India: Big-bang changes to growth and a forward-looking budget Global Economic Outlook, Q2 2015
Q1 2015 was action packed: India witnessed a dramatic revision of GDP and CPI estimates, the first full budget of the new government, and a rate cut by the Reserve Bank of India.
The first quarter of 2015 was action packed, as India witnessed a dramatic revision of its GDP and consumer price index (CPI) estimates, the first full budget of the Narendra Modi government preceded by sky-high expectations, and a rate cut by the Reserve Bank of India (RBI). Using new data sources and a revised base year, the government announced new GDP estimates in January, which suggest that the Indian economy is much stronger than was previously believed, and that growth may be closer to that of China. A week later, the government released a new series of the CPI (combined) with a revised base and incorporated a few methodological changes to estimate the index. These changes led to a downward shift in inflation levels. The highlight of the quarter was the union budget for 2015–16, which provided a balanced policy framework aimed at supporting all sections of the economy.
The first quarter of 2015 was action packed, as India witnessed a dramatic revision of its GDP and consumer price index (CPI) estimates.
The RBI, which has been under immense pressure from both the industry and policymakers to ease monetary policy, finally cut rates by 25 basis points in January. A consistent fall in inflation, the government’s effort to stick to its fiscal targets, and the continuing fall in global commodity prices prompted the RBI to cut rates to boost economic performance. It was also announced that any further easing would be contingent on the government’s fiscal consolidation efforts and inflation data. Right after the budget, the RBI surprised the market by cutting policy rates further by 25 basis points before its scheduled policy review meeting in April. This is perceived as a thumbs-up from the RBI governor to the measures announced by the finance minister in the union budget for 2015.
Overall, the events in the last few months have set the momentum for reforms and drummed up enthusiasm in the market, which can put India on a high, sustainable growth trajectory. The capital market has continued to breach record levels as investors now expect a favorable policy and business environment. That said, the coming years will be crucial for the government, which has to ensure that its promises are executed. Execution will be the key, and the government has a tough task ahead as it tries to balance all the odds and gear up all the segments of the economy at a synchronized and sustainable pace.
The Ministry of Statistics and Programme Implementation released the new series of national accounts on January 31, 2015, revising the base year from 2004–05 to 2011–12. In addition, it announced that “GDP at factor cost” will no longer be in use; as is the practice internationally, “GDP at market prices” will be the official GDP.
Consequently, the redefined real GDP is estimated to grow at 5.1 percent (at 2011–12 prices) during FY 2012–13, and 6.9 percent during FY 2013–14. Earlier estimates of growth (at 2004–05 prices) were 4.7 and 5.0 percent for the respective periods. The upward revisions have primarily come from higher consumption expenditure and weaker imports under the new series. Under this new methodology, the government’s advance estimate for growth in FY 2014–15 is pegged at 7.4 percent year over year. A comparison of new and old estimates of growth is shown in figure1.
Growth of the manufacturing sector was revised up from 1.1 percent to 6.1 percent year over year in FY 2012–13, and from -0.7 percent to 5.3 percent in FY 2013–14. Consequently, the manufacturing sector’s share, too, has risen from 12.9 percent of GDP to 17.3 percent in 2014. The mining sector’s share has been revised up from 24.7 percent of GDP to 30.7 percent. On the other hand, the services sector’s share has been declined from 57 percent of GDP to 51.3 percent.
However, it isn’t just GDP growth that has got a boost from the government’s new series of national accounts. The Central Statistics Office also changed the base of the CPI (rural and urban combined) from 2010 to 2012, which resulted in lower inflation levels than were previously assumed. This downward revision suggests a more benign path of inflation, and the outlook is likely to remain the same this year due to easing commodity prices and low international oil prices. A comparison of the new and the old estimates is shown in figure 2.
However, the revisions raise several questions about a possible slack in the economy, potential growth rate, and the extent of acceleration under the new methodology—especially when the trends are at odds with other high-frequency indicators such as industrial production. There are several anomalies in the details, especially regarding government spending, and the abrupt switch to a new and revised series is creating dissonance amongst analysts.
Improved economic performance
Along with the strong pickup in growth and moderation in inflation, economic performance has been buttressed by improvements in the external account, fiscal deficit, and capital market. The external sector has improved markedly over the last year; the current account deficit (CAD) has remained within 2 percent this fiscal year, while investment inflows have been sufficient to finance the trade deficit.
Trade deficit, which bloated over the initial few months of this fiscal year, fell significantly in recent months due to falling international oil prices. A closer look at the composition of the trade balance this fiscal year suggests that growth in exports remained disappointing (figure 3). Moderation in commodity prices impacted revenues from petroleum products, rice, tea, and coffee exports. In addition, the trade-based weighted real exchange rate (as well as the export-based weighted exchange rate) appreciated, which could have resulted in a fall in export competitiveness, although the domestic currency depreciated with respect to the US dollar. On the other hand, barring in Q2 of FY 2014–15, imports contracted. The fall was primarily driven by a contraction of oil imports and has been significant in the past few months, although it is to be noted that non-oil imports increased in the first half of this fiscal year (figure 4). Additionally, imports in the non-oil ex-gold segment also increased, which implies that domestic growth is perhaps turning around.
Continuing its declining trend, the country’s CAD dipped to 1.6 percent of GDP in Q3 of FY 2014–15 from 2.0 percent of GDP in Q2. Since the services sector has had a consistent trade surplus, the improvement in the trade balance in recent months may result in a surplus current account balance in Q4 of FY 2014–15. Overall, the CAD for this fiscal year is expected to remain below 1.5 percent of GDP, the lowest since FY 2007–08.
The government continued to adhere to the fiscal target for the current year, and, according to provisional estimates of the latest economic survey, the fiscal deficit is expected to be 4.1 percent of GDP in 2014–15.1 The fall in global crude oil prices reduced the government’s subsidy outgo considerably. Further, deregulation of diesel prices and increasing taxes to limit the fall in domestic prices helped shore up government finances. However, tax revenues remained low owing to poor revenues from the manufacturing sector, which has struggled to grow in the past few years.
The Indian capital market outperformed most global markets due to improved economic sentiments. A stable government and its policy initiatives over the last nine months, together with increased global liquidity (because of bond buying by the European Central Bank and quantitative easing by the Bank of Japan), led to increased capital inflows. The Sensex rose sharply, by around 40 percent, during 2014 and crossed the record mark of 29,000 in January 2015. Foreign institutional investments, which were volatile in 2013, rose consistently, providing reasonable stability in the market compared with the previous year. The bond market, too, benefited last year from interest rate differentials with respect to advanced nations as well as from improved economic performance. Since the national elections, the 10-year government bond yield fell from 8.7 percent to 7.7 percent (figure 5).
That said, the pace and quality of fiscal consolidation, poor performance by the manufacturing sector, disappointing export growth, and the banking sector’s deteriorating asset quality pose downside risks to the economy. Tax collection growth has been the worst in recent history, while the pace of disinvestment remains slow. A closer look at the expenditure estimates of GDP shows that domestic demand remains feeble. Recovery in investments remains a concern, as growth in fixed capital formation (per the new definition) fell from 7.7 percent year over year in Q1 2014–15 to 2.8 percent and 1.6 percent in Q2 and Q3, respectively. Growth in private consumption expenditure and government expenditure supported the moderate increase in domestic demand this fiscal year.
The Indian capital market outperformed most global markets due to improved economic sentiments.
The 2015–16 budget analysis
The budget did not disappoint market expectations. The government stuck to its fiscal target of 4.1 percent of GDP for FY 2014–15. Acknowledging the improving economic outlook, the finance minister presented a new fiscal framework by establishing new targets for fiscal consolidation.2 The fiscal adjustment trajectory was changed; the deficit target of 3 percent will now be achieved in three years, instead of two.
The increased fiscal space is being used for productive purposes. The focus is on improving the quality of the deficit, and the government is trying to reduce the amount of subsidy by 0.4 percent of GDP through better targeting recipients while also raising tax rates on services. The government has increased capital expenditure by 0.2 percent of GDP. It has tried to restart the investment cycle by incentivizing more allocation toward infrastructure, revitalizing public-private partnership models by reducing the risks faced by the private sector, and creating a national investment and infrastructure fund. In addition, the finance minister announced an increase in the share of the divisible pool of taxes to states to 42 percent. The total transfer to the states will be about 62 percent of the country’s total tax receipts.
Important changes have been made to both direct and indirect taxes. The purpose of the tax announcement has been to enhance the ease of doing business and make the industry more competitive. In an encouraging message to investors in creating a more robust taxation regime, the General Anti Avoidance Rule (GAAR) has been postponed by two years. It has also been decided that when implemented, GAAR would apply prospectively to investments made on or after April 2017. Corporate tax rates, currently among the highest in the world, are to be brought down in a phased manner to 25 percent from the current 30 percent over the next four years. Other noteworthy measures include stringent provisions to tackle black money, eliminating minimum alternate taxes on foreign institutional investors, removing ambiguity on taxation, and committing to roll out the goods and services tax (GST).
The finance minister announced two game-changing reforms: the GST and what has been called the “JAM trinity”—Jan Dhan, Aadhar, and mobile—for the direct transfer of benefits. The GST will put in place a state-of-the-art indirect tax system by April 1, 2016. The JAM trinity will allow the transfer of benefits in a leak-proof, well-targeted, and cashless manner.
The finance minister also announced “housing for all by 2022” as one of the visions of the prime minister, in addition to other pet projects such as Make in India, Swachh Bharat Abhiyaan, and “minimum government, maximum governance.” Important reforms have been announced to improve the ease of doing business, and due importance has been given to the Skill India program to ensure the success of the Make in India campaign.
Overall, the budget has a balanced approach toward achieving growth and provides a definite direction to economic policies and reforms. That said, it lacks a clear roadmap with respect to the implementation of big reforms like the GST, rationalization of subsidies, and addressing supply-side bottlenecks in the economy. There is clearly an emphasis on public investment in infrastructure. However, given the current status of infrastructure and limited success in bringing in private partnership, building world-class infrastructure will be a challenge. A large transfer to states will significantly reduce the central government’s freedom to spend, while leaving how the additional funds may get used to the discretion of the state. Execution will be the key, and all eyes will be on the implementation of the announced policies in the coming years.