India: Don't believe what numbers say but what investors do Global Economic Outlook, Q4 2015

India seems to be riding the ebb and flow of economic activity. Growth has primarily been driven by consumption expenditure. Amid confusion over growth numbers, capital investment has lagged, with investors waiting to see enough change in economic activity before taking the plunge.

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India seems to be riding the ebb and flow of economic activity. After recording a blockbuster figure of 7.5 percent year over year in Q4 of fiscal year (FY) 2014–15, growth (the official measure of economic growth measured by GDP at market price, henceforth referred to as GDP) unexpectedly dipped to 7.0 percent in Q1 FY 2015–16.1 What is more puzzling is that growth measured by gross value added on the supply side (at basic prices, henceforth referred to as GVA) accelerated from 6.1 percent in Q4 FY 2014–15 to 7.1 percent in Q1 FY 2015–16.

Amid this confusion over growth numbers, investors are still waiting to see enough positive change in economic activity before they feel confident about investing their capital. So far, growth has primarily been driven by consumption expenditure, while capital investment has lagged behind. India needs investment to ensure noninflationary growth in the long run. Global companies are looking for opportunities to invest their capital, and India is an attractive destination owing to its better economic performance relative to its peers and favorable global developments.2 Are policymakers taking advantage of this window of opportunity?

Decoding growth

The disconnect between the two measures of growth (GDP versus GVA) has been baffling economists and investors, who remain doubtful about the underlying growth momentum (figure 1). Setting aside the issue of GDP estimation methodology, the confusion can be attributed to the component of indirect taxes after accounting for subsidies to the government in the last two quarters.3 In Q4 FY 2014–15, strong net indirect tax collections buoyed the measure of GDP and added 1.4 percentage points to the GVA growth of 6.1 percent. However, in Q1 FY 2015–16, GDP growth turned out to be lower than GVA growth, despite higher GVA, robust indirect tax growth (after adjusting for changes in tax rates), and lower subsidies (owing to lower oil prices).4 In other words, higher GVA growth when added to stronger net indirect tax collections in Q1 led to slower GDP growth relative to the previous quarter.

GEOQ415_India_figure1

So far, growth has primarily been driven by consumption expenditure, while capital investment has lagged behind. India needs investment to ensure noninflationary growth in the long run.

The deflator for the net indirect tax collections was the “real�? culprit. Since the nominal increase in the indirect tax collection was primarily due to an increase in tax rates by the government and not to any widening of the tax base, such a rise in tax collections was considered a “price effect.�? While calculating the real GDP growth, this price effect was not included. Thus although net indirect taxes in nominal terms rose 39.9 percent, in real terms the increase was a mere 6.5 percent.5

Amid these conflicting data, it is imperative for investors to understand where India stands in terms of growth in economic activity. Since the GVA estimate removes the distortions due to taxes and subsidies, for now it may be considered a better measure. GVA movement over the last two quarters closely represents actual economic movement, as indicated by the high-frequency economic indicators.6 For instance, monthly numbers for the consumer durables index and the eight core industry indices indicated slower growth in Q4 FY 2014–15 and faster growth in Q1 FY 2015–16; this was somewhat mirrored in the GVA numbers. Economic activities classified under GVA that pointed to growth higher than 7 percent in Q1 FY 2015–16 were manufacturing; trade, hotels, transport, and communication and services related to broadcasting; and financial, insurance, real estate, and professional services.

The disconnect between the two measures of growth (GDP versus GVA) has been baffling economists and investors, who remain doubtful about the underlying growth momentum. 

On the expenditure side, GDP has primarily been driven by consumption expenditure (figure 2). What is noticeable is that the contribution of fixed capital investment to GDP fell steadily. Higher government consumption, with rising nonplanned expenditure, and poor exports might have discouraged investment in the economy, although the government’s emphasis on capital investment lately is expected to crowd in private investments.

GEOQ415_India_figure2

Stepping up investment is the formula for sustainable growth

The economic outlook remains positive as the International Monetary Fund predicts growth to be 7.5 percent in the next two fiscal years.7 The Reserve Bank of India (RBI) also expects 7.4 percent growth in FY 2015–16.8 However, if an economy that has primarily been driven by consumption so far wants to ensure sustainably strong and noninflationary growth in the long run, growth in fixed capital investment will be crucial. India has been suffering from supply bottlenecks since 2007 due to insufficient capacity creation. Investment has been much below its potential over the last few years. From a peak of 24 percent in the last quarter of FY 2009–10, the growth rate of gross fixed capital formation now languishes around zero.9 The stalling of projects, a term synonymous with large economic undertakings in infrastructure, manufacturing, mining, power, and so on, is widely accepted to be a leading reason for this decline.

The good news is that there has been a consistent rise in projects under implementation, as well as a steady decline in the number of stalled projects. Data released by the Centre for Monitoring Indian Economy showed an 8.4 percent rise in projects under implementation in Q1 FY 2015–16, marking the fastest increase in the last three years.10 Private sector projects being implemented rose 0.8 percent, the first expansion in the past two years. Stalled projects declined from a peak of 8.4 percent of GDP in Q4 2013–14 to 6.6 percent in the latest quarter, partly because of the government’s emphasis on capital spending this fiscal year. These improvements will likely bear fruit and boost investment growth in the near future.11

Falling oil and commodity prices have helped to contain input prices, which, in turn, may improve corporate profit margins. Higher margins will likely encourage companies to plough back a share of their increased profits into fixed capital investments.

The falling number of stalled projects, declining global commodity and oil prices, increasing public investment in infrastructure, and signs of increasing consumer demand for goods could persuade businesses to invest in capacity building in the near term.

The government has managed to bring down the fiscal deficit as a percentage of GDP to 4.1 percent in FY 2014–15 from 5.0 percent in FY 2012–13. In addition, to increase productivity, the government is channeling a higher proportion of spending toward capital expenditure. The first quarter of FY 2015–16 has seen a sharp increase in public investment in infrastructure and development projects. Such investment not only generates substantial direct employment but also fuels demand and growth in linked sectors. Increased public sector investment will therefore likely crowd in private investment.

Lately there have been signs that consumer demand, which remained muted in the last few years, may be picking up. The IP index for consumer goods unexpectedly increased for two consecutive months (June and July 2015) for the first time since early 2013, on the back of strong consumer durable goods production. The IP index for consumer durables, which has been in negative territory since the end of 2012, turned positive in the last two months. It is possible that urban demand might have bottomed out and soon may see sustained growth. However, the IP index for consumer nondurables has turned negative in recent months, which implies rural demand is weak and is likely to remain so due to a deficient monsoon. Overall, the turnaround in the IP index for consumer goods bodes well for capital investment in the economy. The IP index for capital goods has been showing strength lately.

In short, the falling number of stalled projects, declining global commodity and oil prices, increasing public investment in infrastructure, and signs of increasing consumer demand for goods could persuade businesses to invest in capacity building in the near term. A rise in fixed capital formation would likely remove supply constraints and boost growth without any inflationary impact on the economy.

Boost from an easy monetary policy?

Capital investment depends significantly on credit conditions in the economy, which are decided by the monetary authority and its policy stance. So far, credit conditions have remained somewhat tight, and there is some space for further easing. The RBI has also been vigilant about credit growth in the corporate sector. The RBI governor has resisted growing pressure from the finance ministry to ease monetary policy; the RBI has cut policy rates intermittently, albeit at a slow pace, citing higher inflation expectations, a poor monsoon, and global uncertainties, including the US Federal Reserve’s (Fed’s) policy rate hike.12

However, current data indicate that the fear of rising prices may be out of line with reality. Inflation has moderated since 2014 due to easing commodity and international oil prices, falling global food inflation, and tightening credit conditions in India. In addition, the government’s proactive supply-side management, especially in respect to onion and pulses; offloading of surplus rice and wheat stocks; and restraining the hike in minimum support prices have helped put a lid on domestic food inflation. The latest data show a 3.7 percent increase in the consumer price index (CPI), while wholesale price inflation (WPI) has been in negative territory since November 2014. A fall in the CPI has been primarily due to a sharp fall in prices of food and beverages, which account for 46 percent of the CPI (figure 3).

GEOQ415_India_figure3

The RBI announced a rate cut of 0.5 percent in its monetary policy meeting held on September 29. The rate cut was more than the market expected, but the Fed’s status quo and sustained domestic disinflationary pressures allowed the RBI to ease its policy stance. The RBI indicated that it intends to be as accommodative as possible given its inflation targets.13

However, this might be the last rate cut for this year. This year’s deficient monsoon might put upward pressure on food price inflation. It is feared that rising prices due to some failed crops may make food inflation go out of control. In addition, favorable base effects will start waning going forward. Latest data show an increase in both short- and long-term inflation expectations. The RBI would like to see a sustainable fall in prices before committing to further rate cuts. Households need to be convinced that inflation will likely remain low once commodity and oil prices start picking up.

Latest data show an increase in both short- and long-term inflation expectations.

Risks to global economic activities are skewed to the downside. The banking sector remains vulnerable to exogenous shocks. Banks in India are facing huge amounts of bad loans. With the current conditions of the stressed asset ratios (gross nonperforming plus restructured standard advances to gross advances) for the banking system rising to 10.9 percent as on March 2015, and credit growth at around 10 percent, the banks’ ability to lend or cut lending rates gets restricted.14 In addition, corporate sector balance sheets are over-leveraged, which limits the sector’s ability to borrow and invest, and, therefore, may deter businesses from incurring investments.

Moreover, easing monetary policy through rate cuts may not be enough to ensure strong investment growth. So far, banks have not cut lending rates, while deposit rate cuts have adversely affected household savings. The RBI stated that, with a cumulative rate cut of 125 basis points since January 2015, it would now prefer to see front-loaded policy-rate reductions translate more fully to lower lending rates by banks before easing policy further. In addition, as an alternate source of funding, the RBI has allowed Indians to issue Indian rupee–denominated bonds with a minimum maturity of five years at overseas locations within the ceiling of foreign investment permitted in corporate debt (which is currently $51 billion).15 These policies will likely benefit private sector credit growth and solidly boost investment sentiment, and thus the capital investment cycle.

Right policies should pave the way

Global companies are looking to invest their capital, and India is an attractive destination. According to a Financial Times report, “India is in pole position to pass both China and the US in the foreign direct investment league tables this year.�?16 All eyes are now on the pace at which the government brings about structural reforms in the economy. The implementation of critical reforms, such as amendments in goods and services tax and in land acquisition laws, is expected to significantly boost the investment cycle and help the economy realize its growth potential.