India: Different stories from the same book Global Economic Outlook, Q3 2015

Economic activity picked up during Q1—in fact, India’s GDP growth was higher than China’s. Yet, apart from GDP numbers, other economic indicators have been rather subdued, leading to concerns about growth.


The news out of India in the past few months has been intriguing. According to the first estimate of national accounts data for Q1 2015, economic activity picked up during the quarter. In fact, at 7.5 percent year over year, GDP growth was higher than that of China (7.0 percent). To the casual observer, such a healthy growth figure would appear out of place with growing calls for more growth-oriented monetary policy. Indeed, on June 2, the Reserve Bank of India (RBI) cut its key policy rate by 25 basis points (bps), the third such move this year. Apparently that was not enough for the equity markets; India’s wider NIFTY index ended 2.3 percent lower on June 2.

Concerns about growth and the need for stimulus are not surprising given that, apart from GDP numbers, other economic indicators have been rather subdued. These include data for credit growth, manufacturing activity, and corporate profits. Of course, this has led to much debate on the new GDP series introduced earlier this year.1 No wonder then that the RBI has been circumspect, preferring to strike a balance between the new GDP numbers and the weakness in key economic indicators while framing monetary policy. And, with inflation going down, the central bank decided on another dose of policy loosening to stimulate growth.

Growth moves up, albeit with weaknesses

The Indian economy picked up pace in Q1 2015, which is also the last quarter of India’s financial year 2014–15 (or Q4 FY 2015). GDP growth went up to 7.5 percent year over year from 6.6 percent in the previous quarter (figure 1). This took overall growth for FY 2015 to 7.3 percent, up from 6.9 percent in FY 2014. While annual growth was a tad lower than the Central Statistics Office’s 7.4 percent forecast in February, it was nevertheless the fastest pace in the last four years.2


In Q4 FY 2015, the economy benefitted from strong private consumption growth, which almost doubled from the previous quarter to 7.9 percent. The recovery in private consumption augurs well for the economy given the sector’s large share (about 60 percent) in GDP. Government consumption fell 8.0 percent as the government tried to get the fiscal deficit down to the targeted 4.1 percent of GDP by the end of the fiscal year. Encouragingly, the government was successful: Latest data show that the deficit fell a little below 4.0 percent of GDP.

The flux in currency markets will continue in the near term, keeping the pressure on India’s exporters even though the rupee will likely to depreciate against the US dollar going forward.

Exports continue to be a big worry, contracting 8.2 percent in Q4 FY 2015; this was the sharpest decline since Q1 FY 2013 from when the new GDP series became available. Like exports, investments have been feeling the heat due to delayed projects, debt-laden corporations, deteriorating asset quality in banks, and high interest rates. Gross fixed capital formation grew 4.1 percent in Q4 FY 2015, up from 2.4 percent in the previous quarter. However, the figure is lower than at the start of the financial year and much below levels required to push GDP growth to the coveted double-digit mark.3

Worrying trend of falling exports

Declining exports (figure 2) do not fit well with the government’s ambitious targets, including the Make in India campaign. In March, goods exports fell 21.3 percent year over year, the sharpest decline since July 2009, when the world was in the grip of the global financial crisis. The story hasn’t changed much in April and May. A number of factors are weighing on India’s exports. First, weak growth in Europe and the United States has dented the demand for exports.


Second, exporters have lost out due to the Indian rupee’s gain against major currencies (figure 3). Concerns about the US Federal Reserve potentially raising interest rates in the next six months has sent emerging market currencies down; among these, the rupee has fared relatively well. Also, central banks in Europe (the European Central Bank, the Swiss National Bank) and Asia (the Bank of Japan) have carried out aggressive monetary easing, thereby sending their currencies lower. These central banks’ actions have also increased currency volatility, a bigger headache for exporters. Another reason volatility has gone up is emerging risks such as the crisis in Greece and a probable equity bubble in China. The flux in currency markets will continue in the near term, keeping the pressure on India’s exporters even though the rupee will likely depreciate against the US dollar going forward.


RBI cuts rates again to stimulate growth

On June 2, the RBI cut its key policy rate by 25 bps to 7.25 percent. A rate cut was definitely on the cards. Data available before the decision showed retail inflation going down to 4.9 percent in April, a four-month low (in May, it went up marginally). However, inflation is not the only reason that the RBI chose to ease monetary policy; the central bank is worried about continued weakness in key economic indicators, especially credit growth (figure 4) and fixed investments. No wonder then that the RBI has eased rates thrice this year by a total of 75 bps.


The RBI’s choice of a 25 bps cut, and not a larger one, on June 2 was due to a number of factors. First, although inflation is currently low (figure 5), the RBI expects price pressures to rise due to the weak monsoon’s impact on food prices. The Indian Meteorological Department has predicted that total rainfall this monsoon season will be only 88 percent of the long-period average.4 Also, inflation could rise if there is any sharp upward movement in global oil prices and the government holds firm on its new policy of market-determined domestic fuel prices.


Second, the central bank appears cautious about the impact of rate cuts. The percolation of rate changes throughout the banking system is important for the success of monetary policy. The two previous rate cuts this year have not been mirrored by the banking system (or at least by a large part of it), much to the chagrin of the RBI.5 Observing recent behavior, it is likely that the RBI has chosen to “wait and watch” before loosening policy further.

Finally, the RBI appears committed to restoring its inflation-fighting credibility, which had taken a hit during 2010–12. The central bank is also intent on forcing the government to take care of supply-side changes, a key factor behind inflationary pressures in India. The RBI is likely to match any fiscal consolidation efforts by the government. After rewarding a decline in the fiscal deficit with a surprise rate cut in March, the RBI will wait for more progress on fiscal correction before any loosening.6

It’s not just about cutting rates but also strengthening banks

So far this year, bank lending hasn’t gone up due to the RBI’s rate cuts. There are multiple reasons behind this. First, Indian banks are under stress given rising nonperforming assets (NPAs) in their portfolios (figure 6). Moreover, the current NPA figure (4.4 percent of gross assets) understates the problem. According to ICRA, a lagged recognition of bad assets will push up NPAs this financial year to 5.9 percent; the figure goes up to 9.5–10.5 percent if restructured loans are included.7


NPAs for public sector banks (PSBs), which account for about 70 percent of total bank assets in India, are a big worry. For example, in 2013, PSBs had NPAs worth 4.4 percent of total assets; in contrast, the figure for new private sector banks was 1.8 percent. So any revival in credit growth is unlikely without an improvement in the balance sheets of PSBs. This requires capital infusion; the current budgeted amount of 69.9 billion rupees is inadequate.8 Also, while the current policy of targeting more efficient PSBs for capital infusion seems prudent, the problems of less efficient banks also must be tackled. The government appears to be in favor of merging weaker PSBs with larger, better-placed ones.9 Until now, however, not much of a roadmap has been available, and it could be a while before any consolidation takes place.

The clear demarcation of powers between the RBI and a debt management agency will prevent a conflict of interest that is apparent in the present system.

The government would benefit from taking this opportunity to improve bankruptcy laws and corporate governance rules, which will go a long way in solving the problem of asset quality in banks. Encouragingly, in the budget for FY 2016, the government has stated that it intends to introduce a comprehensive bankruptcy code this financial year. While the government has taken a few steps to better manage PSBs to improve their efficiency and allow them to compete better with their private sector counterparts, these steps are not enough.10 A good way forward for the government would be to gradually reduce its stake in PSBs to less than 50 percent and cede management control. Also, to increase competition and avenues of credit, the government should relook at policies regarding operations of foreign banks and the current slow pace of granting new bank licenses.

Need to up the ante on reforms

Declining capital quality in banks is not the only problem hindering credit and investments. Low financing opportunities raise the need for other avenues of credit such as well-functioning bond markets. While the budget for FY 2016 proposed setting up a public debt management agency and granting greater power to the Securities and Exchange Board of India to set the base for a strong bond market, the government has now gone back on its position, probably heeding RBI protests.11

The clear demarcation of powers between the RBI and a debt management agency will prevent a conflict of interest that is apparent in the present system. Currently, the RBI sets monetary policy to target inflation and also manages the government’s debt. The first task, which is to set rates, seems to be at odds with the second, which is to be the government’s investment banker. Without separating these two responsibilities, it will not be possible to set up a vibrant bond market with a sound yield curve.

There appears to be not much headway in setting up a monetary policy committee within the RBI. Such a committee is critical for conduct of monetary policy, especially given the RBI’s mandate to target inflation under the new monetary policy framework agreement.12 Other reforms also seem to be stuck. In the previous session of parliament, bills for introducing a goods and services tax and for acquiring land were postponed. All eyes will now be on the next parliament session for progress on these bills.

Getting some of those reforms passed will be a test for the government. But without these reforms, the positive economic momentum created by the current government’s election in 2014 will wane. This could take some of the shine off the government’s efforts to attract global investors and help India become an economic powerhouse in the medium to long term. It will also test the government’s credibility, especially given its poll promises to accelerate economic growth.