India: It’s going to be all about consumption Global Economic Outlook, Q2 2016

The Indian economy has maintained strong macroeconomic fundamentals in the face of the global economic slowdown, rising global uncertainty, and even drought. The government’s latest budget primarily focuses on stimulating rural demand in order to sustain domestic demand.


The Indian economy has shown immense resilience in the face of the global economic slowdown and rising uncertainty in the global financial world. The country, a significant proportion of whose population depends on agriculture for employment and livelihood, also had to withstand drought for two consecutive years. Despite these setbacks, India has maintained strong macroeconomic fundamentals, although a part of the credit goes to falling international crude oil prices. The economy is expected to grow 7.5 percent in the fiscal year (FY) 2015–16 (April 2015–March 2016), in contrast to the estimated average global growth of 3.1 percent in the calendar year 2015.1 Consequently, credit rating agencies assigned a “stable” outlook for India; a few even view the outlook as “positive.”2

The government presented its third budget for FY 2016–17; it is pro-development and pro-reforms, and it primarily focuses on India’s rural sector. After the much-needed emphasis on investment in infrastructure and in the manufacturing sector in the past two budgets, the government focused on stimulating rural demand, which is expected to, in turn, sustain domestic demand. At the same time, the government committed to containing the fiscal deficit to 3.5 percent of GDP in FY 2016–17, down from its estimate of 3.9 percent in FY 2015–16, without significantly compromising on its capital expenditure plans.

Overall, the fiscally prudent budget is expected to provide the desired thrust to economic growth by tending to the core of the economy. With improving fundamentals and strengthening urban demand, this might be a good time for India to unleash the potential of its rural sector to embark on a sustainable growth path.

Consumption to drive growth

It is expected that growth will be driven by consumption in the coming years. Supported by falling oil prices, easing credit conditions, and growing income among the middle-income class, urban demand is probably already seeing an uptick (figure 1). The recent rise in retail loans, car sales, and consumer durables probably indicates that consumption demand growth is improving and will likely get another boost after the implementation of the Seventh Central Pay Commission during FY 2016–17.

Figure 1

In this year’s budget, the government aims to buoy domestic demand through proposed spending on the rural and social sectors, such as farm loan interest subsidies, crop insurance, and health insurance schemes for farmers. The budget also includes measures such as improving various rural job schemes and encouraging diversification into dairies, fisheries, and horticulture, which are expected to help farmers earn higher income. The prime minister pledged to double the income of farmers by 2022, to mark India’s 75 years of independence.3

At the same time, the government has committed to increasing spending on rural infrastructure, including irrigation facilities and roads, expanding market access, and improving processing of farm produce. These measures will likely improve capacity building at the grassroots level, thereby alleviating poverty and creating assets in rural areas. The resulting demand boost will likely sustain domestic demand over the longer term.

The prime minister pledged to double the income of farmers by 2022, to mark India’s 75 years of independence.

Factors that may boost consumption

India has had tremendous success in bringing down inflation to levels not seen in the past 10 years. The decline in prices (figure 2) is due to a combination of factors such as falling international commodity prices, especially global crude oil prices, a favorable base effect, and, lately, a slowdown in rising food prices. Core inflation, which is the net of energy and fuel prices (which fluctuate highly) and is considered to be an indicator of the demand-driven price rise, also has been modest in the past year. Overall, the inflation rate has remained below the Reserve Bank of India’s (RBI’s) target range and is expected to remain so, which will likely improve spending as consumers have more money to spend on goods and services.

Figure 2

In this budget, the government emphasized fiscal consolidation by targeting a lower fiscal deficit of 3.5 percent of GDP in FY 2016–17, which is in line with its fiscal road map (figure 3). This has allayed investors’ fears of a second successive relaxation of fiscal deficit targets. The government has also shown restraint around spending. At the same time, asset sales and higher tax collection (primarily coming from excise taxes) will likely improve government revenues.

Figure 3

The RBI governor called the budget “fiscally prudent.”4 The government’s adherence to its fiscal road map together with falling prices have led the RBI to cut rates in the latest monetary policy meeting, as well as effect measures to ease the liquidity constraints in the banking sector. These measures are expected to ease credit conditions in the economy. There are arguments that rate cuts by the RBI have only been partially transmitted to consumers, and thus further rate cuts may not spur bank lending. Lately, a few prominent public sector banks have started cutting both lending and deposit rates. With measures announced by the RBI on May 5, 2016, such as reducing the minimum daily requirement of banks’ cash reserve ratio and narrowing the policy rate corridor (measured as the difference between the marginal standing facility rate and reverse repo rate), more banks may be willing to lend to consumers and provide much-needed stimulus to consumption expenditure. This bodes well for the consumer and industrial sectors.

Downside risks to demand

Global demand has been slowing, posing risks to the economy through channels such as reduced exports and cross-border investments. Exports have been declining for 14 consecutive months owing to slower growth in world trade and a real appreciation of the Indian rupee against its basket of currencies; this decline will likely continue to hinder growth in the near future. Falling exports have impacted corporate earnings as well as revenue of the highly labor-intensive small-scale enterprises that export engineering goods. That said, the current account deficit is at a comfortable level and is expected to remain so going forward (figure 4).

Figure 4

At the same time, rising global uncertainty has reduced the risk appetite of investors, who are gradually withdrawing capital from emerging markets and investing in safer havens, such as US bonds. The Indian capital market has lately seen a flight of institutional investments due to a combination of factors such as the economic slowdown in China and the United States, falling international crude oil prices, the US Federal Reserve rate hike, and rising uncertainty due to the increasing possibility of the United Kingdom’s exit from the European Union (often referred to as “Brexit”). Coupled with global factors, several domestic elements such as falling corporate earnings, poor industrial production growth, and the slow pace of reforms are diminishing investors’ confidence.

Rising nonperforming assets and poor profitability have increased risk to the Indian banking sector. Banks are under stress due to their deteriorating balance sheets, which is impacting their ability to lend and, thereby, credit conditions in the economy. In this budget, the government has allocated funds for bank recapitalization. However, it has also emphasized the need for merger and consolidation, as well as governance reforms for banks to clean up their balance sheets. That said, rising stressed assets pose risks to the Indian financial sector’s stability.

Rising nonperforming assets and poor profitability have increased risk to the Indian banking sector.

Regulatory impediments and uncertainties in the tax environment continue to be major concerns. The government’s slow progress in implementing institutional reforms is frustrating investors, who are awaiting the removal of structural bottlenecks before they jump-start investment. Slow progress in goods and services tax and corporate tax rationalization are a few such bottlenecks that may influence capital investment growth by the private sector.

Since Q2 FY 2014–15, growth in private consumption expenditure has moderated. The government’s conscious efforts to improve agricultural income and stimulate rural demand are likely to complement urban consumption expenditure and ensure sustained economic growth for a longer period. The impact of the budget measures on rural consumption demand will probably be seen from the third quarter of this fiscal year. However, a lot will also depend on how the monsoon is this year.