Is Indian economy on the mend after demonetization shock?

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The Reserve Bank of India maintained the status quo in terms of policy interest rates, growth estimates and liquidity stances in its Monetary Policy Review on Wednesday. The RBI’s Monetary Policy Committee (MPC) released a nuanced statement. It thinks economic growth is going to accelerate but it is also worried about rising inflation.

This gels with somewhat conflicting macroeconomic data out of Asia’s third-largest economy. Overall, growth improved in the second quarter of the current fiscal year (July-September 2017), but government finances were under stress. Growth in private final consumption expenditure slowed to an eight-quarter low – this contributes about 54% of gross domestic product. Inflation also rose in the quarter.

The MPC sees positive signals in high primary market activity, which will boost growth as this capital is deployed. The improved “ease of doing business” ranking by the World Bank should also sustain foreign direct investment. The implementation of a new insolvency and bankruptcy code (IBC) and the recapitalization of public-sector banks are also long-term positives.

But the MPC also flagged the rise in food and fuel inflation in November and said households should expect higher inflation in future. It expects housing costs to rise, given higher house rent allowances for government servants. The Consumer Price Index (CPI) recorded a seven-month high in October, up to 3.58% year on year. The RBI estimates retail inflation to run within the band of 4.3-4.7% in the second half (October 2017 to March 2018).

The statement also expressed worries about fiscal slippages. More than 95% of the budgeted federal fiscal deficit had already been spent by October. Potential risks include farm loan waivers, cuts in excise rates on retail fuel prices, and reductions in GST (goods and services tax) rates on many items. All these policy measures were driven by electoral considerations. There are likely to be more populist measures, given a large number of state assembly elections through 2018 and a federal election in 2019.

The Reserve Bank of India is braced for currency volatility amid potential global financial instability. The US Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England all have policy reviews due this month

India’s trade deficit and current-account deficit widened through the first half. In October, exports contracted after 14 months of growth and the trade deficit hit a 35-month high of US$14 billion. The current-account deficit was at a four-year high of $14 billion, or 2.4% of GDP, in the first quarter. And it may have gotten worse, given the wider trade deficit in Q2.

The RBI is braced for currency volatility amid potential global financial instability. The US Federal Reserve, the European Central Bank (ECB), the Bank of Japan (BoJ) and the Bank of England all have policy reviews due this month.

The Fed will have a new chairman soon. It is expected to continue increasing America’s policy interest rate and also to start unwinding its balance sheet, selling off the bonds acquired during the years of quantitative easing (QE). The ECB and BoJ have ongoing QEs and negative-interest-rate regimes. Given higher growth and higher inflation, either or both may alter their stances, by raising interest rates or cutting the QE quantum in the case of Japan. (The ECB has already cut the QE quantum.)

In India, GDP growth rebounded in Q2 on the back of a stronger performance by the manufacturing sector, which registered 7% growth year on year. This was after five successive quarters of slowdown. The preliminary estimates indicate GDP growth was around 6.3%, which was an improvement over the 5.7% registered in April-June 2017. Improved growth in gross fixed capital formation to 4.7%, from 1.6% in Q1, is a positive indication, but the GFCF is very low in historic terms.

The services sector, which contributes more than 50% of India’s GDP, seems to be weak, with contraction of activity in November going by the purchasing managers’ index (PMI).

The agriculture sector did pretty badly in Q2, growing by just 1.7%, which was even lower than the 2.3% growth registered in Q1. This was due to a disappointing kharif (monsoon) crop, and it has contributed to food inflation. Global prices of crude oil and metals have risen. The agreement by members of the Organization of the Petroleum Exporting Countries (OPEC) to curtail production through 2018 could put a floor on crude-oil prices.

The chief statistician of India, T C A Anant, admits that the Q2 data could be subject to major revisions. The GST was implemented in Q2 and net tax collections are not yet known. The Ministry of Statistics and Program Implementation has estimated this by proxy, using sales-tax collections on items kept outside the GST basket. It’s also hard to judge consumption trends, since the major Navaratri-Diwali festivals came early this year. Households do a major proportion of annual buying during that period, so we don’t know if better sales in September will be sustained.

So, is the glass half-full or half-empty? The third quarter (October-December 2017) should see the GST settling down. Growth could also be boosted by a low-base effect, since November-December 2016 was hit by demonetization.

Most of the estimates are fairly consonant. The RBI maintains an estimate of 6.7%, implying growth rates of 7% in Q3 and 7.8% in Q4. Goldman believes 2017-18 could see 6.4% growth followed by a bounce to 8% in 2018-19. Fitch Ratings said the Q2 rebound was “weaker than expected” but it also estimates GDP growth at 6.7%.

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