Asia Pacific
Calibrating Upside and Downside Risks to Growth Estimates
December 12, 2008

By Chetan Ahya Singapore & Sumeet Kariwala | India

Calibrating Upside and Downside Risks to Growth Estimates

Chetan Ahya (Singapore) and Sumeet Kariwala (India)

Asia-Pacific

Teaser: We expect AXJ GDP growth to slow to 7.6% in 2008 and deteriorate further in 2009 to 5.3%. AXJ is likely to be affected by global risk-aversion and the external demand shock. We construct a bull case scenario for AXJ growth to be at 6.7% in 2009 and 7.6% in 2010. Our bear case is 3.2% in 2009 and 4.9% in 2010.

Global environment remains challenging: Rising credit defaults in the developed world are paralyzing global financial institutions’ ability to deliver risk capital. Cost of capital remains at high levels even while GDP growth has decelerated sharply. The vicious cycle of rising credit defaults, a shrinking risk capital pool, slowing growth and rising unemployment is unveiling the possibility of a deep recession. While many central banks are cutting policy rates, actual borrowing costs for consumers and the corporate sector have remained high even as growth is slowing. The ability of global financial institutions to deliver risk capital to the real economy is unlikely to revive soon, implying that the duration of this global slowdown will be much longer, in our view.

Asia is unlikely to emerge unscathed: Reflecting the downside risks from the global environment, we project 2009 GDP growth at 5.3%, very close to the trough reached in 2001 at 5.2%. We concede that risks to our estimates are to the downside. We believe that the economies in the AXJ region are likely to be affected in two ways: (a) Risk-aversion in global financial markets transmitting in the form of a higher cost of capital in the region; and (b) External demand shock.

Risk aversion in global financial markets transmitting in the form of higher cost of capital in the region: To analyze the adverse impact of rising risk-aversion in the global financial market, we group the region’s economies in three buckets based on their dependence on credit growth to drive their economic growth and position of their current account balance. The ‘trouble zone’, which includes India, Korea and Indonesia (accounting for 35% of the region’s GDP), have had strong credit growth cycles and also have their current accounts in deficit. Their economies are likely to suffer the most from the global financial market contagion. Sharp declines in capital inflows at a time when their current accounts are in deficit have pushed their overall balance of payments suddenly into deficit. With their banking systems already facing tight liquidity conditions, these balance of payments deficits and foreign exchange outflows have resulted in a disruptive rise in cost of capital over the last three months.

Currency shock leading to large financial instability risk: We believe that Korea, India and Indonesia will face large dislocations in their financial systems, affecting their ability to revive the economies soon. These economies face the risk of a vicious cycle of rising NPLs and a downswing in the growth cycle. While Singapore and Hong Kong are likely to be less affected compared with the ‘trouble zone’ economies, we believe that they will still suffer from a deleveraging trend as both have had a strong credit growth cycle.  Singapore has also had a property cycle. China, Taiwan and Malaysia did not have a strong credit growth cycle and run current account surpluses. This group is likely to suffer much less than the other two groups. Some of the region’s economies are also likely to face the added challenge of external debt refinancing risk. Total external debt in the region was US$1.47 trillion (20.8% of GDP) as of March 2008. Apart from currency depreciation loss on unhedged external liabilities, many countries are facing refinancing risks. The Korean won, Indian rupee and Indonesian rupiah have depreciated 35%, 21%, and 18%, respectively, from their peaks. The sharp move in currency has caused dislocations in the balance sheets of many companies and countries with external liabilities.

Unprecedented external demand shock underway: AXJ’s exports have grown 19.3% year to date in 2008, driven by rest of the world (ROW: world excluding US, Europe and Asia). The ROW group primarily includes emerging markets (the Middle East, Emerging Europe, Latin America and Africa) and decelerated to 20.4% in October 2008. A further slowdown in the US and Europe and a potential sharp slowdown in ROW (largely emerging markets) will result in a sharp decline in the region’s export growth. The follow-through impact on the region’s business capex cycle is likely to be severe. Many countries in the region have built large production capacities to feed global export demand. A sharp slowdown in exports could cause a major dislocation in the balance sheets of regional companies. Corporate investment demand will be hit significantly. While many countries in the region had the support from private sector construction and real estate investments in 2008, we believe that this spending is likely to witness a sharp deceleration in 2009 as domestic as well as international risk capital supply continue to shrink.

External demand shock should hurt Singapore, Hong Kong, Malaysia, Taiwan and China the most, considering their high level of exports to GDP and large current account surpluses. Having said this, we believe that these countries should suffer fewer dislocations in their financial systems compared with countries with strong credit growth cycle and current account deficits. Falling commodity prices should help to partially offset this external demand shock. As a net importer of commodities, the AXJ region suffered from a negative terms-of-trade shock. However, with the sharp fall in commodity prices over the last few months, we expect the commodities trade deficit to narrow sharply. The fall in commodity prices has also helped the regional inflation rate to peak, removing hesitation among the central banks in the region to respond with loose monetary policy. Similarly, a reduced subsidy burden, particularly on food and energy, should create some room for pursuing loose fiscal policy.

Monetary/fiscal policy response – how strong can it be? While most central banks have already responded by cutting policy rates and/or initiating liquidity injection measures, we believe that these moves will be blunted to some extent due to the risk-aversion contagion from global financial markets. These liquidity measures will likely be less effective, particularly in countries like India, Korea and Indonesia.  Although countries with current account surpluses (Singapore, Hong Kong, China, Taiwan and Malaysia) should have better control of their domestic cost of capital, they are also likely to suffer partially from the contagion as reflected in reduced access to risk capital from global financial markets. However, we believe that some of these current account surplus countries, particularly China and Taiwan, will likely get more bang for their buck from a strong fiscal policy response. China has already announced an aggressive economic stimulus package of Rmb 4 trillion (US$586 billion) to boost domestic demand. Taiwan is likely to give shopping coupons to households that will cost the government NT$70 billion (0.5% of GDP) to encourage spending.

A Framework to Assess Upside and Downside Risks to Our Growth Estimates

The upside and downside risks to our AXJ GDP growth estimates will depend on the influence of the global growth outlook on (a) capital inflows into the region and financial market contagion; and (b) the region’s exports.

Richard Berner and Joachim Fels, Co-Heads of the Global Economics Team, highlight that globally there are five key drivers of risk (see Risks to the Global Outlook: The Good, the Bad and the Ugly, December 9, 2008):

“First, the extent of deleveraging by leveraged lenders remains uncertain, and further write-downs and provisioning will intensify the credit crunch in several developed economies.  The extent of further declines in asset values, especially in real estate, will deepen those risks, especially for US consumers.  Second, many central banks have eased monetary policy aggressively and quantitatively, but it is unclear whether and when such policies will get traction.  To be sure, there are recent signs of a revival in liquidity and money growth.  However, monetary policy in many EM economies remains restrictive.

Third, officials, notably the incoming Obama Administration, are considering a massive step-up in fiscal stimulus, with an undetermined amount in infrastructure outlays and tax cuts.  The timing, size and economic effectiveness of such policy actions are likely to remain unclear for a while.  Next, swings in currencies, commodity prices and risk premiums matter for the outlook in many EM economies.  Finally, the extent of the real estate downturn in China is a critical risk factor for that pivotal economy.

Combining the upside and downside risks, our global economics team has added two scenarios to the base case outcome. In our ‘ugly’ scenario, global activity contracts by 0.8% in 2009 and recovers by only 1.3% in 2010 as economic headwinds dominate policy stimulus.  Given that we think of global recession as growth below 2.5%, the ugly scenario would border on something even worse than the most severe recession in the post-war period.  In contrast, the ‘good’ scenario involves 2.3% growth next year and 4.3% in 2010, as a massive range of policy actions overwhelm the downturn. 

Unfortunately, the good-ugly comparison reveals that the downside risks outweigh the upside odds.  The margin is not large in 2009, where growth in the bear case falls short by 1.7 percentage points of the baseline, compared with a 1.4 percentage point gap between the good outcome and the baseline.  But the downside margin of risk widens in 2010 to 2 to 1 (the ugly outcome is 2 percentage points below the baseline, while the good outcome is only 1 percentage point above the baseline).”

We project bull case GDP growth for Asia ex-Japan at 6.7% for 2009 and 7.6% for 2010, compared to our base case GDP growth forecast of 5.3% in 2009 and 6.8% in 2010.

Our bear case GDP growth estimates for Asia ex-Japan are 3.2% for 2009 and 4.9% for 2010, compared to our GDP growth forecast of 7.6% in 2008. 

China: Getting Worse Before Getting Better (Qing Wang)

We think that China’s economic outlook for 2009 is best characterized as ‘getting worse before getting better’, laying the foundation for a firmer recovery in 2010. Further growth deceleration is expected in 1H09, and deflation is a distinct possibility. The effect of massive policy stimulus implemented since October 2008, together with a tepid recovery in G3 economies, is expected to help the Chinese economy regain some growth momentum in 2H09. We construct two alternative scenarios – the bear (featuring 5% GDP growth) and bull (9% GDP growth) cases – to highlight both the downside and upside risks to the 2009 outlook under our base case (7.5% GDP growth). Real estate investment will be the biggest swing factor among the scenarios, in our view.

Hong Kong: Hit By Foreign Trade, Credit and Asset Market Linkages (Denise Yam)

The sharp correction in the asset markets and the tightening in credit conditions are taking their toll on Hong Kong’s economy. Weakening global demand and significant depreciation in regional currencies are set to hurt Hong Kong’s trade outlook. Barring monthly fluctuations, year-on-year trade growth has slowed to mid-single-digits in recent months, but we forecast this to plunge to a 5% contraction in 2009. The HKMA has taken aggressive steps in liquidity assistance and injections into the interbank market to ensure a lower cost of funds to financial institutions. The government is guaranteeing loans to SMEs to help ease the credit crunch. Unfortunately, dwindling fiscal revenues from land sales, stamp duties and direct taxes will likely result in a sizeable deficit in the current fiscal year, limiting policy options on the fiscal front to support the economy. We construct two alternative scenarios – the bear (featuring 4% GDP contraction) and bull (0.5% GDP growth) cases – to highlight both the downside and upside risks to the 2009 outlook under our base case (2.8% GDP growth).

India: Capital Inflows – A Critical Macro Link (Chetan Ahya)

Over the last three years, large capital inflows have been the anchor of the self-fulfilling virtuous cycle of higher capital flows – an appreciating exchange rate, lower interest rates and strong domestic demand growth. However, a reversal in capital inflows since 2Q08 has resulted in a sharp rise in the cost of capital and deceleration in domestic demand (consumption as well as investment). Our base case assumes a major decline in capital inflows in 2009 and a gradual recovery in 2010, in line with the global growth trend. The second growth driver, though less important than the first, is external demand. We expect export growth to be -5.3% in 2009 compared to 12.7% in 2008.  We believe that the monetary policy measures will help but cannot fill the gap created by a reversal in capital inflows and weaker exports. On the fiscal policy front, considering that current public debt to GDP is already high at close to 77% of GDP, there is limited scope for an aggressive fiscal policy response.

Indonesia: Anchored by Commodity Cycle (Chetan Ahya)

Indonesia’s economy has been fuelled by credit, which is funded by capital flows and elevated commodity prices. Amid deleveraging, risk-aversion and declining commodity prices, Indonesia finds itself engulfed in the twin macro problems of a current account deficit and tightening liquidity. The resulting rise in the interbank rate will likely hurt the local banking sector and force a sharp slowdown in domestic demand. Moreover, the vulnerability of the currency from declining commodity prices and its impact on trade balance as well as a relatively open capital account could lead to further tightening in liquidity conditions as the central bank intervenes to buy rupiah and sell US$. We expect growth at 2.5% in 2009 and 4.5% in 2010. Risk appetite, the availability of risk capital and the extent of currency and commodity price swings pose risks in either direction. We note that policy responses to cushion the cycle are hindered as the monetary policy tool becomes less effective in the deleveraging cycle and fiscal responses are similarly curtailed by higher funding costs.

Korea – More Downside from Domestic Demand than External (Sharon Lam)           

While everyone is focusing more on export and construction, we see the biggest downside from consumption due to household deleveraging, wealth destruction and currency depreciation. We believe that Korea’s export growth will perform relatively better than other exporters because of much stronger competitiveness after sharp KRW depreciation. Since exporters’ earnings in KRW terms are not deteriorating as much as the deadline and while deflation is deterred by its currency, we believe that bankruptcy rates will not be as high as the market fears. Meanwhile, we expect another 100bp cut in interest rates to bring the policy rate to a historical low at 3% before mid-2009, and fiscal policies to continue to focus on construction and SME sectors. The biggest downside risks remain with domestic liquidity problems if foreigners continue to sell Korean bonds, thereby squeezing already tight wholesale funding sources. At the same time, the dollar shortage problem will re-emerge if a majority of ship orders are cancelled and therefore shipbuilders cannot meet their external debt payments with trade credits. The upside risk depends on the effectiveness of China’s stimulus measures as Korea’s growth is heavily related to China’s fixed asset investment.

Malaysia – Three-Legged Growth Model Giving Way (Deyi Tan/Chetan Ahya)                         

Manufacturing has already taken a hit from trade deceleration. The public sector economy now also seems likely to slow. Fiscal pump-priming has softened amid a less-expansionary budget, higher resource costs and political uncertainty. Despite the government rebalancing spending towards grass-root levels, consumer resilience will be tested in the face of weakening sentiment. Elevated commodity prices had provided a strong income effect that filtered down to the rural community, given the segmented market structure in agricultural commodity production. However, the reversal in commodity prices amid global demand destruction now undermines this support. We expect GDP growth to slow to 0.5% in 2009 and 4.2% in 2010, with the fiscal deficit standing at -4.8% of GDP and policy rates reaching 1% by end-2009. Trade and asset market linkages pose the key risks in our bull-bear framework.

Singapore: A High-Beta Economy (Deyi Tan/Chetan Ahya)

For an economy strongly leveraged on exports, the important issue is whether continued policy efforts have enabled Singapore exporters to outperform on a relative scale. However, Singapore exporters have underperformed compared to regional counterparts, particularly in electronics, as they are lagging in technology and there is an absence of strong home-grown brands. Domestic demand is unlikely to fill the void as the export-oriented strategy means that even domestic demand has become less domestic in nature. In our base case, we expect -2.5%Y growth in 2009 and a tepid recovery to 3.2% in 2010. In terms of policy responses, we believe that fiscal stimulus of 2-3% of GDP would be required to cushion the slowdown. Monetary policy will continue to be guided within a zero appreciation stance, with downward adjustments of the bandwidth mid-point during policy reviews. Similar to Malaysia, trade and asset market linkages are key risks in our bull and bear scenarios.

Taiwan: Too Focused on Tech Exports (Sharon Lam)

Taiwan cannot escape the global recession as its economy is too focused on tech exports. We expect negative year-on-year GDP growth to extend to 1Q09. However, we do not expect overall negative GDP growth for 2009 since the proactive government supportive measures will start to kick in at the beginning of 2009, which we estimate could boost GDP growth by 2pp next year. We expect CBC to stay ahead of other central banks in the region and cut its interest rate by another 100bp before mid-2009, while fiscal policies will focus on tax reforms. The biggest downside risk could come from any delay in policy execution next year, and further loss of competitiveness to Koreans due to currency. Upside risk depends on global tech demand; however, even if it recovers, it will be very mild, in our view.

Thailand: Idiosyncratic Domestic Risks (Chetan Ahya)

Within ASEAN, Thailand’s sensitivity to changes in global macro conditions is relatively lower. Its trade and asset market linkages are among the lowest. Moreover, tightening credit conditions have less impact since Thailand’s credit cycle had been subdued due to weak domestic sentiment, given political conditions. The absence of excesses both in terms of capex and consumption means that a boom-bust scenario is also less likely, in our view. However, domestic political developments are a risk in our bull-bear framework. We expect growth at 1.5%Y in 2009 and 3.5%Y in 2010 in our base case. In terms of policy responses, fiscal pump-priming is likely to be hindered by execution capability in light of political conditions. The monetary policy tool could be more effective in this regard.

For further details and accompanying charts, please see Calibrating Upside and Downside Risks to Growth Estimates, December 10, 2008.

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South Africa
Fragile Funding Flows Portend Continued ZAR Weakness
December 12, 2008

By Michael Kafe, CFA & Andrea Masia | South Africa

Introduction   

Data released by the SARB in its 4Q08 Quarterly Bulletin (QB) show that South Africa’s current account deficit rose from 7.3% to 7.9% of GDP in 3Q08. While this is no doubt less severe than our central forecast of 8.5%, it is nevertheless a significant deterioration in the country’s external accounts. The lower-than-expected deficit was largely due to an undershoot in imports, relative to monthly data published by the South African Revenue Services (SARS). Quite worrying is the fact that net invisible payments came in much higher than expected. In fact, if one adjusts for the undershoot in visible imports, the current account deficit would have come in at 9% of GDP. This inspires no confidence whatsoever to change our bearish call on the rand.

Weak Global Demand Caps Export Growth

Data from the SARB show that exports rose only marginally from R728 billion in 2Q08 to R755 billion in 3Q08, thanks to subdued growth in both the volume and price of exports produced as external demand for South African exports slowed. According to the bulletin, export volumes and prices rose by only 1.7% and 2%, respectively in 3Q08, with particularly sluggish performance being reported in a wide range of products including motor vehicles and transport equipment, machinery, electrical equipment and precious stones and pearls.

Oil Imports Come in Lower than Expected

Sluggish domestic demand helped to contain import growth at no more than 4.9%Q (quarterly growth rates are seasonally adjusted and annualized unless otherwise indicated), compared with 12.7%Q in 2Q08.  This is despite the fact that import spend was ‘artificially’ lifted by the purchase of two military aircraft. According to the QB, manufactured import volumes were down 2.2%Q, while crude oil import volumes “increased marginally over the period” as oil prices came off. We find the rather benign oil import bill reported by the SARB to be intriguing, given that monthly data reported by the SARS show that South Africa’s mineral imports (mainly oil and coal) rose from R45 billion in 2Q08 to R55 billion in 3Q08 – a 22% increase – on a non-seasonally adjusted and annualized basis.  This huge disparity between the monthly SARS and SARB oil import data accounts for most of the R22 billion undershoot in our forecast of a R66.3 billion deficit versus the actual out-turn of R44.3 billion.

Strong Dividend Outflows Lift Net Invisible Deficit

The bulletin shows that South Africa’s invisible payments on dividends and interest continue to push the current account into deficit: On a net basis, total invisible payments rose from R132 billion to R141 billion (i.e., much higher than our forecast of R134 billion). Of this amount, 52% (R73 billion) was related to dividends and interest on South African investments. On the whole, our calculations show that, had there not been a significant offset from the rather intriguing import data published by the SARB, the huge outflows on the net invisible line would have pushed the 3Q08 current account deficit to a record R208 billion, or some 9% of GDP.

Capital Account Susceptible to Fickle Flows 

Net financial transactions on the capital account of the balance of payments came in slightly ahead of our expectation, thanks in part to stronger-than-expected net FDI flows of R17 billion. However, the total reliance on unrecorded transactions – an extremely volatile balancing item – to fully fund the overall deficit on the country’s basic balance is a deep concern to us.  This R36.1 billion in unrecorded transactions is a historical high.   And while FDI inflows were somewhat higher than expected, this was largely driven by a single deal – the acquisition of a vehicle manufacturing company by its foreign parent company (Toyota Motor Corporation lifted its share in Toyota South Africa by 25% in August). 

Sharp Revisions to Portfolio Investments      

The SARB made significant revisions to its estimates of bond portfolio flows. Initial estimates of -R5.6 billion in August and -R13.1 billion in September were revised to R362 million and -R1.9 billion, as it turned out that the Bond Exchange of South Africa (BESA) had reported some repo trades on the R153 government bond that were subsequently unwound. The SARB rightly excludes these numbers from its final tally, thereby avoiding a repetition of what happened in 2Q08, when BESA reported a chunky R15 billion bond portfolio inflow in one day (April 25). As we pointed out in earlier research notes (e.g., South Africa: BoP Funding Mix Woes, September 5, 2008), such an unprecedented inflow is unlikely to have taken place on a day when bond yields were in fact 2-5bp weaker across the curve.

Local Banks Draw Down FX Deposits and Credit Lines

Thanks to the significant revisions to the portfolio outflows, the funding requirement in ‘net other investments’ came in lower than expected.  Even so, the data confirm our view that local commercial banks have become an important source of ‘funding’ for South Africa’s current account deficit – obviating the need for the SARB to sell its foreign exchange reserves to support the currency. According to the SARB, a R20.6 billion inflow reported in net other investments was driven by a draw-down on short-term loans by commercial banks and an increase in non-residents’ foreign currency deposits with these banks.  A run-down on commercial banks’ foreign currency deposits abroad to help fund local import orders, and foreign currency surrenders to foreign investors disposing of their South African assets also contributed. We pointed out in an earlier note (see South Africa: Further Growth Downgrades, November 14, 2008) that commercial banks have already liquidated up to one-third of their foreign exchange deposits (including advances to foreign banks) over the past 12 months, leaving them with roughly US$17.5  billion in FX reserves as at the end of September.

As we highlighted in that note, commercial banks’ foreign exchange reserves are not infinite: At some point, when these reserves are exhausted, and foreign credit lines dry up, it is conceivable that the rand comes under significant pressure, as commercial banks will have to source all foreign exchange requirements in the local spot market.  

Real GDE Growth Is Disappointing 

Elsewhere, the QB provided valuable insights on the real economy. For example, the bulletin shows that gross domestic expenditure staged a rather disappointing rebound of 1%Q in 3Q08, after contracting sharply (-3.5%Q) in the previous quarter.  Although household consumption growth was in line with our forecast, we were surprised by the strong growth reported in gross domestic fixed investment and government consumption spend. On the part of general government, consumption expenditure rebounded to 9.6%Q after a technical decline of 2%Q recorded in 2Q08. In 3Q08, further outlays on aircrafts and an increase in real compensation of employees drove the reading. Excluding the aircraft, government consumption rose 5.1%Q.

Maiden Contraction in Household Spend Since 1998

Household consumption (accounting for more than two-thirds of real GDP) turned negative for the first time since 4Q98, as disposable income growth moderated, debt burdens remained high and the high cost of fuel, food, beverages and tobacco discouraged private consumption expenditure on non-durables.  Additional evidence that earlier monetary policy action is rapidly percolating was confirmed by a further decline in household debt to disposable income from 76.7% to 75.3%, while household saving as a proportion of disposable income improved moderately from -0.5% to -0.3%. This suggests that South African households are deleveraging – even if only marginally so. However, one must remember that although the household debt/GDP ratio dropped from 46.3% to 45.3%, on our estimates, the fact remains that South African households are still deficit spenders.  Importantly, the fact that the current account deficit is deteriorating despite a contraction in consumption spend confirms our view that the deficit is being driven a lot more by investment spend than consumption outlays.  This should help to lift the country to a higher growth path in the future.

Public Sector Infrastructure Spend Still Buoyant

According to the QB, gross domestic fixed capital formation expanded by 44.3%Q in 3Q08, as public corporations and general government continued to implement South Africa’s capital-deepening program. In 3Q08, investment by public corporations was driven by huge outlays on generation capacity in the electricity subsector, including but not limited to the construction of the coal-fired Medupi and Kusile power stations by Eskom. Upgrades to national airports, the rapid rail link and communications networks also lifted the reading. On the other hand, investment by private corporations slowed from 13.7%Q in 1Q07 to 2.6%Q in 3Q08 as monetary conditions tightened; significant investment cut-backs have been reported in the real estate and business services sectors in particular.

Conclusion

Looking forward, we expect 2010 FIFA-related imports of capital equipment to remain high, leaving the visible trade and overall current account in permanent deficit over the next two years. At the margin, a small recovery in private consumption as interest rates ease through 1H09 should also lift import absorption by households. With all this happening against the background of a significant dearth in global capital flows, it is only reasonable to expect the currency to continue to trade on the back-foot, in our view. For the record, we expect the rand to close the year at 10.0 versus the US dollar, before depreciating further to 10.80 at end-2009 and 11.40 at end-2010, with risks firmly skewed to the upside.

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India
2009 Growth Outlook: Still in a Coupled World
December 12, 2008

By Chetan Ahya | Singapore & Tanvee Gupta | India

Summary

The vicious loop of rising credit defaults, a shrinking risk capital pool, slowing growth and rising unemployment is unveiling. Our economics team has revised its global GDP growth forecast to 0.9% in 2009 from 1.7% about a month back. In this environment, global capital inflows into emerging markets are unlikely to revive soon. Risk-aversion in the global financial markets has resulted in a sharp reversal in capital flows into India. We have always argued that the most important driver of India’s growth cycle over the last four years has been global risk appetite and capital inflows. With the duration of risk-aversion in global financial markets likely to be longer than what we estimated earlier, we are cutting our GDP growth estimate for 2009 for India to 5.3% from 5.8%. We also review the upside and downside risks to our estimates.

Capital Inflows Remain Key for Growth Outlook

We believe that over the last few years, India’s GDP growth accelerated much higher than the potential growth due to large capital inflows – an argument that we have belabored for a long time now. India’s GDP growth accelerated to an average of 9.3% during the three years ended March 2008 compared with an average of 6.6% and 6.0% in the preceding three and five years, respectively. Capital inflows have risen dramatically over the last five years. India received an average of US$10 billion per annum during F2001-03, and that number increased to US$108 billion in F2008. We believe that higher capital flows have been the anchor of a self-fulfilling virtuous cycle of an appreciating exchange rate, lower interest rates and strong domestic demand growth.

Unfortunately, capital inflows into India have less to do with India’s long-term fundamentals, in our view. The trend for capital inflows into EMs has been dependent on global risk appetite, which, in turn, has been driven by liquidity and the growth environment in the developed world. As per IIF estimates, capital inflows into EM increased to US$782 billion in 2007 from US$113 billion in 2002. The trend in India has been very similar.

Indeed, just as the global growth environment has deteriorated, India has witnessed capital outflows. As per our estimates since early July, India has witnessed net capital outflows of ~US$8-10 billion. The systemic sudden stop in capital outflows at a time when the country runs a current account deficit has meant a large balance of payments deficit. We estimate that India’s balance of payments deficit was US$35-40 billion over the last five months. With the domestic banking system already witnessing tight liquidity conditions, foreign exchange outflows at the same time have resulted in a disruptive spike in the cost of capital. Policy rate cuts and liquidity measures cannot prevent a sharp slowdown in the growth of domestic demand. We believe that measures initiated by the central bank are unlikely to help bring down the cost of capital in a meaningful manner before domestic demand and underlying credit demand decelerate sharply.

Unprecedented External Demand Shock Underway

India’s export growth averaged 24.8% over the last three years, driven by strong global growth. However, over the last three months, export growth has decelerated sharply. While until recently the strong demand from emerging markets including Latin America, Emerging Europe, the Middle East and Africa ensured that export growth remained healthy, over the last three months disruptions in the macro environment of these economies have been evident. Apart from weakening demand, exports have also been affected by the lack of availability of foreign trade credit and inventory liquidation. India’s exports declined by 12.1%Y in October 2008 compared with 10.4% in September and 26.9% in August. While we expect some improvement in the second half of 2009, exports are likely to be unusually weak over the next six months. We now expect exports to decline by 5.3%Y in 2009 compared with 12.7% in 2008 (estimated) and 23.1% in 2007.

Industrial Recession Ahead

While deceleration in growth as reflected in GDP growth may not appear as severe, industrial production – which matters for the listed corporate sector – is likely to witness a deeper slowdown. Industrial production decelerated to an average of 4.5% for the three months ending September 2008 from a peak of 13.6% in the quarter ended January 2007. Further weakness in domestic demand owing to the rise in the cost of capital and sharp deterioration in external demand will likely result in industrial production declining for a few months between November 2008 and June 2009. This would be the worst industrial sector performance since the 1991 cycle.

Trimming 2009 Growth Estimates Again

We expect the fixed investment cycle to reverse sharply. Tight lending standards are likely to restrict consumer loan growth and private consumption spending. In addition, weaker global growth will also be apparent in the form of a slowdown in external demand. While lower oil prices should help to reduce the current account deficit, we believe that lower exports and remittance from non-residents should offset a large part of this gain. Moreover, as we have argued, for the balance of payment outlook, capital inflows are more important than the current account balance. Building in weaker domestic as well as external demand, we are cutting our GDP growth estimate for 2009 again to 5.3% from 5.8% estimated earlier. We are also cutting our F2010 (year-end March) estimate for GDP growth in India to 5.3% from 5.7%. This compares with the consensus estimate of 6.6% in F2010.

We expect GDP growth to recover in 2010 in line with our global forecasts. Our economics team expects global GDP growth to accelerate to 3.3% in 2010. US and European GDP growth is expected to rise to 2% and 1.2%, respectively, in 2010 from -1.9% and -0.9% in 2009.  We believe that the improvement in domestic demand in 2010 will be restrained by the fact that the banking sector will likely remain impaired because of large increases in non-performing loans in 2009. We expect a slight improvement in external demand as well as domestic demand. We forecast 2010 GDP growth to be at 6.4% (6.4% for F2011, year-end March). 

Aggressive Monetary Easing but Limited Fiscal Stimulus

We are expecting monetary policy easing to continue through 2009. We now expect the repo rate (the key policy rate) to be reduced to 5.25% by the end of 2009. Most of this reduction will probably be front-loaded, with the repo rate likely to be at 5.5% by March 2009. We also expect the central bank to supplement the rate cuts with additional liquidity support measures. However, we are less optimistic with regards to the fiscal policy response. Indeed, we believe that in an environment of global deleveraging and risk-aversion, the private sector is unlikely to respond effectively to the monetary easing, and therefore a counter-cyclical fiscal policy does assume an important role.

However, the Indian government has been running pro-cyclical fiscal policies over the last few years. In F2009, we estimate that the fiscal deficit including off-budget liabilities will be 9.9% of GDP, one of the highest among large economies in the world. Public debt to GDP after including off-budget liabilities is estimated to rise by 95.9% as of March 2009. Hence, we see no scope for an aggressive fiscal policy response. We believe that the government could try to increase infrastructure spending through bilateral investment agreements with Japan and/or Middle East countries, but the implementation of such an investment program is unlikely to be quick enough to get the growth support in 2009.

A Framework to Assess Upside and Downside Risks to Our Growth Estimates

As discussed earlier, we believe that the two most important factors for India’s growth outlook are global risk appetite, which will be reflected in the form of capital inflows in the country, and external demand. The upside and downside risks to our India GDP growth estimates will depend on the influence of the global growth outlook on these two factors.

Following our global team’s framework, we have tried to assess the upside and downside risks to our GDP growth estimates for India. Richard Berner and Joachim Fels, Co-Heads of the Global Economics Team, highlight that globally there are five key drivers of risk (see Risks to the Global Outlook: The Good, the Bad and the Ugly, December 9, 2008):

“First, the extent of deleveraging by leveraged lenders remains uncertain, and further write-downs and provisioning will intensify the credit crunch in several developed economies.  The extent of further declines in asset values, especially in real estate, will deepen those risks, especially for US consumers.  Second, many central banks have eased monetary policy aggressively and quantitatively, but it is unclear whether and when such policies will get traction.  To be sure, there are recent signs of a revival in liquidity and money growth.  However, monetary policy in many EM economies remains restrictive.

Third, officials, notably the incoming Obama Administration, are considering a massive step-up in fiscal stimulus, with an undetermined amount in infrastructure outlays and tax cuts.  The timing, size and economic effectiveness of such policy actions are likely to remain unclear for a while.  Next, swings in currencies, commodity prices and risk premiums matter for the outlook in many EM economies.  Finally, the extent of the real estate downturn in China is a critical risk factor for that pivotal economy.

Combining the upside and downside risks, our global economics team has added two scenarios to the base case outcome. In our ‘ugly’ scenario, global activity contracts by 0.8% in 2009 and recovers by only 1.3% in 2010 as economic headwinds dominate policy stimulus.  Given that we think of global recession as growth below 2.5%, the ugly scenario would border on something even worse than the most severe recession in the post-war period.  In contrast, the ‘good’ scenario involves 2.3% growth next year and 4.3% in 2010, as a massive range of policy actions overwhelm the downturn.” 

Based on this framework for global growth outlook, we see bull case growth for India at 6.3% in 2009 and 7.5% in 2010 and bear case growth at 4.3% in 2009 and 5.3% in 2010. In the bear case, we are assuming continued risk-aversion in the global financial markets and therefore a sustained adverse trend in capital inflows and sharper fall in exports. In the bull case, we are assuming a recovery in capital inflows and export growth. We have assumed the political environment to be a neutral factor. However, the outcome of general elections scheduled in May 2009 could also bring upside or downside risks to our base case outlook. A stronger coalition government outcome can improve the growth outlook, with acceleration in the pace of structural reforms such as privatization and infrastructure investments. A weaker coalition government can add to the downside risks, slowing the pace of implementation of structural reforms. 

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