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India Reacceleration in F1Q07 Prompts Growth Upgrade View GEF Archive

The growth trend in corporate revenue, industrial production and automobile segment sales points to a rebound in the quarter ended June 2006.  The aggregate BSE 200 corporate sales growth (excluding energy companies) accelerated sharply to a new high of 28% YoY during the quarter ended June 2006 from 18% during the quarter ended March 2006.  The official industrial production data also point towards re-acceleration in growth to a 10.1% average in the quarter ended June from 8.7% in the quarter ended March.  The automobile sector, which is one of the most economic growth-sensitive sectors, has also witnessed a significant bounce-back.  The official GDP growth estimate for the quarter ended June, likely to be released on September 29, should corroborate this trend.

… prompting revision to our growth estimates

Reflecting this stronger-than-expected growth trend in the first quarter of the fiscal year, we are upgrading our GDP growth forecast for F2007 to 7.6% from 6.8%.  We still look for a slowdown in growth in the second half of F2007.  We now expect the industry and services segments to register growth of 8.7% and 9.2% in F2007, as compared to our earlier estimates of 7.2% and 8.0%, respectively.

However, weaker-than-expected agricultural growth will offset a part of this upside in non-agriculture growth.  We are cutting our forecasts for agriculture segment growth in F2007 to 2% from 3%.  The key reason for this change in forecast is the erratic trend in monsoon rainfall.  While some parts of the country have received below normal rainfall, a few states have received way above normal rainfall, resulting in floods damaging crops. This is also evident in the trend in area taken up for cultivation by the farmers. Food grain area taken under cultivation by farmers was only 0.4% higher than last year.

What drove the reacceleration in F1Q07 

Goods trade data as well as the port traffic trend indicate a continued deceleration in export demand.  Hence, most of the acceleration in growth appears to be driven by domestic demand, which in turn has been supported by a sharp rise in bank credit, in our view.  Bank credit growth had accelerated to a new high of 33% as at end-June 2006, making the current credit cycle the longest in the past 35 years.  Indeed, during the quarter ended June 2006, the government also borrowed aggressively to fund acceleration in its expenditure growth.  The government is continuing to pursue the policy of ‘borrowing from future’. Apart from this aggressive leveraging trend supporting growth, the government is also protecting domestic demand by choosing to not pass on the full cost of higher oil prices.  

How sustainable is this reacceleration?

We believe that while household leveraging remained strong until the quarter ended June 2006, anecdotal evidence suggests that banks have started slowing their lending growth in this area over the past few weeks.  Aggregate banking system credit growth also witnessed marginal deceleration during the month of July.  We believe that the credit cycle is about to reverse, considering the lagged effect of the steady rise in real rates over the past few months, increasing supply constraints in banks’ balance sheet (i.e., low deposit growth) and the Reserve Bank of India’s measures to control aggressive credit by increasing risk weights for banks lending to select sectors.  As regards government spending, the finance ministry has also stated that the spike during the quarter ended June 2006 was due to bunching-up of expenditure, and the ministry expects it to slow down.  We believe that the acceleration of growth during the quarter ended June 2006 is unsustainable.  Hence, even as the support from corporate capex remains positive, the weaker trend in the other three drivers including external demand, government spending and household spending should result in a slowdown in growth again in the quarter ended September 2006.

If growth acceleration is maintained, risk of macro-instability could rise sharply

If the growth acceleration trend is sustained by household and government borrowing at a time when the corporate credit demand remains strong on account of capex, it could raise the risks of macro challenges in the form of higher inflation, a trade deficit and a spike-up in the cost of capital:

Inflation: The recent rise in metals prices (YoY) is about to be reflected in the metal products component and headline WPI inflation rate, taking the inflation rate above 5%.  The WPI component excluding food and global commodities (akin to core inflation) has also begun to rise again.  If acceleration in domestic demand growth is maintained, this component could rise significantly, taking inflation above the RBI’s comfort zone of 5-5.5%.  

Trade deficit: The acceleration in domestic demand over the last few months has again started pushing the trade deficit higher.  Although this may not be a major issue from the external stability perspective, it will still weigh on the accretion of foreign exchange reserves and net injection of liquidity.

Cost of capital: Most importantly, continued strong credit growth at a time when the supply of liquidity in the form of global capital inflows has been receding and time deposit growth remains relatively low could cause a further spike-up interest rates, resulting in an aggressive landing of the growth cycle.  Even if global capital inflows were to surprise positively, the central bank is unlikely to allow the absorption of this liquidity as it remains concerned about inflation and the banking system’s ability to avoid a credit quality problem if the current growth rate is maintained.

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