Growth Shows Resilience as Services Soar

India's economy posted growth rates showing that the recovery has taken hold earlier than anticipated, as falling borrowing costs, lower interest rates, and ambitious fiscal stimulus packages, and an expansionary budget boosted domestic demand. During the first fiscal quarter (April–June) of fiscal year (FY) 2009/10 (ending in March 2010), real GDP expanded by 6.0% year-on-year (y/y), according to the Central Statistical Organization. Growth in the first quarter declined from 8.2% a year earlier but rose from the 4.1% registered in the January–March quarter. With the recovery now underway, services and construction provided traction during the quarter. Construction increased by 7.2% y/y, while services, including trade, hotels, transport, and financial services, expanded by 8.1%. Mining and quarrying grew 7.9% in the first quarter. However, manufacturing growth skidded to 3.5%, and industrial production growth during the quarter stood at only 3.7%. The agricultural sector registered meagre growth of 2.4%, with downside risks on the horizon with current drought conditions. Meanwhile, on the demand side, private consumption, the mainstay of India's boom, expanded only 1.6%, government spending increased 10.2%, and fixed investment grew 4.2%. Exports and imports contracted sharply, by 10.1% and 21.2%, respectively.

Lower Monsoon Rains Threaten Agricultural Sector, Offsetting Positive Growth Drivers

Thus far, monsoon rains during the current June–September season stand 24% below the long-run average as of 27 August, according to the India Meteorological Department. Some states in the northern and eastern regions have declared droughts already, before the monsoon season has ended. Drought has now officially hit 278 districts in the nation, despite some acceleration in rainfall in the past two weeks. The department hinted at further deterioration and uneven distribution for the remainder of the season. Any significant shortfall in rain could hit India's agricultural growth, affecting rural demand, and hence, overall private consumption. While government spending targeting the farm sector will undoubtedly shield rural incomes to some extent, the agricultural sector will not escape unscathed. The negative agricultural developments effectively neutralise the upside risks to IHS Global Insight's current GDP growth forecast for FY 2009/10.

Although the importance of agriculture in the economy has waned in the last few decades, the rural populace remains overwhelmingly dependent on the farm sector. Agriculture and allied industries still account for about one-fifth of India's economy, and employ more than half of the country's billion-plus population. Nevertheless, the importance of the once-crucial sector has declined considerably, and there has been little recent indication of any significant agricultural slowdown affecting industry or services, the two key sectors of the Indian economy.

Consumer Prices Tick Upwards; Poor Rainfall Will Exacerbate Inflation

Data released yesterday also showed that consumer price index (CPI) inflation stood at 11.9% year-on-year (y/y) in July 2009, compared with 9.3% in June, reflecting rising prices for agricultural goods. The current weak monsoon portends ill for food price trends in upcoming months. Government officials are seeking to increase supplies of sugar and other food items, and to ease prices of vegetable oils. The government is increasing the minimum selling price of rice and sugar, and has offered to subsidise diesel for farmers to bring down irrigation costs. The authorities are also stepping in to provide additional electricity to key farming provinces, such as Punjab and Haryana. Paradoxically, wholesale price index (WPI) inflation remained in negative territory for the eleventh consecutive week and declined 1.0% y/y during the week of 15 August 2009, according to the Ministry of Commerce and Industry, but prices of primary articles in the WPI, including food, have risen 5.8% on drought concerns. In any case, however, the extent of the impact of the potential drought on the real economy is unclear. In fact, the central bank, the Reserve Bank of India (RBI), warned that the poor monsoon was more likely to drive CPI inflation sharply upward rather than curtail GDP growth.

Monetary Policy Likely to Remain Unchanged Until End-2009

The RBI is likely to keep interest rates unchanged until at least the end of 2009. In a recent policy statement, the RBI indicated that it would reverse its accommodative stance with signs of demand acceleration. The positive GDP figures certainly indicate strengthening domestic demand and easing financial conditions, and spiralling food inflation could quickly lead to higher interest rates. But the extensive government expenditure has created vast amounts of public debt. Government borrowing already stands at 4.5 trillion rupees (US$93 billion) during the current fiscal year that began 1 April, compared with 3.0 trillion rupees a year earlier, exerting upward pressure on market interest rates, and raising borrowing costs for businesses and consumers despite the RBI's declining policy interest rates. In an environment of rising growth and inflation, the RBI has to balance the need to keep interest rates low to aid the bond market in absorbing the flood of new public debt, as well as provide a ballast to rural demand during a weak monsoon. Beginning in early-to-mid 2010, the RBI is likely to begin to tighten and shift monetary policy back to a more neutral level.

Outlook and Implications

Were it not for the potential adverse impact of a weak monsoon, IHS Global Insight would probably have upgraded the GDP growth outlook substantially for the near term. As it is, we have kept our FY 2009/10 GDP forecast unchanged at 5.6%, despite the positive first-quarter GDP data. Upside risks had included the May 2009 positive election outcome, a significant easing in financial conditions, increased capital inflows into India, and improvement in the global economic environment. Next year, we expect higher growth in industry and services, and a pickup in private consumption; consequently, earlier in August, IHS Global Insight raised the FY 2010/11 outlook from 6.6% to 7.0%. Consumer sentiment continues to march upward, and passenger car sales rose 31% y/y in July. The investment outlook has improved considerably, particularly for infrastructure, and the July 2009 expansionary budget specifically incorporated policies to enhance investment. Easing global financial markets have allowed Indian companies to access international capital markets again. Lastly, recent indicators of investment activity, including the purchasing managers' index (PMI), cement production and sales, and the infrastructure production index are all showing surging improvement.

Meanwhile, the external environment is also improving sooner than expected. Although India's large internal market has typically helped insulate it from volatile swings in external demand, a brighter global demand outlook provides an additional upside to growth prospects in FY 2010/11. In any case, however, private consumer spending remains the mainstay for the economy, accounting for 55% of GDP. The resilience and momentum of domestic demand will subsequently be a key variable in the economy's outlook. The downside risks to the FY 2010/11 outlook are a poor agricultural crop impacting rural demand through FY 2010/11, and higher food prices causing aggressive RBI rate hikes, thereby stifling the demand recovery.

Global Insight (Reino Unido)