Reforms to unleash recovery: 2021 Indian GDP outlook

A recovery in India’s economy is getting bogged down by a lack of fiscal stimulus, a delay in monetary easing and fresh headwinds to exports. The good news is, the government has laid the groundwork for faster growth with a raft of structural reforms, and these should clear the way for a brisk comeback in the fiscal year starting in April 2021.

• We forecast the contraction in GDP will narrow to 1.2% year on year in 2H fiscal 2021 from a 13.9% drop in 1H, aided by a relaxation in lockdown restrictions and festive demand.

For fiscal 2022, we expect India's GDP to swing to growth of 13.1% from a contraction of 7.4% in fiscal 2021.

Bloomberg Economics 

• This trajectory means GDP should exceed pre-coronavirus levels of December 2019 by March 2021, and then expand another 6.4% from that level in fiscal 2022.
• Cooling inflation ahead should allow the Reserve Bank of India to resume easing at its February review, and eventually cutting its policy repo rate to a terminal 3% by June 2021.
• The outlook assumes a further relaxation of virus-containment measures and sustained strength in the rural economy driven by favorable winter sowing and a record harvest in spring 2021.

Growth recovery to pick up in fiscal 2022

 

Our outlook doesn’t hinge on a timeline for vaccine availability and distribution. People have already largely resumed normal levels of activity, even in the absence of a vaccine.

The key downside risk is a renewed national lockdown in the event of a second wave of Covid-19 infections domestically. We assign an extremely low probability to a fresh lockdown.

 

Inadequate fiscal stimulus is a near-term challenge

The absence of sufficient fiscal stimulus has hampered a sustained recovery in demand. The government has substituted stimulus with structural reforms. Over the medium term, this strategy should help stoke a robust recovery. In the near term, though, it’s clearly a drag:

• The government has announced policy stimulus of around 15% of GDP in fiscal 2021 -- based on the headline figures.
• But a closer examination reveals discretionary fiscal stimulus in the current fiscal year amounts to just 3.3 trillion rupees (1.5% of GDP), according to our estimates. What’s more, that is redirected allocations -- not new spending -- and falls short of 3.8 trillion rupees in announced expenditure cuts.

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Expenditure cuts have exceeded fresh stimulus

 

Yield curve could steepen in 2021

As the recovery progresses, a steepening in the yield curve could add challenges by buoying borrowing costs for companies. Fuel tax hikes -- which are expected to raise 1.6 trillion rupees in extra revenue in fiscal 2021 -- are turning out to be highly inflationary. This cost-push shock is amplifying upward pressure on consumer prices from the virus-driven supply shock, and is one reason the central bank has refrained from lowering interest rates.

 

• The risk of generalized inflation from the sharp increase in money supply and currency in circulation is likely to prompt the RBI to start tapering surplus liquidity, even as it lowers the overnight policy repo rate.
• This could cause the yield curve to steepen further in fiscal 2022, in our view. Longer-tenor yields stand to face upward pressure from an increase in sovereign bond supply and reduced liquidity support from the central bank -- possibly reinforced by a backdrop of rising global yields.
   

India’s 10-year yield - Heading higher?

 

 

Structural reforms to underpin investment recovery

Over the medium term, substantive structural reforms should help spur faster growth. Before the pandemic, the government rolled out several consequential measures geared toward integrating India’s production into the global supply chain. These included corporate tax rate cuts, a bankruptcy law to facilitate resolution of non-performing assets, and steps that improved the ease of doing business.

Momentum was sustained after the outbreak with additional reforms that should give a sustained boost to foreign and private investment in agriculture and manufacturing catering to domestic and external demand.

Among the latest measures, the government announced production linked incentives for manufacturing, relaxed rules for hiring and firing labor in the manufacturing sector, opened up state monopolies in coal mining, railway services, and power distribution to the private sector, introduced incentives to encourage formal employment and removed barriers to agricultural trade by allowing farmers to enter into contracts with private companies.

A recent win for Prime Minister Narendra Modi’s coalition government in elections in the eastern state of Bihar -- the first polls since the pandemic -- and good performance in by-elections in several other states signal approval for the prime minister’s handling of the virus and should strengthen the government’s resolve to undertake more reforms in 2021.

Above-target inflation to delay rate cuts to 2021

 

A pickup in inflation, which has held above the RBI’s 2-6% target band since April, has kept the central bank on hold, even as the recovery could use additional accommodation. We see the picture changing significantly ahead:

• Key factors that are keeping inflation above target include a rise in food prices due to heavy rains, domestic fuel tax hikes and virus-related supply disruptions. Increased money supply is also a factor.
• Looking ahead, a bumper harvest of the summer crop should start to reverse inflation sharply from November. Daily food price data already confirm fresh arrivals are beginning to temper prices.
• In addition, as the pandemic-driven supply shock abates, we expect the economy’s wide output gap to begin exerting downward pressure on core inflation.
• We forecast inflation will average 6.4% in 3Q fiscal 2021 and 4.9% in fiscal 4Q, down from 6.9% in fiscal 2Q. In fiscal 2022 we expect inflation to hover in a 4-5% range, assuming no new supply shocks.

Cooling inflation should allow the RBI’s now more dovish monetary policy committee to resume easing to support the economy:

• We expect the RBI to deliver a 50 basis point rate cut in February.
• The RBI has implicitly been targeting inflation in the 4-6% range since the pandemic, against its explicit mid-point 4% target.
• We expect the government to raise the central bank’s mid-point inflation target to 5% in an official review to be held by March. That should make room for additional easing in fiscal 2022.
• We expect the RBI to lower the repo rate to a terminal level of 3% by June 2021.