Posted on September 08, 2018

fter several quarters in the doldrums, India’s economy roared back to life in the April-June quarter. GDP growth jumped to a nine-quarter high of 8.2% y/y; up from 7.7% y/y in the first quarter of the year.

The acceleration was powered by a sharp pick-up in the pace of consumer demand growth, which is the largest contributor to GDP. Private consumption gained by 8.6% in Q2; up from 6.7% in the preceding quarter. Both growth in fixed investment and government consumption slowed down versus the first quarter but nevertheless remained solid. Fixed investment’s 10% y/y growth in particular was impressive albeit slower than Q1’s blockbuster 14.4% y/y out-turn.

After several years of weakness, India’s capex cycle finally seems to be turning as the bank sector makes progress on cleaning up bad loans and consumer demand remains vibrant. Lastly, net trade worked to slow GDP growth as imports picked up faster than exports. Viewed in terms of the output of key sectors, growth was relatively broad-based. The agriculture sector, which is still worth around a quarter of the Indian economy, posted solid growth of 5.3% y/y while the construction sector saw its output up a robust 8.8% y/y. The stand out however was the manufacturing sector, whose output soared by 13.5% y/y.

It is important to note that annual growth rates in Q2 were flattered by the economy’s weakness a year ago. Growth had dipped to a lowly 5.6% y/y in the April-June quarter in 2017 as the economy was still recovering from the disruption of the government’s de-monetisation campaign and companies were also slashing inventories ahead of the roll out of the economy-wide Goods and Services Tax (GST) in July. The twin shocks of de-monetisation (November 2016) and GST roll-out (July 2017) have both roiled the Indian economy in the short run, greatly increasing the volatility of GDP growth. To iron out their impact, we look at y/y GDP growth on a two-year smoothed basis. On this basis, GDP growth has actually been remarkably stable at just under 7%; which is probably a fair estimate for India’s current potential growth rate (see Key Chart).

While the pay-offs from recent structural reforms, particularly GST introduction, should help lift India’s potential GDP towards 8% in the next few years, 8%+ growth will be hard to sustain in the short term. Indeed, there are a number of headwinds which are likely to pull GDP growth back towards its underlying 7% growth rate in the next few quarters. First, the combination of India’s turning investment cycle and, most importantly, oil prices hovering near USD80 per barrel suggest further pressure on India’s external accounts. India’s goods trade deficit has widened sharply in recent months. The overall current account deficit was a relatively manageable c. 2% of GDP in the first quarter of the year but may deteriorate further in the rest of the year.

Given the backdrop of steadily rising US rates, generalised USD strength and investors mounting skittishness towards emerging markets, the Indian rupee is unsurprisingly facing depreciation pressure. Now down more than 10% so far this year against the USD, the INR is now Asia’s worst performing currency. Second, the faster growth of recent quarters also appears to be closing quickly whatever output gap the Indian economy had. Price pressures accordingly are on the rise with core CPI accelerating in recent months. INR weakness, not to mention higher crude oil prices, will tend to further exacerbate core inflation pressure in the coming months.

The combination of these factors – a widening trade deficit, INR weakness and faster core inflation – have already seen India’s central bank – Reserve Bank of India (RBI) – nudge up its key policy rate by 25bps at each of its last two bi-monthly Policy Reviews. With the US Fed showing no inclination to back down from its steady pace of 25bp rate hikes, further monetary tightening by RBI looks inevitable (as it does for much of Asia). Our base case is that RBI will make it three rate hikes in a row at its next Policy Review on October 4th.

Third, fiscal policy is also likely to prove a headwind. Higher oil prices in particular swell the central government’s subsidy bill. The latest monthly data show the centre’s deficit already reaching its annual target in the first four months of the current financial year. Having typically loosened their purse strings last year to offset rural distress, India’s states are also collectively under pressure to tighten their budgets this year. The headwinds from tightening policy – both monetary and fiscal – mean that Q2’s stellar growth performance is unlikely to be sustained. India’s growth is likely to once again slip back towards 7% in the next few quarters.

But there are two critical silver linings. First, the weaker INR will give Indian corporates a much needed competitiveness fillip and will also help accelerate direct investment inflows into India. Expect Indian exports to boom next year. Second, on a relative basis, India’s economy is set to remain a star performer, outstripping almost all other major emerging markets, including China. And once recent structural reforms fully bed down, 8% GDP growth should emerge as India’s new normal.