India Outlook: Prospects Brighten- Moody's Analytics
In many ways this is playing to script. Financial markets surged and observers raised their forecasts following Modi's May election victory, but we were reluctant to raise our outlook prematurely. India's economy is a huge, slow-moving entity, to say nothing of the fractious political system. It was always going to take a while for the Modi government to find its feet. Policymakers should have their eyes on the longer term, rather than seeking easy, short-term gains. So far, the signs are promising that Modi will resist the mistakes of his predecessor.
A nicely timed cyclical upturn
India's economy has improved in recent months, though for cyclical reasons unrelated to the new government. Downside risks around inflation, the external and fiscal deficits, and volatile financial markets have all receded, helping restore confidence and drive a slow but definite upturn. GDP grew 5.7% in the June quarter after hovering at 5% for the previous two years, and we expect growth to approach a 6% pace by year's end.
Second quarter growth was broad-based, with most sectors expanding solidly. Fixed investment rebounded after flat lining over the previous 12 months, providing the clearest sign that India's economy has turned a corner. Consumer demand is ticking over, government consumption is growing as austerity fades, and exports surged over the quarter. Imports were flat, but because of restrictions on gold imports rather than any softening in domestic demand. On the supply side, agriculture, manufacturing, utilities and construction all grew at a steady pace, while services continued to outperform. With risks receding and most sectors expanding, our 2014 forecast calls for 5.2% GDP growth, and 6.2% in 2015.
India still has an inflation problem, however. Wholesale prices have cooled, but the central bank is paying greater attention to the consumer price measure, which remains elevated at 7.2% y/y in July. It is increasingly likely that the RBI will not cut interest rates this year. Governor Rajan made lowering inflation the bank's main priority, and it will be difficult to justify a rate cut unless CPI inflation falls comfortably below 6%. Yet the economy's output gap is closing and the current monsoon season, while not as poor as initially feared, could still be 10% below average, cutting crop yields and pushing up prices from early 2015.
We expect inflation to ease from current levels, but not enough to justify lower interest rates. We foresee an initial rate cut in the second quarter of 2015, although this depends on the strength of the recovery, the monsoon rainfall, and the subsequent path of inflation.
Upside risk, long term
Modest downside risks accompany the near term outlook, but longer term we see a substantial upside. The outlook calls for potential GDP growth to ease from 6.5% currently to 5.5% by 2020 and 5% in 2025, driven by slower population growth and productivity convergence.
This is well short of the government's goal of 7% to 8% annual GDP growth within three years. If the Modi government is to hit these targets sustainably, without overheating the economy and creating imbalances, it will need to boost productivity growth. Substantial economic reform is required.
Pieces are in place
Modi has already made some progress. Recent moves to open insurance, railways and defense to foreign investment are all positive, though the government should reconsider its opposition to opening multi]brand and online retail. Continued efforts to set fuel and diesel prices according to market forces will help to free public funds.
Modi has abolished the old Planning Commission in an effort to empower the states. Externally, the prime minister's Japan trip was a success and he seems determined to secure a more assertive role for India internationally. There has also been modest progress reforming India's oppressive labour laws, with companies allowed to make greater use of apprentices, workers allowed to work more overtime, and women allowed to work night shifts. All this adds upside to the outlook.
A manufacturing power?
Perhaps Modi's most promising announcement was his intention of making India a manufacturing hub. Indian politicians are fond of such grandiose announcements, but in Modi's instance it may have some substance. As chief minister of Gujarat he helped provide a reliable electricity supply and attracted both local and foreign owned manufacturing. Many global manufacturers are seeking an alternative to China as costs and risks there rise.
Manufacturing accounts for 15% of India's economy, well short of East Asia's developed economies. When India was growing at 9%, some suggested it could skip the secondary phase of economic development and go straight from an agrarian to a services based economy. That notion has since been discarded. Manufacturing offers the surest way to employ millions of workers in middle income jobs, provide a stable source of foreign currency, and create a reliable path for development. India already has the cheap labour and large local market.
Better infrastructure and easier regulations, especially around labour, will help propel manufacturing. The government has made some progress but ought to go further. It should measure success by whether foreign manufacturers want to do business there.
The pieces are in place for Modi to be an influential leader. Reforms have come slowly, in part because this is Modi's first stint in the national parliament and until recently he didn't know the exact size of his majority. His challenge will be to continue and accelerate the pace, while trying to keep parliament on his side. It is a difficult task, but if Modi achieves it he could lift India's long term GDP growth, which is the surest way to lift millions out of poverty.
