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Inflation, twin deficits are concerns for India's growth momentum

Nevertheless, India would probably remain one of the fastest growing large economies in the world

Aditi Nayar 

RBI, Reserve Bank of India

Amid a closing of the output gap, inflationary risks prompted the Monetary Policy Committee (MPC) to hike the repo rate by 25 bps in the August 2018 policy review. The Committee expects GDP growth to improve from 6.7 per cent in FY2018 to 7.4 per cent in FY2019 and 7.5 per cent in Q1 FY2020. At the same time, its inflation projections forecast a rise from 4.6 per cent in Q2 FY2019 to 4.8 per cent for H2 FY2019 and 5.0 per cent in Q1 FY2020, despite the back-to-back rate hikes.

As many as 10 of the 16 early indicators of the Indian economy tracked by Icra, recorded a healthy expansion above 8.0 per cent in June 2018, while another four grew by 6-8 per cent in that month. The continued benefits of the implementation of the GST are expected to support growth.

Moreover, the hikes in minimum support prices (MSPs) for kharif crops would boost rural demand, but contribute to higher inflation and/or fiscal risks. Continued consumption demand in the rural as well as urban areas, in conjunction with a pickup in capacity utilisation, are expected to set the stage for an investment recovery in H2 FY2019.

However, there is a risk that higher inflation would weigh upon the disposable income of consumers and the margins of producers, preventing a faster pickup of economic growth. While bond yields have hardened over the last year, the two rate hikes would partly transmit into higher bank lending rates, which may constrain the strength of the investment recovery. Additionally, the ability of the public sector banks to support lending growth remains a concern.

Moreover, the MPC’s forecast of inflation at 5.0 per cent for Q1 FY2020, which is well above its medium-term target of 4.0 per cent, suggests that another rate hike of 25 bps towards the end of FY2019 should not be ruled out, notwithstanding the neutral stance of monetary policy.

The recent rupee depreciation would support exports, although the heightened risk of trade wars poses a concern. Overall, Icra expects the GDP growth to record a shallow recovery to 7.1 per cent in FY2019 from 6.7 per cent in FY2018.

The initial trends for the fiscal deficit of the Government of India appear favourable, with a mild year-on-year decline in Q1 FY2019. However, various concerns persist, including whether the targets for revenues related to the GST, dividends and profits, and disinvestment would be realised, and whether the budgeted outlays for revised MSPs, the National Health Protection Scheme, fuel and fertiliser subsidies, and bank recapitalisation would be adequate.

While a fiscal slippage in FY2019 may not necessarily arise, there is a risk that capital spending would be curtailed to prevent breaching the fiscal deficit targets. The size of the market borrowing for both the states and Central Governments for H2 FY2019 would be closely watched, and would influence bond yields.

Additionally, movements in global crude oil prices would impact inflation, the fiscal situation and the current account deficit, transmitting rapidly into Indian bond yields as well as the trend in the INR relative to major currencies.

The widening of India’s merchandise trade deficit to a 61-month high in June 2018, has fuelled concerns regarding the outlook for the current account deficit. Given the current level of commodity prices, Icra expects the merchandise trade deficit to widen significantly in FY2019. However, the services trade surplus and remittances are likely to improve, benefitting from a weaker currency. Overall, the current account deficit is likely to increase to 2.5 per cent of GDP in FY2019 from 1.9 per cent of GDP in FY2018.

To conclude, while recent indicators point toward a positive momentum in Indian economic growth, there are growing concerns regarding its sustainability at these levels, given the outlook for inflation and the twin deficits in the current fiscal.

Our baseline expectation is that Indian GDP growth would be around 7.1 per cent in FY19, lower than the MPC’s forecast, and the current volume growth being displayed by sectors such as automobile, cement and coal production, as well as credit and deposit growth. Nevertheless, India would probably remain one of the fastest growing large economies in the world.


Aditi Nayar is Principal Economist, ICRA

Disclaimer: Views expressed are personal. They do not reflect the view/s of Business Standard.

First Published: Fri, August 03 2018. 10:19 IST
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