018/19– was an important factor.

As agriculture accounts for 44% and 16% of India’s employment and GDP respectively, the rural sector remains vital. The Chart above illustrates that Indian agricultural productivity remains very low — a critical contributor to weak farm incomes and chronically elevated levels of rural poverty. Boosting farm efficiency is also required to allow underemployed rural workers to fill new jobs in the service and manufacturing sectors. So far, India has not been able to create enough jobs consistently to absorb new entrants to the labour force (from population growth and rural sector migrants).

As a result, the Chart above illustrates that India’s employment rate lags other Emerging Market economies. The high proportion of employment in the informal sector — much of it in rural areas — contributes to India’s high poverty levels. Also, note the especially low female employment rate. The rise in India’s unemployment rate during the past year (7.2% from 6.9%) suggests insufficient employment growth is likely to have contributed to the recent weakness in consumer spending. Over the medium term, lowering India’s high level of labour market restrictions is vital to creating the number of jobs India will require (next Chart).

Consumer spending in 2020 should benefit from recent policy changes. Most importantly, the Reserve Bank of India (RBI) has lowered interest rates 135bp. In addition, the government has implemented an agricultural sector Income Support Scheme, and broadened the rural pension program. Also, food prices have recently risen sharply (up 14% in December), which will boost farm incomes. As a result, household spending expanded 5.1% in Q3 2019 compared to 3.1% in the prior interval. Even the hard-hit auto sector may be bottoming — passenger vehicle sales declined only 1% in December compared to a 13% slump in 2019 overall.

Capex: Impact of the Trade War and Business Reform

As in most countries, the prospect of a trade war took a toll on India’s industrial sector, with both exports and business investment slumping sharply. Capital spending, for instance, advanced only 1% in Q3 2019, compared to 17% a year earlier. Meahwhile, export volumes fell 0.4 during the third quarter versus a 14% gain the previous year. The recent Sino-US trade truce raises the prospect of a rebound in world-wide manufacturing sector activity. While still early days, the Chart above suggests export performance may be improving already in some countries, although India has yet to join in. In addition, India eventually may become a target of American trade hawks, as its bilateral surplus with the USA has doubled to $23 billion in the past decade.

In addition to global factors, however, important underlying issues must continue to be address. For example, while India enjoys a high investment rate compared to the OECD, it lags behind key EM competitors (Chart above). More worrisome, the rate of capital formation has slipped during the past decade.

Correcting this slide will require ongoing reform to improve the business climate. The Chart above illustrates significant impediments still exist, although Indian reforms have succeeded in improving the environment more dramatically than elsewhere. In recent decades, likewise, India has enjoyed the benefits from opening its economy to global trade and investment. The following Chart reveals the same pattern for foreign direct investment: external investors still confront headwinds, but the improvements have been profound. Likewise, while tariffs remain higher than in other countries, Indian levies have declined sharply in recent decades.

I am encouraged by the Modi government’s continued commitment to reforms, as witnessed by the recent reduction in corporate taxation and the passage of the 2016 Insolvency and Bankruptcy Code. To be sure, there is scant evidence of a decisive end to the recent slump in Capex and exports. However, PMI surveys (in both the manufacturing and service sectors) have improved in recent months. And, industrial output expanded 2.7% in November compared to only 1.1% during the prior year.

Financial Sector: Strains Reveal There’s More Work to Do

The sharp slowdown in credit availability has also contributed slower GDP growth (Chart above), and illustrates considerable reform is still required in this sector.

The Chart above illustrates that the profitability and capital adequacy of Indian banks is amongst the world’s worst. The following graph highlights that massive public sector banks are at the heart of the problem. However, the Chart also shows that recent reforms are beginning to improve the situation. Indeed, non-performing assets are declining throughout the financial system, including the state-run institutions.

As a result of reforms, private organisations (both bank and non-bank) are succeeding in taking market share away from public sector banks (next Chart). To be sure, there’s much work still to do, as revealed by the continued slump in credit growth in January 2020. Encouragingly, the government has responded. For instance, the RBI has eased monetary conditions considerably. The government also plans to merge unprofitable public sector banks (reducing the number to 12). Regulatory changes also aim to improve capital adequacy of the financial system. And, liquidity has been provided to the private non-bank sector (which has been a cause of the most recent slide in credit availability).

Budget Reflects Limited Fiscal Space

The recently announced 2020/21 Budget’s failure to provide measures to boost near-term growth prospects reveals India’s limited room to manuever on fiscal policy. The following Chart illustrates that despite progress in reducing the central government’s deficit, the shortfall of the overall public sector remains large. India’s debt/GDP ratio also stands at 65%, similar to Brazil’s. Fortunately, India’s superior long-term growth prospects allows it to manage this burden more easily than in Brazil.

To be sure, additional government spending should play a vital role in improving India’s long-term growth potential, reducing poverty, and improving living standards. For instance, the following Chart shows India’s low level of spending on health care. The same is true for education. In addition, India will require large-scale infrastructure outlays to remedy deficiencies in electricity provision, water sanitation, roads, and port development.

Given the already large government deficit, creating fiscal space for the much needed spending will require reforms aimed at increasing the level of government revenue. The following Chart highlights India’s low level of budgetary resources. The recent reform of the VAT system is a step in this direction.

In the absence of fiscal stimulus, the burden of boosting near-term growth prospects will continue to fall on the RBI. In 2019, the decision to reduce interest rates was not difficult, as inflation was below the central bank’s 4% target. However, the recent acceleration in prices — emanating largely from higher food quotes — may limit the RBI’s scope for additional accommodation to some extent.

Strategic Implications

• Slowing credit growth, stagnant rural incomes, global economic weakness, and the trade war have all contributed to decelerating GDP growth. India has taken action on all these fronts. Tenative green-shoots of revival are emerging in recent PMI surveys, consumer spending, and manufacturing output. In the absence of a global recession, I expect India’s GDP growth to rebound towards its 7%-plus long-term trend during the next 18-24 months.
• If the Modi government remains committed to economic reform, I expect Indian GDP growth to outpace the rest of Asia in the next decade, including China. As GDP per capita remains well below other Asian nations, India should enjoy a long period of economic convergence. The recently proposed immigration proposals, however, are alarmingly discriminatory. Potential protest could add to political uncertainty.
• The lack of fiscal action continues to exert pressure on the RBI to provide additional monetary stimulus. However, the recent hike in inflation limits their scope to act. Nevertheless, I anticipate another 50bp interest rate cut in 2020. I expect any INR depreciation this year to be less that prevailing interest rate differentials. The BSE should outperform global indices (e.g. ACWI).