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India Recovery Trend Intact Despite Weaker Agriculture Global V Shapes View GEF Archive

		The Global Economics Team

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Various economic indicators have been surprising on the upside, confirming that the pace of recovery has been stronger than our expectations. Industrial production (IP) growth accelerated to 2.7%Y in May, much higher than our expectations. Leading indicators show that the IP growth trend will be stronger in June and July too. Although the disappointing monsoon trend so far in this season means a cut in our agriculture growth estimates, we believe that higher- than-expected IP and services sector growth will more than offset the downside from agriculture. Consequently, we are lifting our F2010 GDP growth forecast to 6.4% compared to 6.2% earlier even as we reduce our agriculture growth estimate to 1.5% from 3%. Similarly, we are revising our F2011 GDP forecast slightly to 7% from 6.8% earlier as we build in higher growth in the industry and services sub-sectors. On a calendar year (CY) basis, we now expect GDP growth of 6.1% in 2009 and 7% in 2010.

IP Recovery Stronger than Expected

IP growth has turned around, accelerating 2.7%Y in May compared to a trough of -0.8%Y in March 2009. The rebound in industrial growth came two months earlier and the pace of recovery has been stronger than what we estimated earlier. In addition, various other economic indicators are showing sharp rebounds compared to the lows they touched during December 2008. Passenger car sales accelerated to an average of 12.2%Y during QE June 2009 compared to the bottom of 1.2%Y during the three months ended January 2009. Two-wheeler car sales have also picked up, to an average of 11.9%Y during QE June 2009, after touching a low of -9.9%Y during QE December 2009. Indeed, auto sales data for July 2009 as reported by a few companies so far indicate that the recovery has gathered pace.

Pace of Acceleration to Gather Momentum

We expect IP growth to accelerate to 8% by March 2010 from 2.7% in May 2009. Indeed, we now expect the second half of calendar 2009 to record higher growth than expected earlier. Key drivers supporting this recovery will be as follows:

1) Lagged impact of accommodative monetary and fiscal policy action: Since October 2008, the RBI has been very proactive in cutting interest rates and injecting liquidity through various measures. Indeed, during this period, the RBI cut the repo rate (the rate at which it injects liquidity into the banking system) by 425bp from the peak to 4.75%. In addition, it has injected US$117 billion into the banking system since mid-September 2008.  Moreover, the government pursued a very expansionary fiscal policy. The national fiscal deficit (including off-budget items) is estimated to remain high at 11.4% of GDP in F2010 after having widened to 11.8% in F2009 from 6.8% in F2008. This increase in government expenditure is helping offset the downside from weaker private corporate capex.

2) Improved business confidence in view of increased political stability: We believe that the strong political mandate in the parliamentary elections that were held in May 2009 will allow the Congress Party-led government to accelerate the pace of reforms. Some of the key areas where we expect progress include divestment of SOEs, acceleration in infrastructure spending and definite moves towards a medium-term correction in public finances.

3) Increased access to capital markets: We believe that the improvement in global capital markets has been one of the important factors supporting a recovery in India. Increased access to equity and a reasonable cost of debt are helping to heal corporate balance sheets. This, is turn, has reduced the concerns about non-performing loans in the banking sector and their vicious feedback on credit conditions.

4) Recovery in external demand: Although so far the recovery has been driven by an improvement in domestic demand, we believe that a pick-up in exports will help to improve the pace of recovery. The US ISM New Orders Index, which leads India's exports by about four months, improved for the seventh consecutive month (51.9 in July versus 49.2 in June and 46.5 in May 2009). 

Poor Agriculture Growth Unlikely to Derail Recovery

Although the rainfall trend has improved over the last few weeks, we believe that some damage to the summer crops (accounting for about 52% of the annual agriculture production or around 8% of GDP) outlook is irreversible. So far, in the current monsoon season, the rainfall has been 25% lower than the long-period average (as of August 5, 2009). More important, the spatial distribution has remained uneven, with the northern region receiving significantly below-normal rainfall since the start of the season.

Indeed, a few states in the northern and eastern regions have declared droughts in many areas. As of July 31, crop area under cultivation for summer crops declined 6.1%Y. Even after assuming that rainfall will be near normal for the rest of the monsoon season, we expect that agriculture output will be affected adversely. Hence, we are lowering our F2010 agriculture growth estimate to 1.5% compared to 3% estimated earlier. Note that our forecasts assume a normal rabi (winter crop), which accounts for about 48% of the full-year total crop production. However, if rainfall turns out to be below normal in the rest of the season, there could be downside risk to the winter crop outlook. Water levels in the reservoir will need to improve to ensure that the winter crop is not affected, in our view.

Food Inflation Risks - Manageable as of Now

While the headline Wholesale Price Index (WPI) has been in a deflation mode since the first week of June 2009, inflation in the food sub-component has remained at significantly high levels of 7.5-9.5%Y over the last four months.  Similarly, higher food prices have kept CPI-Industrial Workers (CPI-IW) in the 8-10% range over the last 12 months. However, food inflation should start moderating over the next 3-4 months. Considering that the government has adequate stocks of rice and wheat, we do not expect big inflation risk in these two key consumption items. Currently, one of the key sources of high food inflation is the rise in prices of pulses due to poor output last year and low levels of stock. We believe that prices of pulses will likely be tamed post the harvest of the next crop in September-October. For pulses, the area under coverage is 9.6%Y higher for the summer (kharif) crop as of July 31, 2009.  However, if monsoon rainfall deteriorates significantly in the rest of the season, the risk of inflation sustaining for a longer period will increase. Although the government will likely cushion the consumers by increasing food subsidy, we believe that a sustained rise in food prices will hurt private consumption for the low and middle-income population to some extent.

Will Lower Agriculture Output Affect Rural Demand?

We believe that the adverse impact on rural consumption from weaker-than-expected agriculture output will be largely mitigated by other positive factors. Indeed, farm income now contributes less than 50% of total rural income (see Rising Significance of Rural Demand, June 9, 2009). Moreover, we believe that government initiatives in the form of higher minimum support prices (MSPs) and social welfare schemes like National Rural Employment Guarantee Scheme (NREGS), Bharat Nirman, etc., will result in higher allocation of funds to the rural economy and will supplement rural incomes, thus offsetting some of the negative impact from weaker crop output. Indeed, anecdotal evidence suggests that increased participation in NREGS has reduced surplus labour on farms.

Revising Our Growth Forecast Upward

Building in this better-than-expected recovery path, we are now expecting industrial production growth to average 5.4%Y in F2010 compared with 4.7%Y earlier. We believe that stronger-than-expected industrial production growth will more than offset the cut in agriculture growth. Consequently, we are lifting our F2010 GDP growth forecast a bit to 6.4% in F2010 from 6.2% earlier. Similarly, we are revising our F2011 GDP forecast slightly to 7% from 6.8% earlier, as we build in higher growth in the industry and services sub-sectors. (On a CY basis, we now expect GDP growth of 6.1% in 2009 and 7% in 2010.) Moreover, in F2011, we expect the growth mix to improve with the contribution from government spending reducing while that from private spending, particularly private consumption, accelerates. We are assuming that the RBI will initiate its first policy rate hike in February-March 2010, as we believe that it will likely wait for the economy to recover on a sustained growth path before moving to normalize interest rates. We believe that by 1Q10, industrial production growth will have accelerated to 7-8% and WPI inflation will have risen to about 6%Y, warranting the start of normalization of policy rates.

Upside and Downside Risks to Our Estimates

We believe there are three key factors that will influence India's growth outlook in F2010 and F2011. As highlighted earlier, the most important among them will be the global growth trend. This will be reflected in global risk appetite and capital inflows in the country, as well as external demand. Morgan Stanley's economics team expects global GDP growth of -1.3%Y in 2009 and +3.3%Y in 2010. Second, we believe that the pace of structural reforms from the government can also swing the investment growth outlook. Third will be the change in agriculture growth outlook, particularly for F2010, based on the trend in rainfall in the second half of the monsoon season (August and September). In our base case, we expect GDP growth of 6.4% in F2010 and 7% in F2011. The upside and downside risks to India's GDP growth estimates will depend on the influence of the global growth outlook on these three factors. Based on this framework, we see bull case growth for India at 7.4% in F2010 and 8.1% in F2011 and bear case growth at 5.5% in F2010 and 6.2% in F2011.

Global
V Shapes
August 07, 2009

By Manoj Pradhan | London

The rally in risky assets has gone from strength to strength - from relief that the worst is behind us to pricing in a ‘V-for-Vigorous' recovery. And while our US, euro area and UK teams point out significant upside risks to output in the short term, the medium-term outlook does not show such a rosy picture. Markets are pricing in a first 25bp rate hike by January for the Fed and the BoE and February for the ECB. This is not unreasonable if we get a large-sized economic bounce in 2H09. However, we believe that market expectations of a steady tightening campaign that takes rates higher at a rapid clip are unlikely to be realised. The weaker medium-term outlook for the economy and the complicated process of unwinding QE will act as headwinds to a rapid increase in policy rates, in our view.

Sharp Short-Term Upside Risks but Meek Medium-Term Outlook

Our US economics team thinks that 3Q GDP growth could print in a 3-4% range, thanks to a spike in car production, which could add up to 4% to GDP (see US Economics: Roaring Out of Recession in 3Q, August 3, 2009. Car production and the inventory cycle could also lift GDP in the euro area in 2H09 (see End of the Recession, Start of a V-Shaped Recovery? July 30, 2009). Upside risks to growth have materialised in other parts of the G10 world as well. In the medium term, however, there is not as much scope for optimism. Structural stories of over-indebted households in the US and UK trying to increase their savings rate, and conservative consumers in Germany and Japan sticking to their modest spending habits, will probably keep growth in the G10 region subdued. We believe that growth in the major developed economies is likely to be well below the frenetic pace set in the years leading up to the Great Recession.

V-Shaped Policy Response? Probably Not

Markets seem to have taken on board the possibility of a strong economic rebound in the short run and extrapolated this to the medium-term outlook. Markets now expect the first 25bp rate hike in December from the RBA, by January from the Fed and the BoE, February from the ECB and March from the RBNZ. This is sooner than our forecasts suggest (with the notable exception of the UK), but not unreasonably so. If economic growth comes roaring back in 2H09, central banks may indeed be tempted to begin raising rates sooner than we expect. The profile for interest rates over the next couple of years that markets are pricing in, however, seems to be predicated on a strong and sustained recovery over the medium term. Specifically, markets expect that policy rates will rise sharply, reaching nearly 2% in the US, 2.5% in the euro area and 2.75% in the UK by end-2010 - implying respective rate hikes of 187.5bp, 100bp and 200bp in less than 12 months from the beginning of rate hikes in early 2010. We believe that this outlook underestimates the severity of the medium-term economic adjustment that is due and therefore overestimates how aggressively central bankers will react.

Medium-Term Economic Outlook Is Weak Enough to Prevent Aggressive Hikes...

We believe that the painful adjustments to household and corporate balance sheets that are likely, given the excesses of the past, are enough to make the economic recovery a slow and tenuous one over the medium term. By itself, we see this scenario as enough to make central banks hesitant in moving from an expansionary stance to even a neutral one. Given that central bankers believe that inflation expectations are anchored (as ECB President Trichet has repeatedly suggested) and that inflation is not expected to be a threat to the economy (as Fed Chairman Bernanke emphasised in a congressional testimony), they will be more willing to keep interest rates below neutral for longer, in our view. However, this is not the only reason to believe that policy accommodation will be withdrawn gradually. There is the important matter of unwinding QE to deal with.

...and the Difficulty of Unwinding QE Will Likely Lend Weight to a Cautious Approach

Central banks correctly describe programmes like quantitative easing as ‘unconventional'. Being far from the norm, policy-makers do not have much experience in dealing with such unconventional policies with nearly the same familiarity as the interest rate tool. When downside risks were dominating, policy-makers were only too willing to throw everything including the kitchen sink at the problem. For the most crucial passage of time in the past two years (the time since September 2008 when markets froze), central bank purchases of risky assets and government bonds (i.e., ‘active' QE) contributed to lower yields and spreads. Outright expansion of these programmes or the implicit threat that they could be enlarged in scope and/or size also kept yields and spreads from rising too much, and the real economy benefited from these developments. Selling assets purchased according to these ‘active' QE programmes could easily reverse those moves, particularly with a return to growth and the risk of inflation. With very little experience in handling such large unwinds along with the risk of derailing a hard-fought recovery by sending yields and spreads higher, central banks are unlikely to move particularly rapidly.

The ‘Expectations Hypothesis' Helped in Past Tightening Cycles, but This Time May Be Different

Central bankers depended in past cycles on the benefits of the expectations hypothesis - that long-term rates would show an attenuated response to a change in policy rates. (In some cycles, there was very little response of bond yields to moves in the policy rate.)  Our fundamental model for 10-year US bond yields, for example, suggests that a 100bp increase in the fed funds rate leads to a 25bp rise in the 10-year bond yield on average. This time, however, the tightening cycle cannot rely on such relations to hold because of the need to unwind QE. In a recent article in the Wall Street Journal, Fed Chairman Bernanke indicated that the Fed retained the option to hold a "portion" of its purchases of assets to maturity, suggesting implicitly that the sale of a portion of the purchases was on the cards. Sales of Treasury securities or of the vast quantity of mortgage-backed securities it is still in the process of buying would add to the upward bias in yields coming from hikes in policy rates. This raises the risk for a rapid rise in bond yields, and policy-makers will have to proceed with caution, in our view (see "QExit", The Global Monetary Analyst, May 20, 2009). (The expectations hypothesis doesn't sit well with time-varying risk premia, but even this factor is pointing towards an upward bias to bond yields.)

Markets Anticipate Too Much Policy Action, but Too Little Inflation Risk

While the V-shaped recovery and the V-shaped policy response have been priced in, another V-shape is missing - a large bounce in inflation expectations. The rate hikes that are priced in are presumably expected to contain inflation, but with the robust recovery that markets anticipate and the risks associated with unwinding QE programmes that we point out, the risk of inflation should still be high.  They have risen in the US from their lows when deflation was a very real risk to about 1.9% currently for 10-year breakeven inflation. This is well below the average inflation rate of 2.5% for the last 10 years. When you consider that breakeven inflation is supposed to compensate investors not just for expected inflation but also for the variability of inflation in the future, it is clear that inflation markets are expecting the next 10 years to produce less inflation than the last 10 did. Given the massive expansionary policy and the difficulties we have suggested in withdrawing that monetary stimulus, the risk seems to be that inflation will be higher, if anything. Markets will likely respond to this risk in time, in our view.

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